In my last blog, I explained the differences between Traditional IRAs and Roth IRAs. This month, I’ll explain how being thoughtful about which type of account you fund can lower your taxes. While the U.S. Tax Code is incredibly complex, you don’t need to be a tax pro to be a confident investor. A basic understanding of the differences between IRAs and Roths (with the support of a good financial advisor) can help you mitigate taxes while you’re working, after you retire, and even lower your heirs’ taxes. Here are three important principles that your financial advisor can help you apply to make sure you’re not paying any more Federal income tax than necessary.
The Three Tax Savings Principles:
1). Federal income tax brackets are graduated.
2). Keeping taxable income in the lower tax brackets creates substantial tax savings.
3). Income can be legally deferred
Principle 1: Federal income tax brackets are graduated.
Graduated tax brackets mean higher earnings (in a given year) lead to higher taxes. The table below shows how the first $12,400 of a single person’s income is only taxed at 10% while income over $640,601 is taxed at 37%.
Principle 2: Keeping taxable income in the lower tax brackets creates substantial taxsavings.
To illustrate this principle, according to the table above, if a single person made $60,000 in 2026, all their income above $50,401 would be taxed at 22%, which comes out to $2,112. But if that same person legally reduced their income to get below the $50,401 tax bracket, they would save $2,112.
Principle 3: Income can be legally deferred.
Deferring income, that is putting a portion of your annual income into a tax-deferred retirement account, like an IRA, delays when the taxes are due. This can keep you out of the higher tax brackets (in a given year) and create substantial tax savings.
Here’s an example of how deferring income can put you in a lower tax bracket and lower your taxes. To make the math easy, assume the tax on a $100,000 income is 20% or $20,000, the tax on $133,000 is 22% or $29,260, and the tax on $200,000 is 30% or $60,000 (big difference!).
Now let’s assume, over the course of three years a person has a $100,000 income in year one, $200,000 in year two, and a $100,000 income in year three. Their overall tax bill in this simplified example would be $20,000 + $60,000 + $20,000 or $100,000. Ouch!
What if, by deferring income, the same person’s income (for tax purposes) was $133,000 in year one, $133,000 in year two, and $133,000 in year three? Their overall tax bill would be $29,260 + $29,260 + $29,260 or $87,780. While these numbers are just for illustration, it shows how helpful it is to eliminate spikes in your annual income through income deferral. One free tool available that will help evenly distribute income year to year is the strategic use of traditional retirement accounts like Traditional and Roth IRAs. Click here to read last month’s blog to learn the difference between the two.
Using IRAs and Roths to Mitigate Taxes While You’re Working
Unfortunately, we don’t all get to enjoy a “bumper crop” each year. Life is unpredictable, and sometimes that means our income is too. Even when our income is steady, we may have more deductions in a given year due to events like starting a business or a health set back. Since Federal income tax brackets are graduated, we can legally lower our income tax by contributing to IRAs in the “bumper crop” years and Roth accounts during the lean years. The table below illustrates this point.
To help understand the graph, above, say in year 1 a couple’s income dropped because the family’s breadwinner had to take three months off to recover from a knee surgery. That time off temporarily lowered household income which means the couple is in a lower tax bracket. Since they’re in a lower tax bracket, they may be better off contributing to a Roth to create a tax-free bucket of money during their retirement years. Now let’s say in year two, the same couple had both partners working full time and they both received a substantial bonus that year. If they both maxed out their 401(k)s at work, they could defer $49,000 of their annual income and significantly lower their tax bill. These same strategies can be used in years 3 and 4. Over the course of a 40-year career can lead to substantial savings.
What about after a person retires? It seems like being on a fixed income would make deferring income moot. Fortunately, being strategic with Traditional and Roth contributions can save you taxes in retirement too!
Using IRAs and Roths to Mitigate Taxes in Retirement
Just like our income can move up and down during our working years, our expenses can vary during our retirement years. That’s important because most retirees have saved exclusively in IRA or “tax deferred” retirement accounts. Like we discussed above, putting money in an IRA allows people to legally defer their income. As a result, when people pull money out of their IRAs, they have to pay ordinary income tax on those funds. Based on the 2026 Tax Bracket table, a couple who pulls $50,000 out of their IRA to fund retirement, will be in the 12% tax bracket. That doesn’t sound too bad, but what if this couple is pulling $50,000 out of their IRA for ongoing bills when an illness ends up costing $60,000 in medical expenses. As a result, they would have to pull $110,000 out of their traditional accounts to cover both, now a portion of their income is in the 22% tax bracket, and their social security benefit is potentially being taxed.
The way to hedge against unplanned fluctuations in retirement expenses is a strategy called “tax diversification”, whereby a retiree pulls a base amount out of their traditional accounts and uses their Roth accounts to cover the irregular expenses like $60,000 medical events. Click here for details on the differences between IRAs and Roths. This ensures they get to take care of the big-ticket items that come up and continue to keep their income flat so they don’t end up in a higher tax bracket. The table below illustrates the idea.
Using Roths to Help Your Heirs
It’s important to note that accumulating large sums of money in your IRA (or 401(k)) can create a serious tax bill for your heirs because Federal Law requires them to withdraw all the funds from their inherited IRA account within 10 years of yourpassing. That means, if your kids have an annual income of $100,000 and they inherit a $1,000,000 IRA from you, they will have to pull 1/10th of $1,000,000 or $100,000 a year out of their inherited account. So, for 10 years, their income will be $200,000 instead of $100,000. For 10 years, they’ll end up paying closer to 20% on $200,000 ($40,000) instead of roughly 12% on $100,000 ($12,000). Effectively, your heirs are paying tax on the income you deferred.
If this is too complicated, just remember, leaving funds in a Traditional IRA account will increase your heir’s taxable income, potentially pushing them into much higher tax brackets. To mitigate this tax for your heirs, a financial advisor, working alongside your tax professional, can help you convert funds to a Roth, little by little, to make sure Uncle Sam doesn’t keep more than absolutely necessary.
Conclusion
Since Income Tax Brackets are graduated in the U.S., keeping ourselves in the lower tax brackets can create substantial tax savings. Being strategic about funding Roth IRAs and Traditional IRAs can manage your taxable income over time. While the old adage, “nothing is certain but death and taxes” is true, working with a good financial advisor, and your tax pro, can help you mitigate taxes both for you and the loved ones you leave behind.