At Some Point, You Have to Pay the Taxes

During your working years, deferring taxes is often a good strategy for building your net worth. But the purpose of saving money is not to defer taxes forever. Eventually, you'll want to use the money. And that means paying some of the taxes that you've deferred up until now. 

Deferred taxes function a lot like debt. Part of the balance in a traditional retirement account belongs to the government. You may not know exactly when the bill will come due or what the final tax rate will be, but the obligation is there.

And like other forms of debt, it can reduce your sense of freedom.

People sometimes look at a large IRA balance and feel wealthy, but then hesitate to withdraw any of it because every distribution creates taxes. They may avoid spending money they can comfortably afford because paying the tax feels like losing money.

But the tax is not a new loss created by the withdrawal. It is the settlement of an obligation that has been accumulating for years.

Now, that doesn't mean you shouldn't try to manage and minimize that obligation, where possible. But the goal should not always be to pay the smallest possible amount of tax this year.

Sometimes it makes sense to pay taxes sooner to reduce future required distributions. Sometimes it makes sense to realize a gain so you can diversify an investment. Sometimes it makes sense to take a larger withdrawal because there is something worthwhile you want to do with the money. And if you plan ahead, you can access that capital without paying more taxes than you have to. 

So the question is not simply, “How can I avoid taxes?” It is learning to see taxes as a necessary cost of using your money, and then managing that cost as much as is reasonable.

This does not mean you should pay more tax than necessary. Roth conversions, planned withdrawals, charitable giving, and other strategies can all help manage the bill. Nor is the goal always to pay the smallest possible amount of tax this year. These strategies are meant to minimize taxes over your lifetime, rather than in one year viewed in isolation.

Ultimately, the purpose of the planning is to help you use your money to have a great life. Don't let small differences in your lifetime tax bill keep you from doing things you can comfortably afford.