Meet Your Retirement Partner: The IRS (And How to Buy Them Out for Less)

The IRS Is Your Retirement Partner: How to Minimize the Buyout Cost

Many people think of their retirement accounts as entirely their own—a reward for decades of hard work and saving. But there’s a silent partner waiting in the wings: the IRS. While you’ve been diligently contributing and investing, the government has maintained a vested interest in your retirement funds—they’re waiting for their share in the form of taxes.

This isn’t meant to sound ominous or fear-inducing. It’s simply a financial reality. The good news is that you have control over how much you ultimately “buy out” your silent partner’s share. Think of it like a business buyout: your goal is to buy out the IRS’s stake in your retirement for the lowest possible cost. That cost is determined by your tax rate—and with thoughtful planning, you can negotiate a better deal.

Understanding the Partnership

The IRS’s “stake” in your retirement depends on the types of accounts you hold. For example:

• Tax-Deferred Accounts (Traditional IRAs, 401(k)s): These accounts come with an upfront tax break—you didn’t pay taxes when you contributed. However, when you withdraw funds in retirement, both your original contributions and any investment growth are taxed as ordinary income. In this case, the IRS owns a significant portion of both your principal and your gains.

• Tax-Free Accounts (Roth IRAs, Roth 401(k)s): With Roth accounts, you pay taxes on your contributions upfront. By doing so, you’ve essentially “bought out” the IRS’s stake early, while the cost (your tax rate) is relatively low. In retirement, all qualified withdrawals are tax-free, and the IRS no longer has a claim on your future growth.

Your goal is to manage these accounts wisely and buy out your partner at the lowest possible cost throughout retirement.

As a CPA with an MS in Tax, I’ve learned to appreciate the intricacies of this “partnership” with the IRS. And while most partnerships involve some level of compromise, this is one where strategic planning can really tilt the scales in your favor. It’s a part of the job I find surprisingly rewarding.

Strategies to Minimize the Buyout Cost

The amount you pay to the IRS can be controlled through strategic planning. Here’s how you can effectively reduce the buyout cost:

1. Manage The Buyout Price with Tax Bracket Planning

How much you pay your silent partner depends on your taxable income in any given year. The higher your income, the more expensive the buyout. By strategically managing your income from withdrawals, you can “buy out” the IRS’s share at a lower price.

Here’s how this might work:

• Timing Withdrawals: By carefully coordinating withdrawals from taxable, tax-deferred, and tax-free accounts, you can control how much of your retirement income is exposed to higher tax rates.

• Roth Conversions: During years when your taxable income is lower (such as before Social Security begins), converting a portion of tax-deferred accounts to a Roth IRA lets you buy out the IRS’s stake at today’s lower rates.

• Coordinating Income Sources: Aligning withdrawals with other income, such as pensions or Social Security, ensures you don’t unintentionally push yourself into a higher tax “buyout bracket.”

Each of these strategies is designed to keep the cost of buying out your silent partner as low as possible. With careful planning, you can spread the buyout cost over time and avoid paying more than necessary.

2. Use Roth Conversions to Buy Out Early

Roth conversions are a powerful way to eliminate your partner’s future stake in your retirement savings. When you convert traditional IRA or 401(k) assets to a Roth IRA, you pay taxes now on the converted amount. By doing so during low-income years, you effectively buy out the IRS’s future claim on the growth of those assets at a discount, locking in future tax-free growth.

This strategy is particularly effective if you anticipate higher taxes in the future, either due to rising tax rates or increased income later in retirement. Paying the buyout price now ensures the IRS has no claim on your Roth assets or their growth later.

3. Reduce the IRS’s Stake Through Qualified Charitable Distributions (QCDs)

If you’re charitably inclined and over age 70 ½, QCDs offer an efficient way to reduce the IRS’s share of your tax-deferred accounts. By donating directly from your IRA to a qualified charity, you fulfill your Required Minimum Distribution (RMD) obligations while avoiding taxable income on the donated amount.

This effectively removes a portion of your silent partner’s claim on your retirement savings while allowing you to support causes you care about.

4. Choosing the Right Assets for Taxable Accounts

While the focus of this post is on retirement accounts, it’s important to remember that tax planning also extends to your other investments. The types of assets you hold in taxable accounts can significantly impact how much of your investment income goes to taxes each year—and how much stays in your pocket.

Certain asset types can help minimize the IRS’s claim on your taxable income, making your overall portfolio more tax-efficient. For example:

• Municipal Bonds: Interest income from municipal bonds is generally tax-free at the federal level and may also be exempt from state taxes if you invest in bonds issued by your home state.

• Exchange-Traded Funds (ETFs): ETFs tend to have lower turnover than mutual funds, which means fewer taxable capital gains distributions. Their inherent tax efficiency makes them an excellent choice for taxable accounts.

• Low-Turnover Mutual Funds: Actively managed mutual funds with high turnover often generate frequent taxable gains. Opting for low-turnover funds can help minimize taxable events and keep more of your returns working for you.

• Tax-Managed Funds: These funds are specifically designed to reduce taxable distributions, making them another strong option for taxable accounts.

The key is understanding how different types of investments generate taxable income. Interest income, dividends, and capital gains are all taxed differently, so being strategic about the types of assets you hold in taxable accounts can help reduce your overall tax burden and keep more of your portfolio compounding over time.

While this topic deserves its own deep dive, it’s worth noting that making tax-efficient investment choices in taxable accounts can complement your broader retirement strategy and further reduce the “buyout cost” of your IRS partnership.

Looking Ahead: Planning Your Buyout

The IRS may be your retirement partner, but you’re in control of how and when you buy out their share. The goal isn’t to avoid taxes altogether—that’s not realistic. Instead, the objective is to proactively manage your income and account withdrawals to minimize the buyout cost over time. Just as a business owner would negotiate the best deal when buying out a partner, you have opportunities to lower the IRS’s share by carefully timing and structuring your decisions. By managing this buyout cost strategically, you can maximize your savings, reduce unnecessary taxes, and keep more of your retirement savings.