How To Prepare for A Successful Retirement Part 2: Strategies to Minimizing Taxes in Retirement
If you are close to retirement, you probably have a million questions racing through your brain. You have saved for years and diligently planned for this moment but are wondering how all the pieces to the puzzle come together. At this stage in life, you most likely know how much income you need in retirement to cover your monthly expenses. But how exactly do we structure this income to be tax-efficient? With the right withdrawal strategy, you can save thousands of dollars in taxes over your retirement lifetime.
In retirement, you can pull income from three different types of tax buckets (referring to investment/retirement accounts). These buckets are taxed completely differently, allowing you to manipulate your tax bracket in retirement. You need to understand how these different buckets work to accomplish this efficiently. Many retirees have more than one tax bucket and face this challenge. This poses a very common question: In what order should I withdraw from my accounts to provide for my income needs and reduce taxes?
As a general rule of thumb, it’s best to withdraw from taxable accounts first. Taxable accounts include bank accounts, brokerage accounts, and employer stock purchase plans. Taxable brokerage accounts are subject to taxes on capital gains, dividends, and interest. Withdrawing this “tax bucket” first gives your more tax-advantaged plans time to grow and compound. Interest is taxed as ordinary income, whereas dividends are often taxed at long-term capital gain tax rates (depending on your income level and when you owned the asset).
After your taxable accounts are spent down, it’s best to withdraw from tax-deferred accounts. This includes traditional IRAs, 401(k)’s, 403(b)’s, and more. All of these accounts are subject to ordinary income tax upon withdrawal. The advantage here is that you will know current tax rates as you withdraw money, allowing you to estimate your tax liability easily. Additionally, spending tax-deferred accounts second will help with your required minimum distributions later down the line.
You can withdraw money from your Roth accounts after your taxable and tax-deferred accounts are spent down. It’s best to delay tapping into these accounts for as long as possible because Roth accounts are not subject to required minimum distributions (RMDs), and withdrawals are tax-free. If you leave a Roth account to an heir, their withdrawals will also be tax-free.
Other variables may have an impact on the most tax-efficient withdrawal strategy. A great example of this is required minimum distributions. These begin the year you turn age 73 (or age 75 if you were born after 1960) and apply to all tax-deferred accounts. The larger an account balance is, the larger your RMD is. For some individuals, this poses a big tax concern for later on in life.
If someone has a large tax-deferred account and RMDs are a concern, then the main goal is to reduce the balance of this account to relieve most of the tax burden later on. In this case, doing a Roth conversion over several years would be the best strategy. When you convert a traditional IRA or 401(k) to a Roth IRA, you’ll owe income taxes at your ordinary tax rate for that year on the amount you converted, but to many people, it’s worth it on the back end. There is no limit on the amount you can convert in a given year, but executing the conversion over several years usually makes sense to lessen the tax hit. Converting a significant amount in one year might push you into a higher tax bracket.
When doing a Roth conversion, we want to keep income as low as possible to leave more room to convert pre-tax assets. If your income needs are low, you can withdraw from your taxable brokerage account without tapping into principal or other accounts. However, if your income needs are high, you may need to withdraw from your Roth accounts in addition to a taxable account to ensure taxes stay low and you don’t dig into principal.
Having these strategies in place also helps minimize taxes for the next generation. Any pre-tax accounts you pass to your beneficiaries fully become taxable to those individuals. Whether you are doing a Roth conversion or not, that is why we recommend withdrawing from pre-tax accounts earlier in your retirement. Additionally, beneficiaries must deplete inherited pre-tax accounts, such as IRAs, within 10 years of the original owner’s date of passing (unless you are a spouse). Whereas passing on tax-free accounts, such as Roth IRAs, your beneficiaries won’t have to worry about a significant tax burden.
After spending so many years working and planning for retirement, it’s important to continue exploring various scenarios to make your money work for you. Financial security is so crucial when you are no longer working. Having a sound strategy to maximize portfolio income while minimizing your tax liability plays a massive role in that financial security. Retiring with various sizeable accounts is wonderful, but taxes can eat away at them quickly if there has been no panning. Consulting a financial professional to devise a plan is best for optimal results.