As you approach retirement, it’s important to have a strategy to minimize the taxes on your withdrawals. Keeping in mind a few key points can help prepare you to manage your savings in retirement. Since everyone’s circumstances are different, work with your financial advisor to determine the best approach for your unique situation.
Different types of investment accounts
Retirement investments are typically held in three different types of accounts: tax-free, tax-deferred, and taxable. The Roth IRA and Roth 401(k) are examples of tax-free accounts. When you take money out in retirement, you don’t owe any taxes (because you contributed after-tax dollars).
Tax-deferred accounts include the Traditional IRA and the regular 401(k) plans. As long as you keep money in these accounts, you don’t pay taxes on annual investment gains. However, when you make a withdrawal in retirement, the entire withdrawal is taxed at ordinary income rates.
Taxable accounts include regular brokerage accounts. With these accounts, capital gains and dividends are subject to tax each year. Although you might owe taxes even without a withdrawal, when you finally do liquidate a position, the original principal investment is not taxable, just the gain.
When you have a combination of accounts, you have a few different options to minimize your tax liability in retirement. One strategy is to use the funds in your taxable accounts first. This way you’ll continue to enjoy tax-deferred growth on your investment earnings while spending down the accounts that are taxed annually.
While this approach is not without merit, it is likely a bit too simplified to meet the needs of most investors. When you eventually begin taking money out of your tax-deferred accounts, the withdrawals might be large enough to push you in a higher tax bracket than if you had taken out smaller amounts earlier.
Also, when you turn 70 ½, you will probably need to start taking required minimum distributions (RMDs) from your tax-deferred accounts. If you have not planned properly, the IRS’ required minimum distributions could force you to take out a larger sum of money at once, potentially pushing you into a higher tax bracket and creating a larger tax liability.
Seek diversification in how you withdraw funds in retirement
Often the most effective strategy is to diversify, and balance your withdrawals depending on your entire financial situation each year. After age 59 ½, you may begin to access retirement funds without incurring a penalty. During the years that you’re in a lower marginal tax bracket, consider taking withdrawals from your tax-deferred accounts. The low marginal tax rate reduces the amount you will owe in taxes and may also help decrease your RMDs in the future.
After reaching retirement age, if you’re in a high marginal tax bracket, or if you’re still working, consider your tax-free and taxable accounts. Postponing withdrawals from tax-deferred accounts until your marginal income tax rate is lower will help preserve the wealth you have accumulated and can be especially important if you’re still working after age 59 ½. Not only could taking money out of your tax-deferred accounts push you into a higher tax bracket, it could also trigger taxes on your Social Security income.
If one of your main goals is to preserve your wealth for heirs, consider using taxable assets last. By using tax-deferred or tax-free funds, you may be able to pass remaining taxable assets to a beneficiary on a “stepped-up” cost basis, which values the investment on the date of your death instead of the original cost, therefore reducing the ‘basis’ in which capital gains taxes are assessed.
The right approach for you and your family will always depend on your specific situation, goals, and the current tax laws. In any circumstance, having a solid plan and working closely with your financial advisor well before retirement will help ensure your retirement assets will be sufficient.
Interested in learning more about tax efficient withdrawal strategies in retirement? Contact a Darrow advisor for a free consultation today.