Given the recent volatility of the financial markets associated with geopolitical tensions, rising inflation, and the pandemic, people approaching retirement need extra assurance, if not certainty, that they can meet their life goals and not run out of money. Although the common concerns of pre-retirees and recent retirees have been consistent through the decades, the financial advice they require is rapidly changing.
Financially speaking, the place where a person can make the single greatest impact on their retirement income is in how they plan to turn their accumulated resources into income for the rest of their lives. How good is the advice you are receiving about how to generate retirement income? Does your strategy combine the coordination of income, investment, and tax planning? Does it include an intelligent plan for tax loss/gain harvesting or opportunistic planning for partial Roth conversions? And, most pertinent to this article, has anyone discussed with you how best to blend income streams—from Social Security claiming to when and where to withdraw from your various accounts – to pay the least amount of tax possible, both today and in the future?
Much of the advice is following a cookie cutter approach suitable to prior generations: withdraw from taxable accounts until they’re empty, allow tax-deferred accounts to continue to grow for as long as possible, then tap the tax-deferred accounts until exhausted, and finally, tap any tax-exempt accounts, such as Roth accounts. As we’ve written about in prior articles, this lack of pro-active planning is landing many retirees in a higher tax bracket in retirement than they ever thought possible, due to surprisingly high required minimum distributions. Combine this with the fact that the current low-tax rates expire at the end of 2025 and you get the perfect storm. Oftentimes we are seeing the deferral and accumulation of these dollars at a lower tax rate than what a retiree will be at when they receive the dollars – the exact opposite of what should happen!
Therefore, advice on how to carefully plan for the distribution of your assets is vitally important and yet hard to come by. And, it should begin in your accumulation years. How you save for retirement and in what type of accounts you save to becomes almost as important as the amount you save. Tax-diversification in your accumulation account types is the key to a savvy tax-efficient withdrawal strategy. To understand why this is important, let’s look at how different resources are taxed depending on your income:
- Social Security can be tax-free or up to 85% of your benefit can be subject to income taxes.
- Interest can be tax-free or taxed as ordinary income.
- Dividends in taxable accounts can be taxed at 0%, 15%, 20% or at the highest marginal rate.
- Capital gains can be taxed at 0%, 15%, 20% or 23.9%.
- Traditional IRA withdrawals are taxed as ordinary income, Roth IRA withdrawals are tax-free, as are distributions from an HSA (Health Savings Account) for qualified medical expenses.
How, then, do you plan for drawing on your various resources by design rather than by default? The key is to look for opportunities to withdraw from multiple accounts to maximize after tax income and ensure that Social Security income or Medicare premiums are not harmed over time. Let’s look at a simplified example (for illustrative purposes only) of blending income streams, assuming you plan to generate a gross income of $100,000 from your portfolio.
The first way to source this income is to take the entire $100,000 out of your traditional IRA at an assumed tax bracket of 22%. This will incur $22,000 in tax and your after-tax income is $78,000
The second way is to take $50,000 from the IRA at the12% bracket ($6,000 in tax) and $50,000 in capital gains* from a taxable account at 15% ($7,500). Total tax paid is $13,500, a tax savings of $8,500 over the first scenario, and after-tax income is $86,500.
Finally, the third way to source the $100,000 income is to take $33,000 from the IRA at 12% ($3,960 tax), $33,000 in capital gains* from the taxable account at 15% ($4,950 tax), and the remaining $33,000 from a Roth IRA at 0%. Total tax = $8,910 – a tax savings of $13,090 versus scenario 1. After-tax income is $91,090.
*If you have harvested capital losses in your taxable accounts, you may be able to offset the taxable gains to pay even less in taxes.
What is the right strategic retirement income plan that includes tax efficient withdrawals? It depends! Everyone is different. Analyzing different scenarios is critical. When presenting various ways of blending income streams together, you are able to see the significant value in creating a personalized retirement income plan that maximizes your wealth by coordinating resources tax efficiently, allowing you to keep more of your hard-earned money.
When taxable income is controlled, you can also gain control over other stealth taxes: Medicare surcharges, net investment income tax, and the AMT (alternative minimum tax). William Reichenstein, professor emeritus of Investment Management at Baylor University, in his book “Income Strategies: How to Create a Tax-Efficient Withdrawal Strategy to Generate Retirement Income” says advice that combines savvy tax-efficient portfolio withdrawal techniques along with a smart approach to claiming Social Security may extend the longevity of a retired household’s portfolio by up to seven years!
Tax-efficient withdrawal strategies begin with understanding how to save in the accumulation years to best “set the table” for blending income streams in retirement. Next would be the development of a comprehensive financial plan that analyzes Social Security claiming strategies and projects opportunities to withdraw from multiple accounts to maximize your after-tax income. Lastly, it is getting guidance on implementing a long-term plan that coordinates your income, investment, and tax strategies along with advice on implementing a year-by-year tax efficient withdrawal plan. If you would like to speak about creating a tax-efficient income in retirement, please schedule a call with us here.