Maximize Retirement Savings Flexibility
Developing a tax-aware withdrawal strategy starts with diversifying the various types of accounts you own. Ideally, you'd like to build a healthy mix of assets across taxable (savings and brokerage), tax-deferred (IRAs and 401(k) accounts), and tax-free accounts (
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Which Assets Should You Draw Down First?
The answer will depend a great deal on your particular goals. If your main focus is on tax-efficient income, you may want to consider starting with distributions from your taxable accounts, then moving on to your tax-deferred accounts, and finally taking withdrawals from your tax-free accounts. The rationale is that by delaying distributions from your most tax-favored accounts as long as possible, those retirement dollars will have more time to continue growing.
If, on the other hand, you're hoping to leave a significant legacy to the next generation, your income-generating strategy may require a bit more planning. Since tax-deferred accounts, such as IRAs or 401(k)s, don't receive a step-up in basis when you die, if you hold highly appreciated assets (like company stock) in those accounts, you may want to deplete them first to help reduce the tax burden on your beneficiaries.
Some Distributions Will Be Required
To some extent, your choice of which assets to draw-down may be limited by retirement account tax rules. Whether or not you need the funds, you have to begin taking required minimum distributions (RMDs) from your tax-deferred accounts by
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It's essential to factor RMDs into your annual income distribution plan. Why? Because if you don't withdraw your full RMD, you'll be subject to a 50% tax penalty on the amount you failed to withdraw.
Think About the Long-Term Tax Picture
People generally assume they'll be in a lower tax bracket during retirement as their income decreases. But given the reduced tax rates resulting from the Tax Cuts and Jobs Act, combined with the federal deficits and debt resulting from various COVID-19 stimulus packages, there's a strong case to be made that future tax rates may need to be significantly lifted.
Sequence Your Withdrawals to Provide Income
By carefully coordinating the sequence of your withdrawals, you can help minimize the total taxes paid over the course of your retirement — allowing you to potentially increase the amount you spend annually and/or extend the longevity of your portfolio. Typically, this sequence will adhere to the following order:
- Your annual RMDs.
- Cash flows from your taxable accounts (i.e., interest, dividends and capital gains distributions).
- Principal distributions from taxable accounts (e.g., bank withdrawals and investment account sales).
- Distributions from tax-advantaged accounts.
The underlying goal of this sequence is to maximize the compounding potential of your tax-advantaged accounts by keeping those assets working for you as long as possible.
4 Reasons for Reordering Your Distributions
Temporary changes in spending or income may require reordering the sequence of your distributions to minimize taxes or maximize benefits:
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Don't Forget Your Social Security Income
Regardless of how much you've been able to put away in savings,
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Being thoughtful in how you generate income from your various retirement accounts (e.g., tapping into your investment account or Roth IRA rather than your tax-deferred accounts when you're close to the annual combined income threshold amount) can help further reduce your tax liability.
Tax Implications
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Additional Considerations
One additional important consideration you'll need to factor into your income decision is whether or not you expect your tax rate in retirement to be higher than it is now (due to either higher tax rates or high income). If this is the case, you may want to explore converting some of your traditional IRA assets to a Roth IRA.
You'll have to pay income taxes now on the funds you convert, but your distributions in retirement will be totally tax-free.
And given the recently passed SECURE Act retirement legislation, which compresses the timeframe in which beneficiaries must deplete any inherited traditional IRAs and 401(k) plan accounts, converting legacy assets to a Roth can provide tax benefits to your heirs as well. The most important consideration with any Roth conversion, however, is making sure you have sufficient funds (outside of your retirement accounts) to pay the taxes that will be due.
These are just a few of the many moving parts that will impact both your income and taxes in retirement. Other considerations you may want to explore include moving some of your non-qualified assets into an annuity to help reduce capital gains taxes; as well as using a permanent life insurance policy's cash value as an additional tax-free retirement income stream.