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Creating a Tax Efficient Retirement Withdrawal Strategy

Creating a Tax Efficient Retirement Withdrawal Strategy
Rick Henderson, CPA, CFP®, AIF®
October 14, 2019

In working with my retired or soon-to-be retired clients, perhaps the most frequent question I am asked is “What is the best way to withdraw from my investment and retirement accounts in retirement in order to provide me my desired retirement income?”  I believe they ask me this question because many of them have investments in a mix of different accounts with varying tax characteristics such as taxable investment accounts, IRAs, 401k or retirement plan accounts, Roth IRAs, and possibly real estate investments such as rental property.  In addition to that, they may also have retirement income coming in from multiple sources and at different times such as Social Security income, pension income, and deferred compensation. If you are interested in increasing what you can spend in retirement and reducing the impact taxes have on your retirement nest egg, it is important to have a multi-year retirement income plan that takes into account the impact taxes will have on both your retirement income sources, and the withdrawals you take from your different investment and retirement accounts.

To begin, it is important to understand the tax impacts of the various types of account withdrawals:

  • Distributions from pre-tax IRAs and pre-tax 401ks and retirement accounts are taxed at ordinary income tax rates.
  • Qualified Roth IRA distributions and distributions from an HSA that are for qualified medical expenses are tax free.
  • Taxable investment accounts have different types of tax characteristics based on the type of income
    • Interest income is subject to ordinary income tax rates
    • Principal or previously taxed gains can be withdrawn tax-free
    • Capital gains and qualified dividends are usually taxed at lower rates than ordinary income

The Conventional Withdrawal Strategy May Not Be Best

Many retirees have a diversified mix of investment account types and utilize the conventional strategy of withdrawing from taxable investment accounts first, followed by their tax-deferred accounts like their IRAs, and then follow at the end by withdrawing from their Roth IRA assets.  By doing so, you may not be taking advantage of the current low tax brackets and tax rates in the early years of your retirement because you might not be generating enough taxable income to fill those brackets.

To quickly illustrate the difference in tax brackets, the maximum federal tax rate is 12% in 2019 for taxable incomes up to $39,475 for single filers and for taxable incomes up to $78,950 for married filing joint filers.  Contrast that with the marginal federal income tax bracket of 32% on income over $160,725 for single filers and $321,450 for married filing joint filers.

If your taxable income in retirement is low before taking any IRA distributions, it may be advantageous for you to make some withdrawals from your IRA and reduce the amount taken from your taxable investment accounts. By doing so, you may be able to pay tax on those earlier IRA withdrawals at a lower rate, leaving more assets to accumulate in your taxable investment accounts along with their lower capital gains and qualified dividend tax rates to use later.  Under the conventional withdrawal strategy, once your taxable accounts are depleted, you most likely will rely on withdrawals from your IRA to provide the bulk of your retirement income and thus end up paying a higher marginal tax rate on those higher withdrawals in your later years of retirement because of the increased level of withdrawals.

Your Mix of Retirement Investment Assets Will Likely Determine the Best Strategy

One example is in the case of someone who has larger taxable investment accounts, and small balances in IRAs.  In this situation, it is possible that it may be more advantageous to defer pulling money from the IRA accounts until the date Required Minimum Distributions from the IRA(s) are required to start and generate retirement income by selling assets in the taxable investment account(s) and generating taxable income through long-term capital gains.  That is because for 2019, the long-term capital gains tax rates are:

  • 0% for taxable income of $39,375 or less for single filers and $78,750 or less for married filing joint filers
  • 15% for taxable income from $39,376 to $434,550 for single filers and from $78,751 to $488,850 for married filing joint filers
  • 20% for taxable income over $434,550 for single filers and in excess of $488,850 if married filing jointly

Once Required Minimum Distributions from the IRAs start, you could reduce the amount of withdrawals and capital gains produced in the taxable accounts.

A Note About IRAs

Please remember that there is a 10% early withdrawal penalty for IRA withdrawals before age 59 ½, so early retirees, please take note.  Also, for those retirees who are over age 70 ½, you can reduce your taxable Required Minimum Distribution from your IRA (up to $100,000) by making a Qualified Charitable Contribution to an eligible charity directly from your IRA.

A retirement withdrawal and income plan customized for your situation has the potential to save you taxes and increase the amount you can spend in retirement.  However, every retiree or soon-to-be retiree has a unique combination of retirement income sources and investment accounts. Tailoring a plan to fit a client’s individual circumstances requires skill, experience and careful collaboration with tax advisors as well.  To learn more about how we can help build retirement income plan specifically designed for you, or our RetireReadyFIT™ process in general, please contact your Atlanta Financial advisor.

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