You know the importance of saving enough money for retirement so that you have readily available sources of funds to augment your guaranteed income from Social Security and any pensions. But did you also know that how you go about converting your assets into income can have significant tax implications?
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 (Roth IRAs and Roth 401(k)s). This will allow you more flexibility in deciding how much income you should draw down each year and from which accounts to minimize your tax liability.
Since Roth IRAs are funded with after-tax dollars, not only are those accounts not subject to required minimum distributions (RMDs), but any withdrawals you make from them in retirement won’t count as taxable income. Taking distributions from a traditional IRA or 401(k), on the other hand, is different. Those distributions count as annual income that will be subject to taxes.
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 April 1st of the year following the year in which you turn age 72.
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:
• Avoid an increase in Medicare premiums or loss of subsidies for health insurance premiums from a health insurance exchange.
• Avoid subjecting a greater portion of Social Security benefits to income taxes (see Social Security discussion below).
• Maximize the use of the standard deduction.
• Maximize the use of certain carry-forward deductions before expiration (such as charitable contributions or net operating losses).
Don’t Forget Your Social Security Income
Regardless of how much you’ve been able to put away in savings, Social Security will still be an important source of income in retirement. But those benefits may also be subject to income taxes depending on your combined income (your gross income + any tax-exempt interest + ½ of your annual Social Security benefit). The 2021 income thresholds for federal taxes are as follows:
• If your combined income is between $25,000 and $34,000 (for individual filers) or $32,000 and $44,000 (for couples filing jointly), up to 50% of your Social Security benefit will be deemed taxable income;
• If your combined income exceeds $34,000 (individuals) or $44,000 (married filing jointly), then 85% of your Social Security is subject to federal income taxes.
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-deferred assets may be an attractive option for retirees who are charitably inclined for a few different reasons. Through qualified charitable donations (QCDs), a retiree can directly donate to a charity up to $100,000 per year without incurring any taxable income. This can also count toward the tax year’s required minimum distribution.
• Retirees with highly appreciated securities in their taxable accounts can also consider lifetime gifting to charities, since the appreciation will not be subject to income taxation.
• Contributions to a donor advised fund in higher-income years or moving highly appreciated assets to a donor advised fund for charitable giving can also be valuable.
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. Roth IRAs also have no RMDs. So if you don’t need to access the funds for annual income, the account can continue growing tax-free — even beyond age 72, when traditional IRAs mandate that you begin taking annual distributions.
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.
Martin Schamis is the head of wealth planning at Janney Montgomery Scott, a full-service financial services firm, providing comprehensive financial advice and service to individual, corporate and institutional investors. In his current role, he is responsible for the strategic direction of the Wealth Planning Team, supporting more than 850 financial advisers who advise Janney’s private retail client base. Martin is a Certified Financial Planner™ professional.