Retirement Income Planning: Tax-Efficient Withdrawal Strategies
When approaching retirement, it’s essential to shift your focus from accumulating wealth to effectively managing withdrawals. Retirement income planning lays out what you need and when to preserve your capital and minimize your overall tax liability.
A smart withdrawal strategy is one way to extend the life of your retirement funds. However, remember that all investment strategies come with risks, and outcomes may vary depending on your individual financial situation.
Understanding your portfolio composition
To effectively implement a withdrawal strategy, it is helpful to understand the tax implications of your investment accounts. Each type has distinct tax considerations:
- Taxable accounts: The IRS taxes realized capital gains, dividends, and interest income in brokerage accounts annually.
- Tax-deferred accounts: These are traditional IRAs or 401(k)s, where taxes are deferred until the money is withdrawn.
- Tax-free accounts: Roth IRAs and Roth 401(k)s, allow tax-free withdrawals if certain conditions are met.
If your goal is to minimize taxes and effectively manage risk, the composition of your portfolio in these accounts may affect how you plan your withdrawal. Implementing tax-efficient withdrawal strategies may help reduce your tax burden during retirement. Still, your financial situation and future tax circumstances shape the outcome.
Here are three strategies to consider:
Tax-efficient withdrawal strategies
Think sequencing
You may opt to withdraw from taxable accounts, as these funds have already been taxed and typically qualify for preferential long-term capital gains tax rates. Move to tax-deferred accounts to start using the money that hasn’t been taxed yet, and withdraw from tax-free accounts when your tax bracket is lower in later retirement years. While this strategy may help reduce taxes, there is a risk that future tax laws or changes in your income could result in a higher-than-expected tax bracket in later years, potentially reducing the effectiveness of this strategy.
Manage Roth conversions
Manage your tax bracket by considering converting portions of your tax-deferred accounts to Roth accounts in years when you have less income. This strategic conversion has the potential to help save on taxes over the long term and provide tax-free income in the future, depending on your specific circumstances and tax laws at the time of conversion. This can also draw down pre-tax balances in advance of required minimum distributions, which may force you to recognize income on a higher amount than desired. While Roth conversions can provide long-term tax benefits, they also come with the risk of temporarily increasing taxable income that could push you into a higher tax bracket, leading to a higher tax bill in the short term.
Utilize capital gains and losses
You may consider strategically selling investments at a loss to offset gains in other parts of your portfolio, then immediately swapping into a similar investment asset class to help maintain your exposure to that asset class. This method is known as tax-loss harvesting. While tax-loss harvesting may help reduce your taxable income and balance your tax liabilities annually by carrying forward tax losses into future years, its effectiveness depends on your investment performance, tax situation, and the timing of the transactions.
How a strategic withdrawal plan plays out over time
Let’s look at a hypothetical example that illustrates this strategy. Sarah is 62 and recently stepped away from work. She has a good balance of pre-tax and after-tax assets in her portfolio and does not plan on drawing Social Security benefits until she reaches full retirement age, which for her is 67. Sarah intends to draw on her brokerage account, specifically from her fixed-income positions, to supplement her cash needs while she has no income during these in-between years. Sarah also has the opportunity to convert dollars in her IRA to her Roth IRA, which will be in the 12% tax bracket, and will grow tax-free from here on out.
Fast-forward a few years, and Sarah is 67. She has Social Security income, which puts her into the 22% tax bracket. She decides to stop making Roth conversions at this higher tax rate, but continues to utilize her brokerage account to supplement her lifestyle expenses.
A few years later, at age 73, Sarah must begin pulling from her pre-tax IRA, with a $30,000 per year required minimum distribution. This is more than Sarah needs on top of Social Security, so she reinvests the extra into her brokerage account’s long-term allocation.
Sarah only uses her Roth IRA as a relief valve when approaching the top of a marginal tax bracket due to extraordinary expenses in a particular year, to avoid paying the marginally higher rate. For the most part, she plans to use these dollars to fund her bucket list vacations or pass them on to her heirs, as she wants to keep them growing tax-free for as long as possible. However, she knows this is available to her if she needs it.
Timing and retirement income planning
Withdrawal timing is crucial. One strategy is to withdraw funds from pre-tax buckets when you anticipate a lower tax bracket, such as in early retirement before you start receiving Social Security and make required minimum distributions (RMDs). A keen understanding of your projected income and expenses throughout retirement allows you to plan withdrawals that align with your financial needs while minimizing taxes.
A financial advisor can help you navigate complex tax situations, offer personalized advice, and tailor a strategy to your specific financial situation and goals. Understanding the tax implications of different accounts and employing strategic withdrawal techniques can reduce your tax liability and help your retirement savings last longer.
This content is for informational and educational purposes only and should not be construed as individualized advice. Please consult with your adviser for individualized advice tailored to your specific circumstances.
