InvestingRetirement Investing

Tax-Efficient Retirement Withdrawal Strategies – The Ins And Outs

Focusing your savings efforts on enjoying a comfortable retirement after you’re done working is a priority worth paying attention to. That’s only half the equation. Not planning properly for the tax ramifications of withdrawing that money is a far too common mistake.

What goes into a savings account must come out at some point. The 401(k) plan your company is offering is not “tax free” money when you retire. That portion of your income is tax deferred, meaning you’ll have to pay the IRS their share at some point. It comes out of your nest egg after retirement.

There are other retirement savings options that can minimize tax liabilities in your golden years. Diversifying investment accounts long before retirement is the best strategy, but it’s never too late to make some changes. In this article, we’ll review how to do that so you can learn tax-efficient retirement withdrawal strategies and put them to good use.

Tax Witholding

Roth IRAs Versus Traditional IRAs And 401(k) Plans

The top tax-efficient retirement withdrawal strategies begin with diversifying retirement accounts early in your working history. You pay into social security, of course, but that won’t be enough to sustain the type of lifestyle you want when you get older.

The first step, if you’re a W2 employee, is to participate in your employer’s retirement plan. This is typically a 401(k) or 403(b), and contributions are tax-deferred. That’s an important distinction since you’ll have to pay taxes on withdrawals later on.

The IRS imposes a maximum contribution limit on 401(k) plans. That number has nothing to do with tax brackets. The max for 2020 was $19,500, but you can contribute an additional $6,500 if you’re over the age of fifty. This represents the bulk of most American’s retirement accounts.

An IRA is a different animal. There are two types. Traditional IRA contributions are also tax-deferred, similar to a 401(k), but there’s no employer sponsorship. Roth IRA contributions are made with after-tax income, making withdrawals tax free.

IRS contribution limits for IRAs are only $6,000 per year, $7,000 for folks over fifty, so the common belief system is that you only use them after the 401(k) contributions are maxed out. That’s a good savings strategy, but it may negatively affect your withdrawal strategy.

Roth IRAs versus Traditional IRAs -2

Retirement Planning To Minimize Tax Consequences

Think of retirement as a three-legged stool. One leg is the employer-sponsored retirement plan with tax-deferred contributions. The second is your traditional or Roth IRA, which gives you tax free withdrawals in retirement. The third is your brokerage account.  

Brokerage accounts, or investment accounts if prefer, are the leg in the stool that allow you to be firmly seated financially in your retirement. There are no contribution limits, no required minimum disbursements, and capital gains taxes are lower than income taxes.

A brokerage account can balance out the 401(k), traditional IRAs, and your tax-free Roth accounts. You’ll pay full income tax on withdrawals from the 401(k), no taxes on the Roth, and minimal long term capital gains taxes on the brokerage account.

Rather than contributing the max to a tax deferred account, a more tax efficient strategy would be to contribute equally to each leg of the retirement stool we’ve described here. That will ensure a retirement withdrawal strategy with lower overall tax liability.

tax return

Preparing For Required Minimum Distributions (RMDs)

You can start taking social security benefits at age 62, but you don’t have to. Waiting until you’re 70 gives you a higher monthly benefit payment. At age 72, you’re required by the IRS to begin taking minimum monthly distributions from your retirement accounts.

Your required minimum distributions are calculated using an IRS Uniform Lifetime Table. They basically tell you how long you’re expected to live and force you to withdraw a certain amount per year until their projected date has come and gone.

What if you outlive the projection? It’s a legitimate question, particularly with advances in medicine and technology that are helping people live longer. Here’s a thought. The IRS can make you withdraw from your retirement accounts, but not from your brokerage accounts.

Starting to see the picture? By age 72, you can be collecting social security and withdrawing from retirement funds. The income from one can offset the tax liabilities on the other, but the retirement money will run out at some point. That won’t happen with the brokerage account.   

Tax Loss Harvesting And Long Term Capital Gains Tax

A professional financial planner will create tax efficient withdrawal strategies that include tax loss harvesting and holding investments to take advantage of long term capital gains tax rates. Does that sound complicated? It’s actually quite simple.

Tax loss harvesting is the practice of selling investments that have gone down in value, essentially “taking a loss.” That loss can offset gains on other investments, minimizing the tax liability. It’s a common practice with professional asset managers.

Long term capital gains tax is lower than short term capital gains tax. If you hold an investment for more than one year, that investment is in the “long term” category. With retirement accounts, most of the positions should be long term if the fund manager planned properly.

For self-managed investment accounts, which are increasingly more popular these days, tax loss harvesting should be a regular exercise and selling off positions should be evaluated carefully. Dumping a stock after a loss may not be the right move if its above what you bought it for (cost basis).  

Long Term Capital Gains Tax

Best Practice Withdrawal Strategies

For the average retiree, the conventional approach to withdrawing retirement funds is to tap the taxable accounts first (brokerage and self-directed investment), then the tax deferred accounts (401(k)), and then tax free accounts (Roth IRA).

With Roth accounts, you’ve already paid taxes on that money so there’s zero tax liability on withdrawals, including capital gains tax. It’s in your best interest to let that money grow as long as possible before withdrawing it. That’s an argument for contributing the maximum annual amount allowed while still working.

As a final note, make sure you calculate any state income taxes that you might be responsible for when you take distributions. These are often overlooked in the planning stage, which can come back to bite you later on when you start taking withdrawals.

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Kevin is an ambitious entrepreneur that is obsessed with all things related to finance. From a young age, Kevin has always been involved with side hustles ranging from online selling to freelance work. Over the years, Kevin graduated from side hustles and started launching multiple online and offline businesses. Kevin is a serial entrepreneur who loves starting new businesses and exploring all things related to business and finance. He is constantly looking for new ways to save money, invest money, and create income streams.

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