Tax-Efficient Retirement Withdrawal Strategies

Focusing your savings efforts on enjoying a comfortable retirement after you’re done working is a priority worth paying attention to. But, unfortunately, 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. Your company’s 401(k) plan 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, eventually. It comes out of your nest egg after retirement and becomes taxable income.

Other retirement savings options can minimize tax liabilities in your golden years. Of course, diversifying investment accounts long before retirement is the best strategy, but it’s never too late to make some changes to asset allocation in retirement. 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. Of course, you pay into social security, but that won’t be enough to sustain the type of lifestyle you want when you get older.

If you’re a W2 employee, the first step 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 fifty. This represents the bulk of most Americans’ 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 with 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 standard 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 is not a taxable account and gives you tax-free withdrawals in retirement. The third is your taxable brokerage accounts.  

If preferred, taxable brokerage accounts or investment accounts are the legs on the stool that allows you to be firmly seated financially in your retirement. There are no contribution limits, required minimum disbursements, and lower capital gains taxes than ordinary income tax rates. In addition, you can invest in stocks, bond funds, ETFs, and more.

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

Rather than contributing the max to a tax-deferred growth 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 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 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. 

A financial advisor or tax professional can provide a more detailed explanation of withdrawing from your retirement account in a tax-efficient manner.

Tax Loss Harvesting and Long Term Capital Gains Tax

A professional financial planner with experience handling a retirement portfolio 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 selling investments that have gone down in value, essentially “taking a loss.” That loss can offset gains on other investments, minimizing the tax liability of your taxable assets. It’s 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. Most positions should be long-term with retirement accounts if the fund manager planned adequately.

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

Long Term Capital Gains Tax

Here are other things to know to have a tax-efficient withdrawal strategy:

  • Be careful of Medicare premiums, referred to as IRMAA (income-related monthly adjustment amount) which increase with additional income
  • Consider tax diversification of your retirement portfolio by spreading it through different types of tax treatment and different tax characteristics.
  • If you have low income in a year, take advantage of the low tax bracket to convert to Roth assets or other tax-deferred assets.

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).

You’ve already paid taxes on that money with Roth accounts, so there’s zero tax liability on withdrawals, including capital gains tax. So 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 and federal income taxes 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 Flynn

Kevin D. Flynn is a former financial professional with over ten years of experience in the financial industry. He has consulted for financial advisors, online sales reps, and fintech startups. Kevin holds a degree in accounting and finance and continues to expand his knowledge by attending classes and seminars. He commits several hours a day to market research so he can stay on top of the latest news and trends in the financial industry. Kevin's experience in the industry has fueled his successful writing career, which he now focuses on full-time. He currently resides in Leominster, Massachusetts with his wife Evelyn, two cats, and nine wonderful grandchildren.

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