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How To Reduce Your “Silent” Partner’s Stake In Retirement

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Steve Pomeranz, Smart Tax Planning, Great Retirement

What’s your biggest fear about retirement? If you’re like most Americans, “running out of money” is right at the top of the list. According to a recent survey, only health care concerns topped money issues on the fear scale.

Without financial strength in retirement, you could spend your later life scurrying around to make a buck or become a burden to your family. And financial strength requires some things. It requires saving a large enough nest egg, investing those savings properly through appropriate asset allocation, and choosing the right securities.

But for your nest egg to last the rest of your life, you also must defend yourself against the most pernicious wealth stealer of all time—Uncle Sam. Smart tax planning can make a huge  difference between you living your last years in dignity or, worse,  becoming a ward of the state.

You probably have a number of accounts to tap for income in retirement. Usually, it’s a 401(k) or, if you’re a teacher, a 403(b), or an IRA. Maybe a Roth IRA or Roth 401(k) is something you have. While the accounts I just mentioned are either tax-deferred or tax-free, you may also have some taxable investment accounts, perhaps a savings account, too.

But which account should you draw on to minimize Uncle Sam’s bite? That’s what I’m going to look at today.

The Most Important Thing

To keep your taxes as low as possible, you have to know what tax bracket you’re in.  This is a calculation that you should do every year because if you don’t know it, you can’t devise an appropriate tax management strategy.

Your income determines your tax bracket. I think we all know this, and most retirees have at least two primary sources of income, Social Security being one and the required minimum distribution (RMD) that they take from your IRA.

Your RMD is just what it sounds like. Now based on a new law, at age 72, you must begin withdrawing money from your IRA. If you don’t do it, there are stiff penalties. And, the IRS determines how much you have to withdraw each year. It’s based on the value of your IRA divided by a factor from the IRS Minimum Distribution Worksheet, which is a simple table where you can find your number (we’ll provide a link to it on the website).  The number or factor is based on your life expectancy.

To keep the math simple, let’s say you’ve got $1,000,000 in your IRA and you are 72-years old. You go to the table and you find that your factor is 25.6. All you do is you divide $1,000,000 by 25.6 and your RMD requirement comes to just over $39,000. That’s the amount you take out of your IRA and that’s the amount that will be taxed as ordinary income.

Now you can calculate your total taxable income. Combine your RMD amount with your Social Security benefits, add any pension income as well as interest, dividends, and capital gains, and then subtract any anticipated deductions. The number you end up with tells you what your tax bracket will be. By anticipating your future bracket, you can now take advantage of some strategies to lower your tax bill. See how we got to this point?

Who’s On First?

Generally, it makes sense to withdraw funds from taxable accounts before you dip into your tax-deferred retirement accounts. That’s because the money in a tax-deferred account keeps compounding without tax, until you make a withdrawal. When you make a withdrawal, the money is taxed as ordinary income. Still, the tax-free compounding is a huge benefit. It allows the account to grow faster than a non-tax-exempt account. So the money lasts longer.

Another reason to hit your taxable accounts first is because they get more favorable tax treatment. You may, for example, pay a lower tax rate on capital gains or dividends. But keep in mind that a “more favorable tax treatment” doesn’t mean you pay no taxes; it just means you pay lower taxes.

Let’s say you have a mutual fund and you’re reinvesting capital gains and dividends to buy more shares. Even though you are reinvesting, you still owe taxes on the distributions from the fund and on the stock dividends in your account that you may have been reinvesting.

Exceptions

There are times when it makes more sense to tap retirement accounts first.

If, for example, you are under the age of 72, the RMD rules haven’t yet kicked in. As a result, you may now be in an unusually low tax bracket. By withdrawing from your retirement accounts first, you can take advantage of the lower bracket until the required distributions begin. Doing this will reduce the amount of your RMD later because your account balance will be smaller. See how that works? And if you don’t need the money now, you can stash it in a Roth IRA and take it out later, tax-free.

You may also want to tap your retirement accounts first if you have highly appreciated assets in your taxable accounts. Say you bought Google on the IPO at $85 (you wish). Today, GOOGLE changes hands at around $1400 a share. So despite favorable long term capital gains treatment, the tax liability on a sale would be huge.

Plotting Your Tax-Minimizing Strategy

You should always be aware of your current tax bracket and also have a good idea of how your bracket is likely to change. That will tell you how much you should be withdrawing from your retirement accounts each year. If, for example, you expect to be in a lower tax bracket in the future, you should take as little as possible from your retirement accounts between now and then—and absolutely no more than your RMD each year.

But if you expect to be in a higher bracket, it makes sense to take advantage of your income bracket by withdrawing more than the minimum. Even if you don’t need the income.

Roth Or Traditional IRA?

Should you withdraw funds from your traditional IRA first? Or from your Roth? Once again, it depends on your tax bracket.

Use the traditional IRA first if you’re in a low tax bracket. Use the Roth if you are in a high tax bracket. Remember, the ROTH distributions are tax-free.

Other Considerations

As you start to tap your retirement accounts for income, be mindful of your asset allocation. It can easily get out of balance. This is important.

Let’s say you hold the majority of your stocks in a taxable account to take advantage of lower capital gains tax rates. By withdrawing money from that account first, you could soon find yourself dramatically underweight in equities. This will diminish the growth in your nest egg.

So finally, when you recalculate your tax bracket in December every year, check your asset allocation too and rebalance as necessary.

Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. There are no investment strategies that guarantee a profit or protect against loss. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however, their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by the radio show.

Steve Pomeranz
I've been an investment strategist and adviser for over 35 years, leading with a mission of unbiased advice to educate and protect listeners on my weekly radio show on NPR affiliates nationwide. I have been named a “Top 100 Wealth Advisor” by Worth Magazine and “Top Advisor” by Reuters.