This is the second installment of our three-part series on tax efficient retirement planning. Please read part one if you have not yet read it.
By far, the largest wealth eroding factor we face over the course of our working lives are taxes. Minimizing taxes can have a significant impact in the short term. However, the difference that maximizing and optimizing our tax planning can have over the course of our retirements can be nothing short of profound.
I will discuss the second of the three most crucial tax strategies for a successful retirement. Depending on factors such as the amount of wealth we have accumulated, the types of assets we own and how long we live, getting these strategies right can mean tens of thousands, hundreds of thousands, or even millions of dollars in additional net spendable income over our lives.
Keep in mind that this is true at today's tax rates. If taxes rise in the future, as I believe they shall, these strategies will become even more valuable.
The overwhelming majority of retirees whose plans I have evaluated, regardless of wealth or education level, get these strategies wrong. I would like to change that for you.
Another thing I would like to mention is that these strategies are often missed through no fault of retirees. IRA, 401(k), 403(b), Thrift Savings Plan accounts and the like are usually referred to offhandedly as "retirement accounts," both in the media and by financial professionals. And it is no surprise, since that is what they are.
What could be more natural to a retiree than using the money in their retirement account(s) to fund their retirement! Given the way these accounts are labeled, I would argue it would be strange if people did not follow the pattern of accessing their tax deferred accounts first. Unfortunately, following the intuitive path is not always the best way to go.
Withdrawal Sequence Strategy:
This strategy focuses on the best order in which to draw from your retirement and other investment accounts when you stop working. The best method is usually - though not always - to draw money from taxable accounts first, like individual or joint brokerage accounts and cash, tax-deferred accounts like those mentioned above and lastly, tax-free accounts like Roth IRAs and permanent life insurance, also known as Whole Life Insurance.
The rationale is that by drawing down taxable accounts first, a significant portion of the money flowing out will have already been taxed in the form of long term or short-term capital gains. The portion of these accounts that has already been taxed is often referred to as our basis.
Since withdrawing our basis is typically tax free, much of the money we will live on will not be subject to income tax. Depending on various factors, it is possible that none of this retirement income will be taxed! By accessing funds from taxable accounts and cash balances in the initial stages of retirement, we can often keep our taxes lower.
Next, we will begin drawing down our tax deferred accounts. For most folks, these are our IRAs and 401(k)s. All money withdrawn from these accounts will be subject to ordinary income tax. This will likely put us in a higher tax bracket, especially if combined with other income like social security, pensions, annuities, etc.
Having said that, it is important to remember that the required minimum distribution (RMD) is always looming. Depending on your birth year, the government requires that we begin withdrawing money from our tax deferred accounts at some point in our early seventies, whether we want to or not.
Since we must take the money out anyway, we may as well look forward to using it to live a better life. And that is good!
Finally, we will access funds in our tax advantaged accounts last. The reason is that the money in these accounts will not be taxed when withdrawn, and so it is to our benefit to allow them the maximum time for uninterrupted growth.
It is important to point out that depending on variables such as your asset mix, tax bracket and other factors, a different order may provide greater advantage.
Given the complexity of overlapping strategies like asset location and withdrawal sequence, consider working with a financial professional who is knowledgeable, and whom you trust. The result might be keeping substantially more of the money you have worked hard to save.
If you would like more information on establishing and maintaining a tax efficient retirement plan, please call me at 732-844-3000. I am here to help.
Scott R. McGimpsey January 20th, 2025
Certified Financial Fiduciary®
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