A tax-efficient withdrawal strategy can be the difference between the retirement you’ve dreamed of and just scraping by.
Taxes on Withdrawals – The Basics
Check that. There is actually nothing “basic” about retirement withdrawals. Here is a list of the key rules:
Traditional Accounts: All distributions from IRAs, 401(k)s, 403(b)s and 457 accounts are subject to income taxes at ordinary income tax rates, except Roth accounts (assuming all requirements are met) and any funds contributed on an after-tax basis.
Roth Accountss: Withdrawals from Roth IRA and 401(k) accounts are tax-free if certain requirements, such as the five-year rule and reaching age 59 ½, are met.
HSAs: Withdrawals from a health savings account (HSA) are not taxed if they are used for qualified medical and related expenses.
Social Security: Social Security payments may be subject to income taxes if your overall income is over a certain threshold.
Pensions: Pension payments are usually taxable. In some cases, a pension from the state or a municipality will not be subject to state income taxes. If you are receiving a pension from this type of employer check the rules for your state.
Appreciated Assets: Selling appreciated assets in a taxable account can result in long-term capital gains if they are held longer than one year. These gains are taxed at preferential capital gains rates. Short-term gains are taxed as ordinary income.
Annuities: Annuities will be part taxable and part tax-free. If you annuitize, the portion of the payment attributed to the amount you contributed to the contract will be non-taxable. The rest will be considered as gains on your investment and will be taxed as ordinary income. Partial lump-sum withdrawals are taxed as gains until that “layer” is used up.
This overview of the basics is useful when planning a tax-efficient retirement withdrawal strategy.
Here are some tips to make your retirement withdrawals as tax-efficient as possible.
Review Your Situation Each Year
It is important that you stay on top of your income and potential tax liability each year. Your investment returns may be significantly different this year than last and other changes may impact your strategies. Tax planning should be done early in the year to allow you to make decisions as to your best options for tapping retirement accounts and funding your retirement income needs for the year.
This is one of the reasons you might find it useful to maintain a comprehensive retirement plan. If you have all of your data saved, it can be easier to update and then assess different retirement withdrawal strategies.
When you use the NewRetirement retirement planning calculator, you create a user name and password so you can return to you plan at any time to try different scenarios. You can shift account types, update rates of returns, assess how much you will need to withdraw in any given year and more.
Take Required Minimum Distributions but Manage Carefully
Required Minimum Distributions (RMDs) start at age 70 ½ and as the name implies are a requirement. Holders of IRAs, 401(k)s and other retirement accounts funded with pre-tax contributions are required to take a distribution based upon an IRS table and the amount in the account(s) as of December 31 of the prior year.
This distribution (another word for withdrawal) is fully taxable on top of any other taxable income that you may have.
Watch Your Total Income for the Year: The RMD might push your income to a level where your Social Security becomes taxable or could even push up the amount that you pay for Medicare. If possible, reduce income from sources other than the RMD if this will be a factor.
Donate to Charity: IRA Qualified Charitable Distributions allow those who are 70 ½ to direct some or all of their RMD to a qualified charity. This amount will be excluded from their income, though they cannot take a charitable deduction as well. This is only available for IRA accounts. If you don’t need all the money, and have charitable inclinations, this is a tax-efficient way to meet those goals. These RMD contributions are capped at $100,000 annually.
Work: If you are working at 70 ½ you can avoid RMDs from your employer’s 401(k). Your employer must have made this election to their plan and you cannot own more than 5% of the company. If these criteria are met you need not take the RMD from that account only until you leave the company.
One strategy to consider is a reverse rollover from IRAs or other plans. If you company allows this and the was contributed on a pre-tax basis, this money can be transferred to your current 401(k) and RMDs can be delayed while you are working.
Consider Health Savings Accounts (HSA)
Ideally this is a strategy you will implement prior to retirement. Funding an HSA account is a great way to combat the rising cost of health care in retirement and to do so with tax-free withdrawals. The HSA allows you to contribute money on a pre-tax basis.
Leave this money invested while you are working and pay current out-of-pocket medical expenses from other sources. You can then use this money to cover qualified healthcare expenses in retirement with tax-free withdrawals.
Evaluate Roth Accounts
Roth IRA accounts and Roth 401(k) accounts allow for tax-free withdrawals in retirement. There are no RMDs on Roth IRA accounts to boot.
The trade-off is that Roth contributions are made with after-tax dollars so you need to decide if current savings or tax-savings in retirement are more valuable to you.
Conversions to a Roth account are taxable in the year of conversion. A conversion might be a good strategy prior to the commencement of RMDs. You will want to look at your income in the years prior to 70 ½ and decide if paying the tax now to reduce the size of your RMDs down the road is a good strategy for you.
Profit from Net Unrealized Appreciation (NUA)
This is an opportunity for those with appreciated company stock in a company retirement plan to pay taxes at lower capital gains rates on the stock.
When leaving the company, you would take a taxable distribution on the stock, but roll other assets in the plan to an IRA. Taxes would be paid on the cost basis of the stock, not the appreciated value. The shares would go into a taxable account. When you sell the shares down the road you would pay taxes on the appreciation at lower capital gains rates. This can save a tremendous amount of money in taxes.
Take Distributions Along the Way
Once you reach age 59 ½ it can make sense to take distributions from traditional IRA accounts and other traditional retirement accounts even if you have other sources of funds that may not be taxable. This makes sense if your income is low and you have “room in your current tax bracket.”
This strategy can reduce the amount subject to RMDs and reduce your taxes in retirement. This is a strategy that will vary from year-to-year as your situation evolves.
Summary of Retirement Withdrawals Strategies
Managing distributions from your various taxable, tax-deferred and tax free accounts during retirement is critical. Developing a tax-efficient withdrawal strategy is a balancing act that needs to be reviewed and revised (if needed) annually. The effort is worth it and the payoff can be more money for you to enjoy in retirement.
Get started today and use the NewRetirement retirement planning calculator to find personalized answers about retirement withdrawals:
- Are your retirement savings enough?
- How much do you need to withdraw from savings — if anything — to make ends meet
- What will the value of your accounts be when you turn 72
- And more…