When the Tax Man Follows You Into Retirement
Investors in the U.S. are keenly aware of how managing taxes can help to build wealth—as evidenced by the trillions of dollars that we’ve invested in IRAs, 401(k)’s and other tax-sheltered accounts.
What too many of us fail to consider, however, is the need to remain tax-conscious even after we’ve built our wealth. For retirees seeking to preserve and appreciate their wealth, tax-savvy decisions are especially important.
One of retirees’ key tools for tax management is known as retirement withdrawal sequencing. In plain English, this refers to the order in which you make withdrawals from various account types to fund your retirement.
Those who have saved successfully often have a combination of taxable, tax-deferred and tax-free accounts. When that’s the case, proper planning about which accounts to tap first can allow you to defer a substantial amount in taxes while maximizing the opportunity for the remaining accounts to appreciate.
Here’s a review of the three broad categories of retirement-savings accounts:
- Tax-deferred: Tax-deferred accounts such as 401(k)’s and traditional IRAs are funded with pre-tax income. Principal and earnings from those contributions are taxed when they are disbursed to you in retirement.
- Tax-free: After-tax income is used to fund tax-free accounts including Roth IRAs and Roth 401(k)’s. So you pay taxes up front, but never again. Principal and earnings grow tax-free right up until withdrawal.
- Taxable: Investors often turn to taxable brokerage accounts after hitting the contribution limits on their tax-deferred and tax-free retirement accounts. Contributions to taxable accounts are after-tax, but taxes do apply to any capital gains, interest and dividends you earn.
Each retiree’s withdrawal-sequencing strategy should be custom-designed, since individuals’ situations and goals differ. But one iron-clad rule is to start by taking required minimum distributions (RMDs) from your traditional tax-deferred accounts. The reason: Failing to take RMDs from accounts such as traditional 401(k)’s or IRAs triggers penalties in the amount of half the required withdrawal.
After that, the most common order of withdrawals is 1) taxable accounts, 2) tax-deferred accounts, and 3) tax-free accounts. Starting with taxable accounts makes sense because the maximum tax rate on long-term capital gains and qualified dividends is 20%.
Traditional 401(k)’s and IRAs, by comparison, are taxed at the much-higher ordinary income rate, which tops out at 39.6%. It’s typically best to let such higher-tax accounts grow, tax-deferred, for as long as possible.
Roth plans should typically be left for last: Since taxes for these accounts were paid up-front (and because RMDs are not required), the longer they have to appreciate, the better.
Again, there is no single retirement-withdrawal sequence that will work for every retiree. One reason is that retirees may have a broader range of investment types, including real estate or annuities. Furthermore, blindly following a formula could lead to unintended consequences such as, for instance, being pushed into a higher tax bracket for a given year.
The bottom line: Retirement isn’t the time to get complacent about taxes. Careful planning is required to ensure that you minimize your taxes and maximize your potential for growth.