How to be More Tax Efficient with Retirement Saving and Spending

By GARY LISKA | Special to the Palisadian-Post

Along with your Social Security and any other guaranteed income sources such as a pension or annuity, your savings will need to fund lifestyle expenses for a retirement that may last 30 years or longer.

Success, however, is going to depend not only on how much wealth you’re able to accumulate before you transition to retirement, but also how efficiently that wealth is distributed across the three primary account types:

Tax-deferred retirement accounts (such as traditional IRAs, and 401(k)/403(b) employer plans) where contributions are able to grow tax-deferred until withdrawn in retirement; at which point distributions are taxed as ordinary income.

Tax-free retirement accounts (e.g., Roth IRAs and Roth 401(k)s) where contributions are made using after-tax dollars, but in most cases, any withdrawals during retirement are tax-free.

Taxable savings including brokerage accounts, bank accounts and CDs for which retirement withdrawals aren’t taxed as income but are subject to capital gains taxes.

As with most financial decisions, the optimal mix of assets allocated to each of these different account types will depend on your individual circumstances, goals and preferences. But by taking time to work with your advisor and thoughtfully diversify your retirement savings across all three, you’ll be able to help ensure you have enough access to liquidity if needed, maintain greater control over your future tax liability and gain valuable flexibility in generating more tax-efficient retirement income distributions.

Determining the Right ‘Draw Down’ Strategy

At some point in the future, you’ll need to begin gradually converting some or all of your savings into a stream of annual income that allows you to achieve your goals—ideally, without ever running out of money. Keep in mind that traditional tax-deferred retirement accounts impose mandatory required minimum distributions (RMDs) that you’ll need to withdraw each year starting at age 72—whether or not you need the additional income.

So, given a choice, in what sequence should you withdraw assets from each account type? Not surprisingly, the answer is: “it depends.” But the following considerations can aid you in the decision-making process:

Plan on leaving your entire estate to your spouse? If so, you may want to draw down your taxable accounts first. Why? Because spouses receive preferential tax treatment when it comes to retirement assets. A surviving spouse can roll your retirement assets into their own IRA without any tax consequences—allowing the funds continue growing tax-deferred until withdrawn.

Is leaving an inheritance to your children a major goal? In that case, you’ll need to make sure your retirement plan and estate plan sync up. For instance, when tax-deferred accounts are inherited, the assets they hold don’t receive a step up in basis. So if you have considerable holdings of highly appreciated assets (e.g., company stock) in your IRA or 401(k), you may want to draw down those accounts first.

Less concerned about leaving a financial legacy? Typically, you might want to sequence your withdrawals starting with your taxable accounts, then your tax-free accounts and lastly your tax-deferred accounts. By reserving your tax-deferred accounts until later in retirement, you’ll be able to keep those assets growing longer and delay paying taxes as long as possible—hopefully when you’re in a lower tax bracket.

Why Consider a Tax-Free Roth IRA?

Although contributions to a Roth IRA aren’t tax deductible, the qualified distributions from them are tax-free. And unlike tax-deferred accounts, Roths don’t have any RMD requirements—so if you don’t need the income, you don’t have to draw down the account.

You can also choose to convert some of your traditional IRA assets to a Roth. But there’s a near-term cost. You’ll have to pay income taxes on some or all of the amount you convert. But if you have enough cash on hand, a conversion may be worth it—especially if you:

Expect tax rates to be higher in the future. If your current tax rate is lower than your future rate, you’d benefit by paying taxes now instead of later. A Roth can help act as a hedge against future tax increases.

Would like to leave a legacy to heirs. Roths don’t require minimum distributions during your lifetime and withdrawals from inherited Roth’s continue to be tax-free for your beneficiaries.

Want to hedge against a potential large expense. Suppose you have a costly healthcare crisis in the future. Rather than drawing down your traditional IRA (which would increase your tax liability), you could take the money you need from a Roth without affecting your tax status.

Allocating your assets across different account types, and then finding the optimal way to sequence your withdrawals, is a complex but vital undertaking—one that can have a tremendous impact on the ability of your assets to sustain you throughout your life. Take time now to sit down with your advisor to explore this important topic.

Gary K. Liska may be reached at 310-712-2323 or seia.com.