Americans typically begin their careers in their early twenties and continue working until their mid-to-late sixties, or even later. One’s ideal retirement date is an individualized choice, and it can be a big adjustment when regular paychecks cease. Planning for retirement and managing income sources efficiently is crucial for maintaining financial stability during your later years. The tax ramifications to replenish your income stream need evaluating in conjunction with your long-term planning goals.
Tax withdrawal strategies in retirement refer to the various methods retirees can use to manage their income and taxes efficiently during their retirement years. The goal of these strategies is to maximize income while minimizing the tax burden. In this article, we will delve into these strategies and additional considerations in retirement.
- Utilizing Current Sources of Income
Part-time income, social security, pension payments, and rental income are important sources of income. It is wise to allocate these funds for covering monthly living expenses since they are often taxable at ordinary income tax rates when received. Using these funds for day-to-day expenses can help you minimize the need for tapping into other investments and potentially incur higher taxes.
- Interest and Dividends from Investment Portfolios
Interest and dividends are generally taxed as ordinary income. Therefore, it makes sense to use these toward monthly living expenses as well. By doing this, you are not drawing down on the principle of your investments which allows them to continue to grow.
- Required Minimum Distributions (RMDs)
Once you reach the age for RMDs you must withdraw a certain percentage from tax-deferred retirement accounts. These withdrawals are subject to ordinary income tax. Therefore, utilizing these distributions for living expenses is prudent. Anything you do not need for expenses should be reinvested into your taxable personal account. Or, if you are charitably inclined, consider a qualified charitable distribution (QCD). A QCD allows you to transfer your RMD amount directly to a charity and this amount is excluded from taxable income.
After exhausting the sources above, it is now time to tap into your investment accounts. First and foremost, per the chart below, understanding tax ramifications as well as other considerations for each type of account is extremely important.
The traditional withdrawal sequence suggests accessing taxable accounts first, followed by tax deferred accounts and finally Roth accounts. This strategy is based off the premise of allowing your retirement assets to grow tax deferred for as long as possible. For investors who have enough assets to meet retirement needs and their estimated future RMDs are likely to be less than their retirement living expenses will be, the traditional withdrawal method makes the most sense. When accessing taxable accounts try to focus on investments held over 1 year to lock in long term capital gain tax rates. You also want to make sure your financial advisor is actively providing tax loss harvesting, scouring your personal taxable accounts for securities that are at a loss to purchase cost, so that these losses may help offset some or all the gains.
A primary reason you would want to tap into tax deferred assets next is that they are not the most ideal asset to pass along to your heirs. Since the passing of the Secure Act of 2020, most non-spouse beneficiaries must distribute the entire inherited account within 10 years. This may force them into higher tax brackets than necessary. Roth accounts should be last and left to grow as long as possible. Even though Roth IRAs fall under the 10-year distribution rule for non-spousal beneficiaries, as long as you follow the rules, all distributions are tax free making them the best asset to pass along to heirs.
The traditional withdrawal sequence may not be suitable for everyone, especially individuals with large tax deferred accounts because those accounts can lead to a significant increase in one’s tax liability when RMDs begin. One approach is to draw down your tax deferred accounts earlier to decrease the RMD amount. However, depending on how much you are withdrawing, these distributions can drive up social security taxation, Medicare premiums, and capital gains taxes. An alternative strategy is to withdrawal from taxable and tax deferred accounts simultaneously. This is called the proportional withdrawal strategy. This approach can help alleviate the tax deferred accounts from growing too large thus minimizing the amount of future RMDs. Overall, this can help reduce future RMDs and smooth out taxes over time.
Remember, everyone’s financial situation is unique, and there is no one-size-fits-all approach to retirement planning. Before any decisions are made it is imperative that you collaborate with your advisor at Fragasso Financial Advisors and your tax professional to customize a strategy that aligns with your specific income needs, retirement goals, and tax position. This collaboration can have a meaningful impact on the amount of tax you will pay, the longevity of assets, and a retirement income plan’s success.