Retirement Withdrawal Strategies

Are you retired or thinking about it? That probably means you are preparing to transition from a regular paycheck to drawing income from your investments. Don’t forget—taxes will follow you wherever you go. Creative tax strategies are just as important during retirement as they are when saving for it.

Many retirees spend most of their working years planning for retirement, dreaming about a life of leisure, but what may not be top of mind is the cumulative impact of federal and state income taxes on withdrawals from their retirement savings. In some situations, retirees will end up paying more taxes than when working.

How can retirees keep more of their hard-earned nest egg?

One of the most essential components to retirement taxes is considering the source of the income—including Social Security benefits, pensions, wages, and any earned interest, dividends or IRA withdrawals. Deciding which accounts to draw from and when, can be a complex decision. And when you draw from them can greatly impact your tax burden. Be strategic so that you don’t owe more taxes than you have to.

Each taxpayer is unique and requires individualized calculations prepared by a professional to uncover which approach is best for their situation. There are a number of different strategies and opportunities outlined below.

Traditional Withdrawals

The idea of a traditional withdrawal strategy is to start drawing from one account, and once depleted, move to the next. It makes sense to progress from the taxable accounts to the tax-deferred accounts and finally the Roth accounts, where withdrawals are tax free. With this plan, taxpayers will most likely have more taxable income earlier in retirement than later. In addition, traditional withdrawals allow the savings to grow in tax-deferred accounts.

The idea of a traditional withdrawal strategy is to start drawing from one account, and once depleted, move to the next. It makes sense to progress from the taxable accounts to the tax-deferred accounts and finally the Roth accounts, where withdrawals are tax free. With this plan, taxpayers will most likely have more taxable income earlier in retirement than later. In addition, traditional withdrawals allow the savings to grow in tax-deferred accounts.

Proportional Withdrawals

In other cases, a proportional withdrawal strategy can greatly reduce your tax burden in retirement. By spreading out taxable withdrawals proportional to each retirement savings account, this allows each investment to grow over time. This approach can also have a positive effect on reducing Social Security and Medicare taxes by thinning the taxable income over many years.

Hybrid Approach

Depending on your taxable income and filing status, long-term capital gains tax rates are 0%, 15%, and 20%. If you foresee a large amount of long-term capital gains from your portfolio (and you will arrive at the 15% tax threshold), then a hybrid approach of blending both the traditional and proportional withdrawal strategies will best align your taxable position. Withdrawal from nontaxable accounts first, then proportionally withdrawal from the remaining accounts in order to avoid paying the long-term capital gains tax for as long as that option is available, or until you will be in a lower tax bracket.

Roth Conversions

As part of a broader tax-minded retirement withdrawal strategy, you may opt to convert a portion of traditional IRA savings to a Roth account. Savings held in a Roth account can be withdrawn tax free; however, the conversion will be taxed at your ordinary income tax bracket rate at the time of the crossover. So, it wouldn’t be sensible to convert if the tax rate will be the same or higher when taking distributions in retirement.

Roth conversions are best suited for those who either experience a lower-than-average income year or those early in retirement before required minimum distributions (RMD) kick in.

They are also ideal for affluent households if you hope to leave an estate to your heirs, and think that their rate won’t be lower than the rate you pay on the conversion, or if the RMDs on your traditional accounts will likely be taxed at a higher rate than the Roth conversion.

Charitable Deductions

If you’re looking to reduce your taxable income, taxpayers over 65 years old may consider gifting directly from their retirement funds. This strategy would allow a deduction “above the line” reducing annual gross income (AGI) and increase the allowable medical deductions and other areas limited by AGI. Taking this approach would generally be instead of an itemized deduction (which also has its own limitations). The state tax deduction limitation makes it more difficult for people to make their contributions count when included in itemized deductions.

Start Planning

Diversifying your investments in multiple types of accounts will allow more flexibility when choreographing tax strategies in retirement. If you have questions or would like to start shaping your retirement tax plan, contact me at tgoodall@bpw.com or (805) 963-7811.