Society of Certified Senior Advisors: Tax Strategies for Retirement

Taxes can take a big bite out of your retirement income. Keep more of your money with these tips.

Financial advisors boost client returns by investing and taking out retirement funds in a manner that minimizes tax consequences, according to a recent analysis by Morningstar researchers. In fact, they discovered that doing so can increase retirement income more than 4%, which is the same amount considered to be a safe withdrawal rate by many money managers. In other words, ensuring your funds are invested and withdrawn to minimize taxes can give you a return equal to the amount you’ll withdraw. The strategy literally pays for itself, and gains may be even larger for those holding Roth accounts.

Roth Option

Roth accounts hold money you’ve already paid tax on, so you can withdraw it completely tax-free in retirement. What’s the catch? You give up the earnings that tax money would have made for however many years the investment lasts. Compare the two here to see which is right for you. Most people will benefit from using a Roth, either in a 401(k) or IRA.

How Is Investment Income Taxed?

Understanding how income is taxed is an important factor in tax planning. Withdrawals from Roth accounts are tax-free. Withdrawals from traditional IRA and 401(k) accounts will be taxed as ordinary income. Money held in taxable accounts is taxed according to its source:

Interest income, such as from certificates of deposit (CDs), savings or checking accounts and most bonds, is taxed at your ordinary rate.
Capital gains are income that is made by selling an investment for more than the price at which it was bought. If the investment was owned for at least a year and a day, it’s considered long-term and qualifies for the favorable capital gains rate. Less than that, and it is short-term and taxed as ordinary income.
Dividends usually benefit from preferential rates, as long as they are paid by a US corporation or qualified foreign corporation and don’t fall into an excluded category. The corporation that pays the dividend also must be owned for at least a year and a day. And if the dividend isn’t considered “qualified,” it will be taxed at ordinary rates.

Roth accounts are a way to avoid future tax consequences for those who will be in a higher tax bracket in retirement. This includes retirees whose income will shoot up at age 72 when they must begin taking required minimum distributions (RMDs) from traditional retirement accounts. The Roth option is also valuable for early retirees, who must wait to begin taking withdrawals from 401(k) or traditional IRA accounts until age 59.5 or pay a 10% penalty.

Another reason to choose a Roth account now? No one can predict the future, but tax rates are at historical lows. It is wise to assume that they will rise in the future, especially since the SECURE Act tax cuts expire after 2025. Finally, the Roth investment vehicle itself may be on the chopping block in the future as the government seeks ways to cover spending.

Some retirees may benefit from funding Roth accounts with rollover contributions after they have quit working (and income is lower) but before they reach age 72 (when RMDs start). It’s also a way for high-income individuals to avoid income limitations on Roth contributions. To explore a Roth rollover, check here.

Asset Allocation

Most people have a variety of accounts: taxable, traditional 401(k) or IRA, and a Roth 401(k) or IRA. Maximize your tax savings by holding the right investments in each type of account.

Taxable accounts are great for tax efficient investments. This includes stocks and stock funds, which produce capital gains. Capital gains are taxed at a lower rate than ordinary income, or sometimes not at all. Municipal bonds are also a good choice for taxable accounts, since they are not taxed.

Other bonds and bond funds may be best in traditional retirement accounts. Most of their returns, which are in the form of dividends, are taxed as ordinary income.

Withdrawals

Generally speaking, you should take money out of taxable accounts first, then draw down 401(k)s and IRAs, and save Roth accounts for last. “That’s a pretty good rule for the vast majority of people out there,” says David Blanchett, a co-author of the Morningstar study and head of retirement research at the financial services company.

But some investors may want to strategize further. For instance, if an investor has withdrawn funds to the limit of a certain tax bracket, it may be wise to take any additional monies from a Roth account to avoid getting hit with a higher rate. It’s a plan that can also be used to avoid hitting income levels for annual Medicare premiums and taxes on Social Security benefits.

Best Practices

To sum it up, there are a handful of ways to minimize taxes in retirement. Invest in Roths, make strategic withdrawals, choose tax-efficient investments, and invest for the long term. Find a fiduciary financial advisor to assist you with these complex decisions and you’ll be well on your way to the best financial outcome for your retirement nest egg.