For many people, thinking about a comfortable retirement simply means contemplating enjoyable and leisurely ways of spending time during these “golden years” of life. For those closer to leaving the work force, and for younger individuals keen on planning ahead, considering retirement may also mean creating a comprehensive financial plan to prepare for their fiscal needs and desires, an approach we wholeheartedly endorse. What some people may not take into account, however, is the impact that taxation can have on retirement savings, investment accounts, and withdrawals for living expenses or spur-of-the-moment purchases.
Just as it is important to make a plan for contributions to your retirement fund – and it is never too soon to start – it is also wise to consider your strategy for withdrawals in advance of your actual retirement. This can help you to align your anticipated tax burden with your personal and financial goals, as well as to explore the options available to you with time to give each of them serious consideration.
In planning your future withdrawals from one or more retirement accounts, it is important to have a defined strategy for maintaining necessary income while minimizing the impact of taxes, all while keeping your portfolio balanced and your investments appropriate for your individual risk tolerance. Of course, this is an excellent time to work with your financial advisor and / or tax professional, and no one strategy is right for everyone. With that in mind, here are four general strategies you may consider as you make your plan for retirement on your terms. Please note that these are informational overviews only, and that BFA Wealth Management does not provide legal or tax advice.
#1: Keep it simple; withdraw from your accounts in sequence.
The least complex strategy of these four involves withdrawing from your accounts in an order that leaves tax-exempt accounts for last. In this scenario, you would first take required minimum distributions, or RMDs, from your retirement accounts – this avoids any penalties that may be assessed for failing to withdraw your full RMDs.
Next, you would withdraw from taxable accounts until you have reduced their balances to zero. Utilizing these taxable investments for retirement withdrawals keeps more of your funds in accounts where that money has the ability to grow while taxes are deferred; any such growth would enjoy higher potential for compounding interest, as taxes would not be levied until the time of withdrawals.
Third in this sequence, you would withdraw from your tax-deferred traditional retirement accounts. This leaves the remainder of your funds, in this hypothetical scenario, invested in one or more Roth accounts – from which qualified withdrawals will not be taxed, making them available without tax liability for predictable income later in your retirement plan, for unexpected expenses, or for passing on to your heirs if your Roth accounts will represent all or part of their inheritance from your estate.
This approach may be appealing due to its simplicity, but it does come with at least one potential drawback: while taking withdrawals from your tax-deferred accounts, your tax liability may increase enough to impact other areas of your financial plan. Should this be cause for concern, you may want to consider a strategy oriented around minimizing the likelihood of a shift in your tax bracket:
#2: Keep your tax bracket consistent; withdraw simultaneously from multiple account types.
If avoiding a bump up to a higher tax bracket is important to you, you may want to consider dividing up each of your planned withdrawals among several account types. By withdrawing from multiple accounts at a time, taking only a portion of your needed money from each, you may be able to balance potential taxable investment gains with tax liabilities associated with withdrawals from tax-deferred accounts. The goal of such a strategy is to manage your income with a targeted marginal tax rate in mind – one you would choose before proceeding with your retirement withdrawals, and which you would most likely have to revisit with fresh calculations before each tax year of your retirement.
Yet another consideration you should include in your financial plan is the income you may be eligible to receive from Social Security benefits, for which the IRS maintains a unique taxation formula. If limiting your tax liability on Social Security benefits is a prime concern for you, you may want to organize your retirement plan around a third strategy created for just this purpose:
#3: Keep tax liability on your Social Security benefits to a minimum; actively manage your withdrawal distribution much as you would in strategy #2.
If you intend to minimize your tax liability on Social Security benefits, a strategy you may want to consider involves distributing your withdrawals among several accounts in much the same way you might if your goal was maintaining a desired target tax bracket. Social Security benefits are treated differently than ordinary income or investment gains by the IRS; as such, any approach that focuses on minimizing tax liability on Social Security benefits must also account for any additional income, whether from non-investment sources or from retirement accounts or other portfolios.
The same general principle we outlined in strategy #2 is at play here, but with one key difference: instead of targeting a specific tax bracket, you would instead be focusing on IRS thresholds for taxation on Social Security benefits. Your goal here would be to organize your withdrawals, and resulting taxable income, around staying within the income bracket you wish to target. As with each of the hypothetical scenarios we have outlined here, this is a complex matter that you should discuss with your tax professional and / or financial advisor before making adjustments to your financial plan.
If you find yourself contemplating the prior three concepts and asking how each could impact your capital gains tax rate, you may wish to consider a withdrawal plan that centers on capital gains tax liability more prominently. In that case, our fourth scenario may be worth considering:
#4: Keep your capital gains taxation to a minimum: focus on long-term advantages early on.
As your investments may carry the potential for gains, as well as losses, any increase in the value of your portfolio may be subject to capital gains taxes. While the IRS updates their regulations frequently, as of the 2016 tax year, individuals in the 10% and 15% tax brackets were able to realize long-term capital gains, or to receive qualified dividends, free of taxes on this income (current information is always available at IRS.gov). This means that individuals whose taxable income fell into these brackets for the 2016 tax year could have sold investments held longer than one year at a notable tax advantage during this period.
If a large percentage of an investor’s retirement assets were held in taxable accounts during this period, and a lesser amount was realized from income such as Social Security benefits, they could have incurred a potentially favorable tax scenario by selling longer-term stock holdings. This may or may not be true in any given year, and it is critical to keep abreast of the regulations imposed by the IRS on each aspect of your financial plan as well as on each scenario that you may consider when discussing potential changes to your plan with your financial advisor and / or tax professional.
These are just a few of the potential options available to individuals concerned with taxation on their retirement earnings, and are not intended to be representative of the broad array of choices any given investor may consider. These general, broad-stroke strategies are presented for informational purposes only, and are intended merely to help you start considering your options as you begin to outline a financial plan for the future as you define it. BFA Wealth Management does not provide legal or tax advice, and we encourage you to consult with the tax professional of your choice when considering the role that present and future taxes may play in your plans for retirement or otherwise.
One key area where our firm can play an important role in the process of planning your financial future is in acting as project manager for the team of specialized professionals you trust to advise you on critical matters. BFA Wealth Management often works with clients who have built relationships of trust and loyalty with professionals in areas such as tax and accounting, divorce law, estate planning, and real estate, to name just a few. We would never ask that any client of ours forego these rightly-earned relationships simply to refer a member of our own network. Rather, when any matters in our clients’ lives have the potential to affect their financial plans, BFA Wealth Management can take a leadership role in collaboration with other professionals in service of our mutual clients. As a true fiduciary, we advocate on behalf of your financial goals, as well as handling the technical details of working to make them a reality – alongside any other trusted professionals you’ve chosen to advise you, freeing up more of your time to be spent living your life and making plans for your future.
If you would like to learn more about how various withdrawal strategies may impact your retirement plan or investment portfolio, or if you are interested in getting a second opinion on the plan you have already set in motion, BFA Wealth Management would be happy to offer you a complimentary investment analysis and risk management assessment to help you understand the options available to you. Contact us today to learn more about planning your retirement on your terms or to schedule your complimentary, zero-obligation investment analysis. Let’s talk.
(BFA Wealth Management is not affiliated with, nor endorsed by, the Social Security Administration or any other government entity.)