It is not unusual for a new retiree to have multiple accounts, including traditional retirement accounts, Roth accounts, and taxable savings or brokerage accounts, but not have an adequate understanding of how to tap into those accounts in a way that maximizes their available capital. There are many issues for consideration and many risks for the unwary or unknowledgeable.
The traditional approach for management was to focus almost entirely on what would reduce taxes the most; based on the conceptual assumption that tax reduction meant the most money in the long run. One strategy to this end was to have retirees withdraw amounts from their accounts proportionately: the amount withdrawn being an amount proportionate in relation to the retiree’s overall accounts in total. This concept is now almost archaic in comparison to new approaches that have been refined over the past 20 years.
Today’s modern planning focuses not only on tax savings issues, but also upon rates of return and estate planning options. As one commentator warned, “Tax minimization is not the same as tax efficiency.” The meaning behind this statement is reducing taxes does not necessarily mean increasing income.
One basis for the warning is that different assets have different tax treatment. For example, savings accounts trigger ordinary income while investment holdings often trigger long term capital gain at reduced rates: sometimes even resulting in no tax liability on Roth plans. These tax implications need to be considered, but they are far from the sole determinant of what course of action is best. Why? Because factoring in the productivity of assets, your gain to date and the reasonable expectation for well-above average returns going forward, may indicate that investments expected to catapult over time may be worth the added taxes incurred. “Strategies that produce the highest final total account balance rarely produce the lowest taxes” is a good maxim to keep in mind.
The internet can be a useful tool and can be used to find articles discussing some of the issues that one must face when planning retirement. The following examples provide a brief illustration of some of the important considerations:
1. How much gain do you have in your assets? A single person can earn up to $38,600 in long term capital gain before incurring any tax liability, $77,200 for a married couple, so selling just enough to live on up to these thresholds can be a good strategy if the are low-growth stable investments. However, if they have been large gainers and you think such gains may continue, selling other assets may make more sense.
If you wish to sell more than the maximum amount of assets, the tax rate between $38,600 and $425,000 in capital gain earnings is 15% and gains in excess of $425,000 are taxed at 20%. Married filing jointly would have double the thresholds. If you are in an enviable position and have long-term capital gains of this magnitude, you might be less averse to the tax bite.
2.Tax loss Harvesting – For those above the aforementioned thresholds, tax law provides an opportunity to mitigate liability incurred. Capital assets sold at a loss serve to reduce the amount of capital gain recognized. For example, an asset sold at a $20,000 capital loss would effectively increase the thresholds by $20,000. – meaning you could have up to $58,600 in capital gains before incurring tax liability. As every tax year comes to an end, this is an issue to review.
3. Required distributions – Some retirees are required to receive minimum distributions due to age or a retirement plan’s rules. For example, people may be required, due to age, to take at least 3.65% of their plan assets at age 70 and/or 5.35% at age 80. Other plans may require a certain minimum, such as 10%, be taken out per year. Be sure to take both age and Plan issues into account so you do not get penalized. Even worse than minimum distributions can be mandatory distributions of various sized because of a triggering event such as death, termination, disability or retirement. Be sure to check your Plan language for any mandatory distributions.
4. Limitations on withdrawals – On the opposite end of the spectrum, some plans may place a cap on how much can be liquidated in a year. If you are in a Plan enforcing a maximum cap, you need to take into consideration how much can be siphoned off from the Plan during a year. Some people may elect to play the “calendar game”, the practice of taking out a maximum distribution in December and another max distribution in January of the following year. The tax implications of the withdrawals are not changed, but the retiree may find benefit or comfort in planning withdrawals in this way.
5. Are you planning to pass assets to heirs? If you are trying to pass on a large amount of assets, your thought process will likely be different due to two primary concerns. Firstly, passing along assets that have a large amount of long-term capital gains is a smart idea because of the automatic step up in basis that occurs in the event of your death. Secondly, if you are married, the assets passing to your spouse are tax free and qualify for the step up in basis.
6. Clear rules for all strategies – Specified financial needs, such as living expenses, itemized deductions and taxes, should first be satisfied by Social Security and cash account withdrawals. All interest and dividends are tie be reinvested. Withdrawals occur on the first day of the year. While some retirees may find these rules petty and simple, some experts have clearly identified these rules as being required to be followed as much as possible if the primary goal is to maximize the final total account balances. Of course, special needs can arise in a year and render one or more of these rules impractical. Following these rules, however, should maximize total end balances.
7. If you start planning early enough, you might be able to accomplish the highly desired “Roth conversion” – As one expert explained, “Basically starting at age 59.5 you try to take taxable income to the top of the 15% tax bracket and move that money into a Roth IRA. Rother IRAs offer two huge benefits. Your savings grow tax free and can be withdrawn tax-free. And the tax-free benefit can be passed onto future generations so it’s a very powerful estate planning tool.”
A Rother conversion is the best of all worlds and readers are best advised to consider how they can accomplish such a conversion.
While this list of issues is not intended to cover every possible issue that may arise, the research is clear that these are the primary issues which one should take into consideration when engaging in retirement distribution analysis where the primary goal is maximization of total account balance through proper account sequencing.