The Finance Of Longevity

Retirement Income & The Tax Bite

3 ways to manage retirement withdrawals tax-efficiently

New research from Fidelity Viewpoints. Reprinted with permission. Visit here for more information

Chances are your clients contributed to a 401(k) or IRA as they saved for retirement. Now the time has come to use that money. Withdrawing from retirement savings accounts with an eye toward reducing taxes is important. Taxes can reduce income, as well as diminish potential future earnings and growth, which affects how long savings may last.

“The important thing to remember is that managing withdrawals with taxes in mind can help boost income in retirement,” explains Ken Hevert, senior vice president of retirement at Fidelity. Let’s start by reviewing the types of investment accounts and then some tax-efficient ways to withdraw from them. Of course, everyone’s situation is unique, so it is important to consult a tax professional.

3 types of Investment Accounts

A typical retiree may have 3 types of accounts: taxable, tax-deferred, and tax-exempt. Each has an important, but different, role to play in helping manage tax exposure in retirement.

Taxable accounts such as bank and brokerage accounts. Any earnings from these accounts, including interest, dividends, and realized capital gains, are generally taxed in the year they’re generated. In the case of capital gains, keep in mind that any increase in value of the accounts’ investments, such as mutual fund shares or an individual stock, isn’t a taxable event in itself. It’s only when an appreciated investment is sold that the gain is realized: that is, it generates a taxable capital gain or loss. When you own a mutual fund, however, capital gains may be realized by the fund manager and distributed to you—often subjecting you to a tax liability—even if you haven’t sold your fund shares.

Tax-deferred accounts such as traditional IRAs, 401(k)s, 403(b)s, SEP IRAs, and annuities. Most, or all, of contributions to these accounts were likely made “pretax.” That means ordinary income tax on those contributions is owed when withdrawals are made in retirement. Any earnings from these accounts are also typically taxed as ordinary income when they’re withdrawn.

Tax-exempt accounts such as health savings accounts (HSAs), Roth IRAs, Roth 401(k)s, and Roth 403(b)s. Contributions to these accounts are typically made with after-tax money. That means the contributions—and any earnings—are not taxable at withdrawal, provided certain conditions are met.1

Manage withdrawals to help reduce taxes

The aim is to manage withdrawals to help reduce taxes, thereby maximizing the ability of remaining investments to grow tax-efficiently.

The simplest, most basic withdrawal strategy is to use money from savings and retirement accounts in the order below, with one important caveat. For certain retirement accounts, if you are 722 or older, required minimum distributions (RMDs) come first. For inherited qualified accounts like a traditional IRA, RMDs may come before age 72, but the rules are complex, so be sure to check with a tax professional.

1. Taxable accounts (brokerage accounts)
Money in taxable accounts is typically the least tax-efficient of the 3 types. That’s why it usually makes sense to draw down the money in those accounts first, allowing qualified retirement accounts to potentially continue generating tax-deferred or tax-exempt earnings.

Investments may need to be sold when taking a withdrawal. Any growth, or appreciation, of the investment may be subject to capital gains tax. If you’ve held the investment for longer than a year, you’ll generally be taxed at long-term capital gains rates, which currently range from 0% to 20%, depending on your tax bracket. (A 3.8% Medicare tax may also apply for high-income earners.) Long-term capital gains rates are significantly lower than ordinary income tax rates, which in 2019 range from 10% to 37%. These are federal taxes; be aware that states may also impose taxes on your investments. If you have a loss, you can use it to reduce up to $3,000 of your taxable income, or to offset any realized capital gains.

Investments may need to be sold when taking a withdrawal. Any growth, or appreciation, of the investment may be subject to capital gains tax. If you’ve held the investment for longer than a year, you’ll generally be taxed at long-term capital gains rates, which currently range from 0% to 20%, depending on your tax bracket...

2. Tax-deferred accounts, such as traditional IRAs, 401(k)s, 403(b)s, SEP IRAs, and annuities
You’ll have to pay ordinary income taxes when you withdraw pretax contributions and earnings from a tax-deferred retirement account, but at least these investments will have had extra time to grow if you take withdrawals from a taxable account first. You may find yourself in a lower income tax bracket as you get older, so the total tax on your withdrawals could be less.

On the other hand, if your withdrawals bump you into a higher tax bracket, you might want to consider taking withdrawals from tax-exempt accounts instead. This can be complex, so it is a good idea to consult a tax professional.

And remember, the IRS requires you to begin taking RMDs from IRAs the year you turn 72. For employer-sponsored accounts, like a traditional 401(k), you may be eligible to delay taking RMDs if you’re still working at the company and do not own 5% or more of the business. You cannot, however, delay starting RMDs for retirement accounts for employers you no longer work for.

3. Tax-exempt accounts, such as Roth IRAs, Roth 401(k)s, Roth 403(b)s, and HSAs
Last in line for withdrawals, generally, is money in tax-exempt accounts. The longer these savings are untouched, the longer the potential for them to generate tax-free earnings. And withdrawals from these accounts, in most cases, won’t be subject to ordinary income tax. They’re totally tax-free, as long as certain conditions are met.1

And leaving any Roth accounts untouched for as long as possible may have other significant benefits. For example, money for a large unexpected bill can be withdrawn from a Roth account without triggering a tax liability (as long as certain conditions are met1. Qualified Roth withdrawals are not factored into adjusted gross income (AGI) because they are not taxable income. This may help reduce taxes on Social Security and other income because they don’t bump up taxable income.

For Roth IRAs, it is important to note that RMDs are not required during the lifetime of the original owner, but for Roth 401(k)s and Roth 403(b)s, the original owners do have to take RMDs. That can be a good reason to consider rolling Roth 401(k)s and 403(b) accounts into Roth IRAs. Roth accounts can be effective estate-planning vehicles for those who wish to leave assets to their heirs. Any heirs who inherit them generally won’t owe federal income taxes on their distributions. On the other hand, Roth accounts are generally not an advantageous vehicle for charitable giving, so those involved in legacy planning may want to avoid the use of Roth accounts to the extent that this money is intended for charity. Be sure to consult an estate planner in either case.

You may also have access to another type of tax-exempt account, an HSA, which is typically used to pay for qualified medical expenses like vision and dental care, hearing aids, and nursing services. You can also use your HSA to pay certain Medicare expenses, including premiums for Part B and Part D prescription-drug coverage, but not supplemental (Medigap) policy premiums. For retirees over age 65 who have employer-sponsored health coverage, an HSA can be used to pay your share of those costs as well.

Lastly, your HSA can be used to cover part of the cost for a “tax-qualified” long-term care insurance policy. You can do this at any age, but the amount you can use increases as you get older.

Creating a Plan

While the traditional withdrawal hierarchy of taxable, tax-deferred, and tax-exempt assets is a good starting point for many retirees, a person’s situation and changing circumstances may mean making adjustments. That’s why it is important to have an overall retirement income plan and regularly revisit it and update it when necessary. (Create a plan with our Planning & Guidance Center.)

Suppose, for example, that a person’s tax rate will be higher later in retirement than in the first few years. For instance, they move from a low-tax state to a high-tax state. If so, they might want to consider strategies where they pay taxes on their retirement savings earlier in retirement in order to potentially lower taxable income later. One way to do that, depending on a person’s situation, would be to shift more of savings to a Roth IRA by converting a portion of a traditional IRA.

Those who have a significant portion of investments in taxable accounts may be looking for ways to lower a tax bill on the earnings as they gradually draw down the principal to cover retirement living expenses. One consideration that might help is to invest the bond portion of taxable accounts in a diversified mix of municipal bonds, the earnings from which are generally exempt from federal income tax.

Another situation that many retirees experience when they begin withdrawing money from their traditional IRA or 401(k) is that the amount pushes them into a higher tax bracket. In that case, it might make sense to consider withdrawing from a tax-deferred account until taxable income nears the top of a tax bracket, and then tapping a Roth or other tax-exempt account for any additional income.

Those age 72 or older who don’t need their RMDs for retirement income might also consider making a qualified charitable distribution (QCD) to satisfy all, a portion of, or even an amount greater than an RMD—up to the IRS limits ($100,000 in 2019). Because the amount donated directly from an IRA to a qualified charity isn’t considered taxable income, this move can help avoid being pushed into a higher tax bracket. It can also be a very useful strategy for those whose high incomes result in phaseouts of itemized deductions. Be sure to consult a tax professional in such cases.

Other factors that could play a significant role in a retirement tax strategy are whether a person intends to continue working, the income tax rate in the state and locality where they plan to retire, and how much of an inheritance they would like to leave for family members or to a charity.

Know Your Situation

The keys to managing withdrawals from retirement accounts are to know your situation and tax exposure, to understand the basics of smart tax planning, and to consult a trusted professional to get the help you need in designing a tax-efficient retirement income plan.

You work long and hard to build retirement savings; smart tax planning can help keep your savings working for you.