by Ryan W. Smith
Managing retirement account withdrawals is not as simple as setting up a monthly deposit into a checking account. Making sure funds last as long as possible, whether drawn to pay expenses or still in the account, is among the most important facets of retirement planning.
While regular expenses, minimum distributions and unplanned expenditures are all part of the equation, few variables are more important to retirement account than tax liabilities posed by withdrawals. There are fewer CPAs active currently than years past, partly due to technology making it easier for non-certified professionals to do some of the work, which is leading many financial advisors to be much more involved in tax planning than they were even 10 years ago for all investment accounts, including retirement accounts.
Therefore, a well-thought-out, informed implementation of tax minimization during a withdrawal strategy can both increase the amount of spending the account is able to sustain as well as prolong the life of the account in the first place.
Here are four ways to minimize tax liabilities for retirement account withdrawals:
1) Required Minimum Distributions
Any person over 70½ years old with assets in a tax-deferred retirement account must take a required minimum distribution (RMD) or face 50% taxes on that required withdrawal amount. Accounts where the RMD is applicable include Traditional IRAs, Simple IRAs and SEP IRAs, along with 401(k) accounts, profit-sharing plans and 403(b) accounts. Roth IRAs do not have a withdrawals component until the owner’s death.
The IRS provides a required minimum distribution worksheet at https://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf. For example, if someone owns a Traditional IRA that had a $1,000,000 balance on December 31 of the year before they turned 70½, the IRS table says they have “distribution period” of 27.4. Therefore, the amount of their required minimum distribution would be $1,000,000 / 27.4 = $36,496.35 per year.
2) Pay Attention to Taxable Amounts
All interest, dividends or capital gains that are part of distributions from taxable accounts, are in fact, taxable. It doesn’t matter if those distributions are spent or reinvested, these amounts are typically taxed at the long-term capital gains tax rate so long as they are held for at least one year. For most the long-term capital gains tax rate is 15%, but for those in the highest tax brackets, long-term capital gains are taxed 20%.
Any income from bonds is typically taxed at regular income rates, but funds which exclusively hold US Treasuries can be exempt from state taxes, while any income from municipal bonds are tax-free altogether.
3) Tax-Advantaged Accounts versus Tax-Free Accounts
Deposits into some accounts, traditional IRAs, Simple IRAs, Rollover IRAs and SEP IRAs, along with 401(k) accounts were not taxed. Because of this, their withdrawals are taxed at income tax rates. Meantime, deposits to Roth IRAs are after-tax so they have tax-free withdrawals.
One important factor to consider when determining whether to pull funds from tax-free or tax-advantaged accounts is present versus future tax rates. If, for example, future tax rates will be lower for an individual, it is often best to withdraw money from a tax-free account first, since future tax burdens will be lower. This scenario would most likely come into play for a retiree who is working part-time in addition to receiving retirement benefits which might include social security.
4) Beneficiaries and Heirs
While it might be prudent to withdraw money from a tax-free account while still working part-time, retirees who want to pass assets to their heirs with minimal tax burdens might want to delay pulling money from any Roth IRA accounts. Amounts from Roth IRAs can be withdrawn or passed to heirs tax-free. Rollover IRAs, 401(k)s and Traditional IRAs are taxable to heirs, who might have a higher tax rate than the retiree who left the sum.
In cases like these, retirees might want to spend down the tax-deferred assets so any potential tax burden to heirs is reduced as much as possible. Another way to do this is with stocks a retiree has held for a long time since heirs would only have to pay taxes on gains from the time of inheritance until selling, called a “step-up.” This means the Ford stock a retiree has held since 1977 would have a much lower tax burden after inheritance, rather than merely selling the stock so that the assets become part of the estate.
Tax concerns for retirement withdrawals are among the most important variables to ensuring that retirement accounts provide the necessary income needs, and hopefully, estate assets that a retiree wants to leave. It is incumbent on financial advisors to be aware of factors like health of the retiree and her spouse, possible unplanned large expenditures the retiree is exposed to such as dental work, an older home that might need a roof or water heater or a car that needs engine work.
Prudent advisors will begin to look at tax ramifications early in their relationship with a client. For example, it might be wise to utilize Capital Gain Harvesting while a client still has a lower tax rate. Because there is no wash-gain rule prohibiting repurchases, a client can immediately go back in and repurchase the positions. However, their long-term capital gains have been locked in at their current, lower tax rate. The more well-known Capital Loss Harvesting can be utilized in the opposite scenario, where capital losses can help reduce tax burdens for those in higher tax brackets.
Technology can benefit advisors in myriad ways in helping their clients reduce tax burdens for retirement withdrawals. Some will utilize tax preparation software to assist in their preparation. Many other advisors will use calculators and widgets like AdvisoryWorld’s Monte Carlo simulation that can assist in forward-looking projections based on current allocations, historical return and standard deviation information. Many of these programs, like AdvisoryWorld’s, will also allow for input of future cash flows, both deposit and withdrawals, to help paint a fuller picture of future considerations that clients and advisors need to consider.
Provided that the main objective for an advisor is to utilize tax ramifications for accounts and withdrawals in a manner than extends the life of retirement accounts, the tools above and many others make this more possible today than ever before.