As the busy tax season gets into swing, we like to tap friends in the financial planning world to help our clients and subscribers with their planning. Jeremy Gussick of LPL Financial is no stranger to our subscribers. Today, he talks about taking distributions from various types of retirement accounts in the most tax-efficient manner.
Did you know that the vast majority of assets currently saved for retirement in this country are all in the same tax-structured account type? And by saving in this fashion, you may be placing some significant limitations on your ability to grow and distribute your assets during retirement in the most tax-efficient manner? In addition, you may be setting yourself on a path that could almost guarantee your Medicare premiums will be more expensive in retirement as well.
In general, there are three types of accounts we can use to accumulate assets for retirement, and each type has its own unique tax characteristics.
- Taxable Accounts: these would include your typical brokerage or investment accounts, checking/saving accounts, etc. Simply put, activity in these accounts can generate taxes each year, even if you do not actually take distributions.
- Tax-Deferred Accounts: these would include your Traditional IRA’s, 401k, 403b, 457 plans, etc. With these you typically receive a tax-deduction when contributing, and you pay income taxes only when you take distributions.
- Tax-Free Accounts: these would be your Roth IRA’s and Roth 401k’s. You do not receive any tax deduction when contributing to these accounts, however they grow and are distributed tax-free (assuming certain rules are followed).
According to the IRS Statistics of Income Division at the end of 2018, 91% of all IRA assets were in Traditional IRA accounts, while only 9% were in Roth IRA’s. Similarly, according to Vanguard’s How America Saves 2018 Report, which analyses Vanguard retirement plan participant habits, of the 68% of Vanguard retirement plans which offer Roth 401k options, only 12% of the participants in those plans are using the Roth option. Does this sound like you?
Unfortunately many people approaching or living in retirement find themselves with the vast majority of their assets in tax-deferred accounts. If you’re one of these people, and you are at or beyond your Required Minimum Distribution (RMD) age, your planning options may be limited. If you need to distribute money to pay your expenses, you will have little choice but to pay income taxes on these distributions, at the current tax rates. And if you need to distribute a significant amount for an unexpected expense in any given year, you could find yourself in a much higher tax bracket.
How to Distribute Your Retirement Assets to Minimize Taxation and Maximize Savings.
Hopefully, you’re fortunate enough to be someone who does have some tax diversification in their savings, with assets in several of the account types listed above. This may create some planning opportunities to help you minimize your taxes in retirement, while maximizing the potential growth of your retirement assets.
Once you transition to retirement, your first sources of retirement income are likely to be your Social Security benefit and perhaps a pension (if you’re fortunate to have one). Beyond these sources, the common research would suggest the following distribution order from your various retirement accounts to meet your additional income needs:
- If you are of RMD age (previously 70 ½), you should first take your Required Minimum Distribution income from your tax-deferred accounts. With the signing into law of The SECURE Act in December 2019, RMD’s will now be delayed to age 72 for anyone who will turn 70 ½ in 2020 or later.
- Next, you should take any additional income needs from your Taxable Accounts. This allows you to potentially capture long-term capital gains tax rates on these distributions, rather than higher income tax rates, while also allowing for continued growth of your other tax-deferred and tax-free accounts.
- If you still need additional income to meet your spending needs, most advisors would likely suggest you take additional distributions from your Tax-Deferred Accounts. The theory being that the tax-free growth benefits of the Roth accounts should be touched last. However, depending on where your income level falls in any particular year, splitting the remaining distributions from your tax-deferred and Roth accounts may make more sense, especially if you need to keep your income below thresholds which could create additional taxation and/or Income Related Monthly Adjustments (IRMAs) on your Medicare premiums.
- Lastly if you’ve depleted your other accounts, then you would access your Tax-Free Roth Accounts. Allowing these accounts to defer the longest provides for the potential of additional years of tax-free growth. In addition, Roth accounts are a great estate planning tool, as they maintain their tax-free status when distributed to beneficiaries.
Strategy for Those Retiring Well Before RMD Age
As I referenced, the above distribution order is what common research would typically suggest. However, as an Advisor who primarily serves clients who are in, or approaching retirement, I find that there are often scenarios which may suggest a different path.
For example, if you’re retiring with the vast majority of your assets in tax-deferred accounts, and you have some time before you will reach your RMD age, it may make sense to consider delaying your Social Security benefits, and instead drawing down assets from your tax-deferred accounts first during those years. Or, if you do not need the additional income to support yourself, you may consider doing small Roth Conversions during these years, which is the process of taking tax-deferred assets and converting them to Roth assets, so the future growth and income will be tax-free. (Naturally you’ll need to pay income taxes when you do the conversions, so it’s important to involve your tax professionals in this process).
Considering these options may provide several significant benefits:
- First, you may end up paying less in income taxes on these distributions/conversions while your income is lower, versus perhaps a higher income when you combine your future RMD’s with your Social Security benefits later down the road. And since you’ll know what the current tax brackets are in any given year, you can control how much you distribute each year, to avoid jumping into a higher tax bracket.
- Second, by delaying your Social Security benefit potentially to your maximum benefit age of 70, you will be increasing your guaranteed income from Social Security by no less than 32% if you’re delaying from age 66 to age 70, or no less than 24% if you’re delaying from age 67 to age 70 (plus any cost-of-living adjustments that are announced during those years).
- Third, by drawing down your tax-deferred assets earlier and/or converting them to Roth accounts, you will potentially be reducing your future RMD’s, as your tax-deferred balances will be lower, and Roth IRA’s do not have RMD’s. Being forced to take higher RMD’s, even if you don’t need the income to live, can create additional taxes later in life. And since Medicare premiums are income-based, your Medicare premiums can end up costing you more each year, simply due to these higher RMD’s.
If You Still Have Some Years Before Retirement – Review Your Savings Plan NOW
Most retirees with wealth are shocked to learn the impact their RMD’s will have on their taxes, their Medicare costs, and ultimately their assets and income in retirement. And usually, by the time they figure it out, it’s too late to do much about it. For those of you who still have some time before you’ll be contemplating retirement, you have the opportunity to make some wise savings decisions today, which can significantly impact your tax flexibility in retirement.
I recommend you consult with your financial and tax advisors to review your current retirement savings strategy to make sure it includes a balance of the various types of tax-structured accounts available to you. Hopefully you’ll just be confirming that you’re already on a good path. But if you’re not so sure, please ask your advisors to help you understand your current savings strategy, and the short and long-term pros and cons of potentially considering a different approach. Trust me, it will be time well spent.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Please consult me if you have any questions.
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Jeremy Gussick may only discuss and/or transact securities business with residents of the following states:
CA, DE, FL, MI, MO, NC, NJ, NY, PA, TX.
Jeremy R. Gussick, MBA, CFP® is an independent CERTIFIED FINANCIAL PLANNERTM professional who focuses on Retirement Income Planning. He can be reached at email@example.com. Jeremy Gussick is not affiliated with Drucker & Scaccetti, which is a separate entity from LPL Financial.