Managing Taxes During Retirement: An Ongoing Concern

In Cash Flow and Budgeting, Estate Planning, General Financial Planning, Personal Financial Planning, Retirement Planning, Tax by Chip Hymiller

During the “accumulation” phase, the decision of where to invest your money is somewhat automated.  Making contributions to 401(k) plans, Roth IRAs and personal brokerage or mutual fund accounts is pretty straight forward and can remain on auto pilot for years.

However, for retirees taking money out of their investment accounts, the decision of “which account?” can be a bit more cumbersome.  In fact, most retirees should reassess their distribution strategy on an annual or even semi-annual basis.

Why is this decision an important one?  To answer this question, it is important to understand how distributions from various types of accounts are taxed.  Consider the tax treatment from each of the following types of accounts:

IRAs and 401(k) Plans (qualified accounts).  Withdrawals from qualified retirement plans are considered “taxable” income and are generally taxed to individuals (at their tax rate) on a dollar for dollar basis.

Personal accounts (non-qualified accounts).  Personal accounts can be established at brokerage firms, mutual fund companies and banks.  Income, interest and capital gains generated in these accounts are taxable in the year they are earned or realized.  If a stock or mutual fund is sold, the gain on the sale is a capital gain and is generally taxed at capital gains rates.  Investment losses realized in personal accounts can be used to offset gains and up to $3,000 of taxable income.   Taxes are paid as income is earned or realized, not as they are distributed. 

Roth IRAs.  Income, interest and capital gains realized in Roth IRAs are not taxable.  In addition, distributions from a Roth IRA by those above the age of 59 1/2 (with some exceptions) are not taxable.  From a tax standpoint, distributions from Roth IRAs are much more favorable than personal accounts or IRAs.Financial Tax Planning Investment Adviser Chapel Hill Cary Raleigh RTP

Tax Management

As you can see, each type of account has varying tax attributes.  As such, with proper planning it is possible to effectively control, or at least manage, taxable income.  In doing so, there are a number of other items that may be impacted including:

  • Taxability of Social Security
  • Deductibility of Medical Expenses and other Miscellaneous Itemized Deductions
  • Cost of Medicare Part B Premiums
  • Effective Income Tax Rates

Other Financial Planning Considerations

While it is important to consider the tax impact when developing a retirement distribution strategy, there are times when it is appropriate to take a more holistic approach.  This is particularly important when making multi-generational and estate planning decisions.  Consider the following example:

You are 65 years of age and are currently in the 15% marginal tax bracket.  You have designated your son, as the beneficiary of your IRA.  As the owner of a successful business, your son expects to remain in the highest tax bracket and has never been able to contribute to a Roth IRA. 

Together, you decide that it is appropriate to execute a Roth conversion strategy, whereby you convert a portion of your IRA into a Roth.  In doing so, the distribution from your IRA is taxed to you at your lower tax rate.  At your death, your son will inherit the Roth IRA and distributions would never be taxed.

As you can see, making tax-efficient distribution decisions during retirement can create significant tax savings for you and your family.  We believe that proactively managing your tax strategy is an integral component of a financial planning and investment advisory relationship.  Please contact our office should you have any questions.