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How to Minimize Taxes in Retirement

Written by Brian Puckett, CFP®, CPA/PFS, Attorney at Law.

If you're an investor, you've surely heard the saying "It's not what you earn, it's what you keep." Minimizing taxes is important when you're growing your savings for retirement—but it's at least as important after you're retired.

That's why retirees with different types of taxable and tax-deferred accounts should carefully plan the sequence in which they will withdraw money from those accounts. At stake is not just tax savings but also the potential for greater investment growth.

The various account types include traditional IRAs and workplace plans such as 401(k)'s, which are funded with pre-tax dollars. In these vehicles, taxes are deferred until withdrawal so that those assets can compound and grow faster. Roth 401(k)'s and Roth IRAs are funded with after-tax dollars, and their assets grow and are withdrawn tax-free. Finally, many investors have taxable brokerage accounts, which are funded with after-tax dollars and accrue taxes on gains, interest, and dividends.

Let's look at some of the rules and guidelines when it comes to retirement-account withdrawals. One rock-solid rule is that retirees should prioritize taking their required minimum distributions (RMDs) from their traditional 401(k) or IRA. Failing to do so will trigger penalties—half of the withdrawal that was required—that outweigh any other advantage.

RMDs kick in at age 70 ½. They are calculated based on your life expectancy and the assets in your account. A simple example: A retiree with a 20-year life expectancy and $100,000 in a traditional IRA would be required to withdraw one-twentieth of his assets ($5,000) and pay tax on that amount.

Beyond that, the rules should be considered more flexible based on your individual circumstance and needs. Once RMDs are taken, the standard sequence is to withdraw from taxable accounts, then tax-deferred accounts, then Roths, in order to minimize the tax bite.

In general, taxes are highest on traditional 401(k)'s and IRAs. Withdrawals from these accounts are subject to ordinary income tax, with rates as high as 39.6%. By comparison, long-term gains and qualified dividends in your taxable account are taxed at a lower rate that tops out at 20%.

It's often best to leave Roth accounts for last. Since they are not subject to RMDs and assets are withdrawn tax-free, it makes sense to let the account balances grow as large as possible.

Withdrawal planning should be flexible from year to year. One reason is that an individual's tax picture can change based on their expenses, their available deductions and other factors. For instance, large deductions in a given year could drop you into a lower tax bracket. In such a case, it may make sense to withdraw more from a traditional 401(k) or IRA to take advantage of the temporary low tax rate.

On the other hand, retirees should take care to avoid having withdrawals kick them into a higher tax bracket. The bottom line: The taxman doesn't retire when you do. To minimize taxes and to stretch your retirement income as far as possible, withdrawal planning is a must. Please contact us with any questions you may have.