Getting to retirement with a sufficient nest egg is a significant accomplishment in and of itself. But once your clients reach retirement there is more work to be done. The issue of which accounts to tap and in what order is one that deserves attention. One key driver of this decision is the tax implications of withdrawing your savings.

The Basics

Most of us know the tax implications regarding various types of accounts but let’s review the basics: (For more, see: Top Tax Strategies for Retirement Planning.)

  • Withdrawals from traditional IRA accounts are taxed as ordinary income. The exception to this is any portion that was contributed on an after-tax basis. Likewise, for traditional 401(k) accounts.
  • Withdrawals from Roth IRA accounts are tax free as long as the account holder is older than 59½ and the first Roth contribution was made at least five years ago. Roth 401(k) accounts receive the same tax treatment.
  • The sale of taxable investments is subject to preferential capital gains tax treatment as long as they have been held for at least a year and a day.
  • If annuitized, non-qualified annuities are taxed as a ratio of the cost basis to the total account value at the time annuitization commences. In the event of partial withdrawals, it is assumed that gains are taken first and they will be fully taxed. In either case all taxes are at ordinary income rates.

Social Security

Up to 85% of a client’s Social Security benefit can be subject to taxes. Social Security uses combined income which consists of adjusted gross income (AGI) plus one-half of the Social Security benefit, plus their non-taxable income from sources like muni bonds. This may or may not be a significant enough factor to determine which accounts to tap in a given year, but it certainly should be one consideration. There is no one right answer in terms of which accounts to tap and in which order, but let’s take a look at a couple of approaches. Keep in mind the best approach for a given client might change from one year to the next due to changes in their circumstances. (For more, see: Top Tips to Reduce Required Minimum Distributions.)

Taxable Accounts First

Investors who are 70½ or older would always need to take their required minimum distributions (RMD) from IRAs or other retirement accounts first. This includes any inherited IRAs that might require an RMD as well. Once those distributions are satisfied, one withdrawal strategy might be to tap the client’s taxable accounts first. The advantage is the ability to take advantage of the lower capital gains rates from the sale of any appreciated securities that are held for at least a year and a day.

For most clients the capital gains rate is likely to be 15%, though it could run as high as 20% plus an additional 3.8% Medicare tax for the highest income taxpayers. Even at the higher end of the scale these rates will usually be lower than paying taxes at ordinary income tax rates for distributions from traditional IRA and 401(k) accounts. This allows assets in tax-deferred retirement accounts like IRAs to continue to compound and grow tax-deferred until such time as the client uses up their taxable money. Likewise, with any Roth accounts which will continue to grow tax free. (For more, see: How to Calculate Required Minimum Distributions.)

The problem with this approach is that once the client uses up all of their taxable investments they must take distributions from retirement accounts which will be taxed at their ordinary income tax rate. They lose any tax diversification they might have had and their planning opportunities are a bit more limited.

Manage Tax Bracket

Rather than having a set order of the accounts to tap, you and your client should decide each year what their income situation looks like and react accordingly in terms of a withdrawal strategy. Financial advisors can help their clients look at their anticipated income needs and the state of their portfolio. This type of analysis should include:

Estimate the client’s taxable income. This entails doing a tax estimate before the impact of any retirement account withdrawals. Identify all other anticipated sources of the client’s income for the upcoming year. These might include investment income, Social Security (if they’ve already filed), any income from employment (including self-employment) and any required minimum distributions that must be taken. (For more, see: 5 Ways Your Clients Can Shrink Their Tax Footprint.)

Choose a target marginal tax bracket. After estimating the client’s taxable income, you will know where they expect to be and in which tax bracket they fall. For example, for a married couple filing jointly, the estimated 2016 15% marginal tax bracket goes up to $75,300 and the 25% bracket goes up to $151,900 of taxable income. The combination of targeting where the client realistically can be in terms of their tax bracket and balancing this against their cash flow needs will help guide which accounts to take distributions from. At this point there are a number of planning opportunities. If you have a lot of room left in the tax bracket perhaps it makes sense to take some extra from tax-deferred accounts. This will serve to reduce the amount of future RMDs. If the client is close to the upper limit of their tax bracket, perhaps they can tap a taxable account. If there is already cash in the account, then there shouldn’t be any tax ramifications from this withdrawal.

Other Considerations

Some other considerations for retirement account withdrawal tax planning include:

Timing of when to claim Social Security. If the client has other sources of income and cash flow and doesn’t need to take their benefit early on in retirement it generally pays to wait as long as possible to claim their benefit. This eliminates or defers the issue of paying taxes in the benefit. (For more, see: How Much Should Retirees Withdraw from Accounts?)

Consider qualified charitable distributions. If your client is charitably inclined, and is at least 70½ and doesn’t need the money, they should consider giving some or all of their required minimum distribution to a qualified charitable organization. The distribution will not be taxable and this may serve to reduce their taxable income which helps the following year for Medicare and other items.

The Bottom Line

Tax planning around retirement plan distributions is crucial and as a financial advisor is another way for you to add value to your client’s retirement planning efforts. Taxes can take a major bite out of their retirement assets and anything you can do to help mitigate their impact is a plus for your clients. (For more, see: Top Tips to Reduce Required Minimum Distributions.)

Read more: Tips for Tax-Efficient Retirement Plan Withdrawals | Investopedia
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