Retirement Income Planning: Let’s Be Tax Efficient!

Congratulations! You made it to retirement, but saving money in different types of investment accounts is only half of the battle. The other half is how do you get your hard-earned assets back to you in a tax efficient manner? There are a number of retirement distribution strategies that can be used to stretch your money further for a long retirement and these can be combined and changed over time. These strategies are specific to each person’s own situation, and is why it makes sense to review your financial plan often. Some of the specifics could include the current market conditions, an individual’s tax rates, and expected longevity.

One strategy I would like to discuss is what is called the flooring strategy. Some accounts provide a guaranteed amount of money on a regular schedule, and provide for your basic necessities. This would include things like Social Security, pensions, or the income you receive from purchasing an annuity. This income is automatic, recurring, and is not tied to market performance. The idea behind the flooring strategy is to build up enough of this guaranteed income to meet your basic needs.

How can you accomplish this? One option would be to delay your Social Security benefit as long as you are able, or until your plan dictates which would provide the most optimized benefit for your situation. Each year you delay your Social Security benefit past full retirement and until you reach age 70 will provide you with an 8% increase in your benefit per year resulting in a significantly larger benefit at age 70 versus 62 or even full retirement age.  For married couples keep in mind the survivor will receive the larger of the two Social Security benefits so the decision to delay really affects two people not just one.

Another important thing to consider is keeping up to a year of spending needs in cash reserves outside of your investment accounts.  Why would you do this when interest rates are so low?  Because as we just witnessed in March of this year, the stock market can be very volatile and cause major drawdowns in your investment portfolio.  While bonds should be used as a buffer against the volatility, holding cash outside of your investment portfolio can be effective as well.  While the 2020 Coronavirus Bear Market was a rapid decline followed by a quick recovery, most Bear Markets are not as fast and can take 2-3 years to recover the portfolio losses.  Having a year of spending in cash prevents you from having to dip into your investment portfolio to cover living expenses while you are waiting for the accounts to recover and eventually grow again. So even though your cash may not be earning a lot of interest it can ultimately have a huge positive effect on your total portfolio rate of return.

Another thing we like to keep an eye on is minimizing the required minimum distributions from your 401(k) or Traditional IRA accounts. These distributions have the potential to increase a retiree’s taxable income, and must be taken starting at age 72. Once you start taking required minimum distributions they increase every year until you die. We find that a number of people do not need this additional income, and it just becomes a tax burden at that time. It is possible to reduce these distributions by converting all or a portion of your traditional IRAs into Roth IRAs. Roth IRAs grow tax deferred, and can be distributed tax free.  Taxes will be owed on any amount converted, but if you are delaying Social Security there may be a few years of low income in retirement which could be a great time for the conversion. We like to target years between your retirement and age 72 (the year required minimum distributions start) as optimal years to implement Roth conversion strategies designed to reduce future tax bills

If you are forced to take required minimum distributions beyond what you need to spend you can invest the cash in a taxable account.  This allows you to put the excess RMD to work and keep it growing.  This also does an interesting thing from a tax perspective.  When you die your beneficiary will enjoy a “step up in basis” on your taxable account.  This means that any taxable gain that was in the account during your life is eliminated as the cost basis gets “stepped up” to the value of the account at your death resulting in the ability of your beneficiary to sell everything in the account and not pay a dime in taxes. Usually you have to wait a year and one day to receive the more favorable long-term capital gains tax rates, but the beneficiary gets to enjoy these even if they have gains after the first day of inheriting the account.

So, if you do need additional income above and beyond your pension or Social Security which accounts do you draw from first? When it comes time to make those systematic withdrawals, we need to be strategic on where we pull assets from. This is known as account sequencing and can help optimize the payment you receive from your accounts while minimizing taxes which can allow other assets in your long-term buckets to continue to grow tax deferred. With that being said, and with the current tax code, a general rule of thumb would be to take your first distributions from your taxable accounts (individual, joint, or Trust) because of the more favorable capital gains tax rates. This would allow for your IRA and Roth IRA to continue to grow and delay taxes even further. The next account we would look to take distributions from is your IRA which would further delay the distributions from your Roth IRA, and will provide more tax-free income later.

In 2019, the stretch IRA which was an estate planning tool that allowed an individual who inherited an IRA to stretch the distributions out over his or her lifespan has been eliminated by the passage of the SECURE act. The new rule requires that an IRA must be fully liquidated within ten years from the date of death of the original owner (certain exceptions apply like when a spouse is the beneficiary or someone less than 10 years younger is as well). The point is that this opens a new world of financial planning techniques to consider, and why it is so important to meet regularly to review your financial plan.