NEW YORK (MainStreet) — With tax season underway, many retirees must be wondering: "Gee, how can I cut the tax bite for next time?"
For retirees with various types of taxable and tax-advantaged accounts, it turns out there's only one cardinal rule on withdrawals: Start by taking your required minimum distribution (RMD) from any traditional 401(k)s or IRAs. After that, stay flexible.
"Most investors are familiar with the idea of maximizing their assets by minimizing taxes during their earning and wealth-building years," says Ken Hevert, vice president of retirement products at Fidelity, in a report on withdrawal strategies. "Limiting taxes on those savings in retirement is equally important."
Unfortunately, this clashes with many retirees' preference for a low-stress approach, doing the same thing every year.
"[It's] a mistake to be dogmatic about withdrawal sequencing," says Morningstar Personal Finance Director Christine Benz in a report on retirement withdrawal strategies. "The reason is that your tax picture will change from year to year based on your expenses, your available deductions, your investments' performance and your RMDs, among other factors."
Taking the RMD must be the top priority because of the huge penalty for not doing so — half of any required withdrawal that wasn't taken. After turning 70.5, an investor must begin withdrawing funds from traditional 401(k)s, IRAs and similar accounts based on government life expectancy tables.
A retiree with $100,000 and a 20-year expectancy, for instance, would be required to withdraw and pay income tax on $5,000, or 1-20th of the assets. People with more than one such account can divide the withdrawals in any way they choose so long as they satisfy the minimum overall.
Once the RMD is taken, it may make sense to leave the balance in these accounts untouched to get the maximum benefit from tax-deferred compounding. Roth IRAs and 401(k)s are best left alone because because withdrawals are tax free.
So the standard sequence is to take the RMD, then withdraw from taxable accounts, then tax-deferred accounts, then Roths. But the order could be different as circumstances change. A key concern, Hevert says, is to avoid having withdrawals kick you into a higher tax bracket.
Generally, the tax bite is highest on traditional 401(k)s and IRAs, because withdrawals face ordinary income tax at rates as high as 39.6%. Interest earned in taxable accounts is taxed as income. But many investment gains and dividends are taxed at the long-term capital gains rate, which is 15% for most investors, 20% for the wealthiest.
So the savvy retiree, Benz says, thinks about minimizing taxes not just in the current year but over the entire retirement.
In a paper on retirement strategies, The Vanguard Group notes: "It is generally recommended to spend from tax-deferred accounts when current tax rates are expected to be lower than future tax rates and, conversely, from tax-free accounts when current tax rates are expected to be higher than future tax rates."
In a given year, for example, the investor might be in an unusually low-income tax bracket because of big deductions for things such as medical expenses. In this case, it might pay to take more money out of the traditional 401(k)s or IRAs to pay tax at a low income tax rate rather than a higher one later.
Withdrawing more than the RMD during these favorable years will reduce the RMD requirements in future years because the tax-deferred holdings will be smaller. That would give the investor more flexibility in the future.
In another year, the investor might need an unusually large income for one-time expenses. Since big withdrawals could lift the investor into a higher tax bracket, it might be best to pull money from a Roth account, because there would be no tax.
Of course, the retiree should also consider the investment prospects for each holding. Generally, an asset with good prospects should be left to grow even if selling it looks like the best tax move. As the pros say, the tax tail should not wag the investment dog.
— By Jeff Brown for MainStreet