Barry and Adam wrote and published the book “Guided Retirement Income Planning” in November 2020 to create higher levels of financial literacy and to show a comprehensive and logical process for executing income planning in retirement. Since we believe that this subject matter is so important and relevant, we are going to roll out one chapter each month. While our approach and philosophy will remain consistent in every economic cycle, customization for each household will vary.
We want to emphasize that some of you are not close to retirement and it is never too early to plan. You may also have loved ones, friends, or colleagues that are in need of help. We would be pleased to send them a complimentary copy of our book. We simply hope to help as many people as possible. As we present these chapters, we invite you to circle back to us with any questions or concerns about the content and how it relates to you.
Please enjoy Chapter 16 below! If you missed any of the previous chapters, you can read them all on our blog here.
Your Partners at MGFS
Tax Planning and Order of Distribution
“A penny saved is two pennies earned … after taxes.” (Randy Thurman – author)
The primary objective of a tax-efficient withdrawal strategy is to increase after-tax retirement income by saving on taxes. A withdrawal strategy needs to be a customized approach for your circumstances and flexible to react to tax law and lifestyle changes. There are several categories of assets or accounts that can be converted into retirement income. For simplicity, we will refer to account types below:
- Taxable (non-qualified) – An account that is owned by an individual, joint tenants, or trust. Earnings distributions such as interest, dividends, and capital gains, are taxed, with some exceptions.
- Tax-deferred (qualified) – Employer-sponsored and individual accounts set up for retirement purposes. Taxes are deferred until distributions are made and then fully taxable as ordinary income.
- Tax-deferred (non-qualified) – Accounts that grow and produce earnings that are taxed upon distributions, such as annuities. When withdrawals are made from annuities and executive deferred compensation programs, the earnings are taxed first and treated as ordinary income. Once earnings are depleted, the initial investment, or cost basis, is returned tax-free. Executive deferred compensation programs are fully taxable when distributions are made.
- Tax-exempt – Employer-sponsored Roth 401(k) plans, Roth IRA accounts, and municipal bond investments. With more advanced planning, cash values from life insurance policies and home equity can be additional sources of tax-exempt income.
There are no specific rules regarding the order in which you take distributions but many strategies are dependent upon your financial circumstances. You will likely derive your income from a combination of these accounts. For best practices when using your investments for income, consider the following general guidelines:
- The more you can move into tax-exempt accounts, the more tax-efficient your retirement plan will be. Some people employ a systematic conversion strategy to achieve this goal.
- If you own non-qualified annuities, they will need to be assessed independently.
- If you own highly-appreciated, non-qualified investments, you may choose to keep these intact for your heirs to receive a step-up in cost basis (in order to manage, if not eliminate taxes).
- Tax harvesting non-qualified accounts (the offsetting of realized gains with directed losses) can be a good way to manage taxes.
- Tax bracket management should be carefully considered to minimize unintended consequences with capital gain rates, taxable social security, Medicare premium expenses, and increased marginal tax rates; all of which may require greater withdrawals to meet your income objectives.
- Required minimum distributions (RMDs) from your qualified accounts should be identified and calculated. You should review past tax returns, current projections, and tax brackets to determine adequate tax withholding.
- Thinking about delaying your RMDs? In certain situations a Qualified Longevity Annuity Contract (QLAC) may make sense.
- Spending needs should be reviewed once or twice a year to determine if adjustments are needed.
- There are several kinds of IRS penalties for tax-qualified accounts or non-qualified annuities if distribution rules are not followed. Also, there are numerous exceptions for penalty-free withdrawals prior to age 59½. If unfamiliar, it is important to consult with your tax or financial advisors.
- Look for opportunities in low-income years to do a Roth conversion. (See Chapter 17)
- Consider charitable giving for both philanthropy and as a tax strategy. These approaches can be implemented annually. Among many IRS-approved charitable strategies, Qualified Charitable Distributions (QCDs) and Donor-Advised Funds (DAFs) can be effective!
Having different categories of accounts will provide flexibility for tax-sensitive cash flow and allow for an effective tax diversification strategy. Since everyone’s financial situation is unique, you will want to review your income and tax strategies each year. No surprise, you may want to consult with your advisors to fine-tune these processes for optimal distributions.
The Lighter Side of Aging from Bob Hope
- You know you are getting old when the candles cost more than the cake.
- I don’t feel old. I don’t feel anything until noon. Then it’s time for my nap.
- The older you get, the tougher it is to lose weight, because by then your body and your fat are really good friends.