Tax-Efficient Retirement Withdrawal Strategies

Earlier this year Fidelity reported that the number of 401K millionaires hit an all time high of 168,000 and the number of IRA millionaires hit 156,000. Now that the 76 million Baby Boomers are starting to retire and reach the age of Required Minimum Distributions – planning for tax efficiently drawing down their savings is becoming a bigger concern. Additionally many people believe we may be in a once in a generation window of low taxes , and that taxes will likely rise in the future to pay for programs like Obamacare (Affordable Care Act), Medicare and Social Security as we (hopefully) live longer.

Why RMDs (Required Minimum Distributions) Matter 

Let’s say you’re a 60 year old married couple with $500,000 in retirement savings held in a Qualified account like a 401K or an IRA and through the miracle of medical advances you live to 100. To keep this simple let’s say you can live on a combination of Social Security and RMDs and that you can achieve a 7% rate of return (effectively doubling your money every 10 years) and are subject to a progressive effective tax rate. You can see below that your annual income tax bill starts to get pretty significant as RMDs increase over time.

Given this as a backdrop what can people do tax efficiently draw down their assets?

I recently gave a talk about tax efficient retirement withdrawal strategies to 300 Certified Financial Planners alongside experts from Vanguard and Schwab. What follows is a summary of the big take-aways from that talk.

Conventional Wisdom and Advanced Tax Bracket Management

Conventional wisdom calls for drawing down your taxable accounts first, then tax-deferred accounts (401Ks, IRAs), then tax-exempt (Roth IRAs), since this maximizes the time that your tax deferred and tax exempt assets can grow. It’s also simple and easy to follow.

A more advanced tax bracket management strategy calls for taking a multi-year tax planning approach and trying to identify lower income and lower tax rate years early in retirement where you can convert assets from tax-deferred into tax-exempt (aka a Roth conversion). Basically starting at age 59.5 you try to take taxable income to the top of the 15% tax bracket and move that money into a Roth IRA (see the illustration below). Roth IRAs offer two huge benefits your savings grow tax free and can be withdrawn tax free AND the tax free benefit can be passed onto future generations, so it’s a very powerful estate planning tool.

Other best practices and guidelines include:

• Bucket your investments as a way of managing the risk of needing to sell into a downturn
  • Bucket #1 has one year of expenses held in cash in bank accounts
  • Bucket #2 has two to four years of expenses held in low volatility investments that generate income
  • Bucket #3 has longer term assets targeting growth and income
• Optimize for long term capital gains – if you have securities held less than 1 year and can realize gains, try to hold them for longer than 1 year so you can receive long term capital gains tax rates. This assumes the investment still fits with your long term goals.
• Tax loss harvesting – this is the practice of selling down investments that have gone down in value in order to capture the loss and offset other gains. You can offset other gains as well as up to $3,000 in non-investment income. Note you need to be aware of the wash-sale rule which prohibits repurchasing a “substantially identical” investment for 30 days.
• Consider the tax efficiency of an investment and factor that into which type of account you hold it in. In general more tax efficient investments (ex. index funds) can be held anywhere, but tax inefficient assets (ex. REIT funds, high yield corporate bonds) are better placed in tax free or tax deferred accounts.

Consider other big factors

Where will you live? It’s worth considering the state income taxes and property taxes of the state you plan to retire in. There are several annual studies like this one from Kiplinger on tax friendly states for retirees.

Will you work in retirement? Working in retirement is likely the single biggest lever for most people, since it allows you to save and grow investments longer, delay tapping your retirement funds and ideally provides access to company funded healthcare. Additionally if you work past age 70 and have access to a company 401K – you can delay taking RMDs by transferring money into your companies 401K, since you are not required to take RMDs from your current employers 401K.

How will you claim Social Security and Pensions? A lot has been written about how to claim Social Security, but the conventional wisdom on guaranteed income sources like these is to delay them as long as possible to maximize your income and survivor benefit. If you’re planning on working past age 62, then you likely want to delay Social Security until at least your Full Retirement Age to avoid the Social Security work penalty.

Should you use a QLAC (Qualified Longevity Annuity Contract)? Longevity annuities purchased with qualified funds allow you to defer any mandatory withdrawals until age 85. You can learn more about QLAC pros and cons here.

Should you consider using home equity in retirement? For most people home equity represents the largest part of their net worth, but many people aren’t willing to use it as part of an integrated strategy until it becomes an urgent need. However, as people live longer more people may explore pro-actively using their home equity as part of their draw down strategy. Since it’s typically accessed as debt – the cash flow doesn’t create income tax obligations.

The 401k was created in 1980 so it’s almost 40 years old and so far everyone has been focused on the Accumulation of assets. Now we’re reaching the point where people need to start seriously thinking about the Decumulation of those assets. It’s an emerging complex problem that requires good retirement planning since all of the components of a person’s wealth, income and taxes are interactive. Per the factors above work, Social Security, where you live, asset positioning, asset draw down sequence, annuitization and home equity all come into play as part of an integrated tax efficient withdrawal strategy.