How to Make Tax-Efficient Withdrawals From Retirement Funds
Benjamin Franklin famously said, “There are two things in life that are guaranteed: death and taxes.” He’s not wrong. While we may not be able to avoid taxes, we can try to be tax-efficient.
As a financial advisor, part of my job is working with clients to try and help minimize and mitigate the tax ramifications associated with their decisions. One of the most important is making tax-efficient withdrawals from their retirement funds.
There are three main ideas involved with tax-efficient withdrawals from retirement funds.
- Location of the asset
- Order of the withdrawals
- Tax impacts within the location
What does the location of the asset mean?
We’re not talking about location in the sense of property. The location of the asset means the type of account in which the money is invested. Take a 401k plan, for example. Many people have one, but there may be two locations or buckets for it. There are traditional 401k and Roth 401k versions, for example.
Another type of location may be company stock. Some Disney cast members have company stock as part of their retirement plan.
Location matters in the taxation of the asset because there are different types of tax implications when it comes to the location of your retirement funds. How you’ve been saving will determine the taxation at retirement.
Asset locations can vary widely. Let’s look at the four primary types of account locations.
Traditional 401k or Traditional IRA
These types of accounts work as tax-deferred accounts. When the money goes in, you receive a tax benefit on the money. Any earnings along the way are tax-deferred.
When money is taken out at retirement, assuming it’s after age 59 ½, there are no penalties for withdrawing the funds, but they are taxed as ordinary income. The amount you withdraw will be added to your other income sources and taxed appropriately.
Ordinary income is the tax bracket under which you fall. It may be 12%, 20%, or 25%, so it’s essential to understand how withdrawals may affect your taxes.
Roth Accounts
With a Roth account, you don’t receive a tax benefit when the money goes in. However, when the money grows, it grows tax-free. This means that when you withdraw funds, you do not pay any taxes on the money at all.
That’s right…zero taxes.
All transactions along the way are not taxed within that account. So it’s tax-deferred and tax-free. Whether you earn interest or have capital gains within the account doesn’t matter. When you take the money out, it’s tax-free.
Non-Qualified Accounts
Also known as non-retirement accounts, these accounts are taxable in the year the income is earned. The IRS code is set up on what’s called realizing income or earning income. These taxable accounts give you tremendous flexibility.
You can put money in and take money out with no tax consequences. Because you can take money out, there are no tax consequences other than capital gains, if applicable. Let me explain.
Let’s say you used $10,000 to buy an investment. Your initial investment was $10,000, but now it’s worth $20,000. If you sell the investment, you will now pay capital gains taxes on the $10,000 it grew.
This is why the location of the asset is so critical. If it’s in a traditional IRA or a Roth IRA, you don’t pay taxes on that, but with a non-retirement account, you will pay taxes on it.
Hybrid Accounts
There are also some hybrid-type accounts, such as an annuity. Annuity is a bad word for many people. There are reasons they feel that way, and I’m not discounting their feelings. However, an annuity is structured so the money goes in after taxes and grows tax-deferred.
Remember, tax-deferred means you only pay taxes on gains, interest, or dividends once you withdraw the money. Annuities are a hybrid approach. When you withdraw your funds, you don’t pay taxes on what you contributed; you only pay ordinary income taxes on the earnings.
There are formulas for how the income is taken out depending on whether you annuitize it or take it out in bits and pieces, which can have some complications.
Why is the order of withdrawals important?
First and foremost is your tax bracket. When you’re working, you don’t necessarily think about your tax bracket as much. Most people are focused on making money to live, pay for the kids’ college, save for retirement, etc.
When you retire, you now have a pot of money, which is your retirement fund. Your total assets may include funds in different types of locations. For tax-efficient withdrawals, you don’t have to take equally from all sources. You can take from one place or another or proportionately from others.
Example 1
As a new retiree, you may want to wait before you start drawing Social Security. You may choose to withdraw funds from your non-retirement accounts first to keep you in a lower tax bracket or give you the ability to a Roth conversion or something similar.
You will have to pay taxes on the money anyway, so it may be more tax-efficient to use this type of account sooner rather than later and let your Roth, IRA, or 401k account continue to grow tax-deferred.
Example 2
If you want to leave an inheritance to your children, you may reorder your withdrawals based on your long-term goals. Your kids may rather inherit a non-retirement account that would not be taxable to them at all.
They can sell it, take the money, and run, even if there are capital gains. With a retirement account, they will have taxes associated with it. If you want to leave a legacy or leave money to your kids or grandkids, it may be worth it to consider changing the order in which you start to take money out.
How does asset location affect taxes?
Two essential things related to asset location are needed to make tax-efficient retirement fund withdrawal decisions.
- Knowing the tax impact of the location
- Understanding the tax impact within the location
The two sound similar but are sometimes different.
Some investments produce different types of taxation, which may matter depending on the location of the account. Some accounts are taxed on the interest you earn or the gains you accumulate, whether short-term or long-term.
As I mentioned earlier, your retirement accounts will be tax-deferred, whether traditional or Roth. Whatever taxation occurs on a year-by-year basis, such as capital gains, dividends, interest, etc., will continue to be tax-deferred. The only thing that matters is the location.
What you invest in will produce different types of taxation. Especially on non-retirement accounts like
- Checking accounts
- Savings accounts
- CDs
- Stocks
- Mutual Funds
Ordinary Income
Ordinary income is usually produced by interest-earning investments. For example,
- Corporate bonds
- US government bonds
- CDs
- Interest-earning savings accounts
Based on your total earnings, these will come in at ordinary income tax rates (whatever tax bracket you fall into).
Capital Gains Rates
You also have a capital gains rate. Capital gains are split into short—and long-term rates. Short-term rates fall into the ordinary income bucket, which is typically a higher rate.
Long-term capital gains generally fall into a more advantageous bucket for taxation, either 0% or 15%. Can you believe that you could possibly earn money and not have to pay any taxes on it if you’re smart about the timing?
Additional Tax Ramifications
An additional tax for high-income earners was added to what’s called the “Obamacare Tax” or net investment interest income tax, which adds just under 4% to the 15%.
Potential additional taxation does exist for retirement accounts. For instance, there is a 10% penalty if you withdraw the money early. Withdrawing funds before the age of 59 ½ is taxed and also has early withdrawal penalties. I discuss ways to help mitigate the penalties here.
Not using the funds in a college or 529 savings plan for college or withdrawing funds early will also have additional taxation penalties.
Takeaways
Having a tax-efficient strategy for withdrawing retirement funds is essential. Remember to look at the
- Location of the asset
- Order of the withdrawals
- Tax impacts within the location
We don’t always know what tax rates will be. Working with an experienced financial team will help you create a tax-efficient strategy for now and your lifetime.
Important Information
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