Tax Efficient Retirement Withdrawal Planning


Developing A Withdrawal Strategy With Your Retirement Savings

Tax Efficiency in Retirement

And so, we are wrapping up now. We blew through a lot of numbers, but I wanted to show you some real world examples of how these seemingly small decisions can make thousand dollar differences.

And all of this adds up. You will likely buy a few cars in retirement, and likely have several other large one-time expenses. Each one of these is a chance to do some planning and potentially save a bit of money in taxes.

In general, we find that a few ways we can create savings for clients is to:

Spread payments out over several years, like our car example or even a 5 year mortgage. This can help reduce hitting those tax cliffs and filling up higher tax brackets.

Taking advantage of lower income years means recognizing when you are not spending as much as you might in future years. It might mean making sure you fill that 12% bracket if you know there will be years ahead where you will enter the 22% bracket, for example.

Using different account types can also help. If you have accounts other than just a qualified retirement account, say a taxable account or Roth IRA. Those can help supplement withdrawals to create much less of a tax burden. We didnt cover this in much detail today as this was getting long, but we will have a future webinar that touches on this topic.

And, dont completely write off loans for large purchases. You should never buy something just because you can afford the loan payments of course, but if done correctly and at low interest rates, it can be beneficial.

Finding The Optimal Amount For Early Partial Roth Conversions And Avoiding Too Much Tax Deferral

Ultimately, the key concept to recognize in the tax-efficient liquidation of retirement accounts is that there really is such thing as too much tax deferral. An IRA , or other pre-tax retirement account) that is allowed to compound long enough will eventually be so large that the retiree is driven into even higher tax brackets just trying to tap the account, whether its to generate retirement spending or simply because the distributions are forced out when RMDs begin.

Accordingly, the fundamental goal to spend from the portfolio in a more tax-efficient manner is to find constructive ways to whittle down a pre-tax account and stop it from growing too large, either by taking distributions outright at an earlier phase, or by doing partial Roth conversions. Of course, if too much is withdrawn or converted in the early years, the retiree may drive up their tax rate now, which doesnt help the situation either. In other words, the end goal is to find the balance point between the two.

Nonetheless, the strategy for the tax-efficient spend-down of a retirement portfolio remains the same to allow for maximal tax-preferenced growth in retirement accounts by spending from taxable brokerage accounts first, but not letting low tax brackets go to waste by filling them with partial Roth conversions along the way!

Big Ira Distributions Drive Up Tax Brackets

While the example above shows how deferring withdrawals from a pre-tax IRA can allow more wealth to compound, there is a significant caveat: the IRA is being subjected to a 20% average tax rate because the withdrawals are happening from the IRA all at once and driving a portion of the distributions into the 25% tax bracket.

For instance, continuing the prior example, the reality is that initially the couple would likely only be in the 15% ordinary income tax bracket. After all, if the couple is receiving $30,000/year of Social Security benefits , and the taxable portfolio generates about $20,000/year of interest and dividends, and available exemptions/deductions are $25,000, their taxable income after all deductions would be barely over $20,000/year. This would put them at the bottom of the 15% tax bracket, and would actually mean any qualified dividends are eligible for a tax rate of 0%! Its only by stacking a $100,000 gross withdrawal from the IRA on top that drives them into the 25% bracket, with technically about half of the withdrawal taxed in the 15% bracket, and the other half of the IRA distribution taxed at 25%.

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Take Required Minimum Distributions But Manage Carefully

Required minimum distributions start at age 70 ½, and are a requirement, as the name implies. Holders of IRAs, 401s, and other retirement accounts funded with pre-tax contributions are required to take a distribution based upon an IRS table and the amount in the account as of December 31 of the prior year.

This distribution is fully taxable on top of any other taxable income that you may have.

Watch Your Total Income for the Year: The RMD might push your income to a level where your Social Security becomes taxable or could even push up the amount that you pay for Medicare. If possible, reduce income from sources other than the RMD if this will be a factor.

Donate to Charity: IRA Qualified Charitable Distributions allow those who are 70 ½ to direct some or all of their RMD to a qualified charity. This amount will be excluded from their income, though they cannot take a charitable deduction as well. This is only available for IRA accounts. If you dont need all the money, and have charitable inclinations, this is a tax-efficient way to meet those goals. These RMD contributions are capped at $100,000 annually.

Work: If you are working at 70 ½, you can avoid RMDs from your employers 401. Your employer must have made this election to their plan and you cannot own more than 5% of the company. If these criteria are met, you need not take the RMD from that account only until you leave the company.

Expecting Relatively Large Long

4 Steps For Tax

Spreading traditional IRA withdrawals out over the course of retirement lifetime may make sense for many people. However, if an investor anticipates having a relatively large amount of long-term capital gains from their investmentsenough to reach the 15% long-term capital gain bracket thresholdthere may be a more beneficial strategy: First, use up taxable accounts, then take the remaining withdrawals proportionally.

The purpose of this strategy is to take advantage of zero or low long-term capital gains rates, if available based on ordinary income tax brackets. Tax rates on long-term capital gains are 0%, 15% or 20% depending on taxable income and filing status. Assuming no income besides capital gains, and filing single, the total capital gains would need to exceed $40,400 after deductions, before taxes would be owed.

Tax rates: Singles


One strategy for retirees to help reduce taxes is to take capital gains when they are in the lower tax brackets. For example, single filers with taxable income less than $40,400 are in the 2 lower tax brackets. That equates to a 0% tax on capital gains. If taxable income is between $40,401 and $445,850, long-term capital gains rate is 15%. Remember, the amount of ordinary income impacts long-term capital gain tax rates.

The big difference: Jamie pays zero on her long-term capital gains because her income is below that key threshold of $40,400, but David pays 15% on his $5,000 because of his higher earnings.

$995 $5,414

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Blending Withdrawals From Ira And Taxable Accounts

Given that taking full distributions from the IRA up front can drive the couple into higher tax brackets, and taking full distributions from the IRA in the later years will also drive the couple into higher tax brackets, the solution is actually remarkably simple: to take distributions from each account along the way.

The benefit of this tactic is that by taking only partial distributions from the IRA each year, the distributions can occur at “only” the 15% bracket without ever reaching the 25% bracket. Yet by taking at least some withdrawals from the IRA every year, the brokerage account lasts longer before it is ever depleted . For instance, the chart below shows the results when the retiree takes half the desired spending from each account every year, assuming their tax-savvy withdrawals keep them in the 15% tax bracket throughout.

Notably, the spend-brokerage-account-first scenario still had a higher final account balance, but this is due in large part to the fact that the IRA still has a significant looming tax liability that will have to be spent someday . On a net after-tax basis, the split-strategy that allows the IRA withdrawals to be blended across the 10% and 15% brackets actually fares better than either of the alternatives!

Retirement Income & Its Impact On Your Tax Rate

At the inception of retirement, theres usually a noticeable drop in ones tax rate. Generally, there’s a sigh of relief from retirees without any thought as to what it may mean for their future taxes. Soon after, retirees start Social Security and see a slight uptick in their tax bracket. When retirees see age 72, the big tax bill comes back with a vengeance as Required Minimum Distributions are taken from pre-tax retirement accounts . Depending on your financial and tax situation, this is something that could have been mitigated during those years of lower income after retirement.

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Invest For Dividends Only If Your Income Is $25000

Dividends from public Canadian companies actually have a negative tax rate if your taxable income is in this range. Thats right negative tax.

The danger, though, is that dividends are taxed at an extremely high 62% rate if your income is below $25,000!

You need to be careful because dividends are the highest taxed investment income if your taxable income is below $25,000, but the lowest taxed income from $25,000-$46,000.

Why is the dividend taxed so high for the lowest income? The GIS clawback is on the grossed-up dividend. Dividends are a disaster for low-income seniors!

Dividend tax on low-income seniors is strange but important to understand. If your income is under $25,000 and you receive a $1,000 dividend, it is grossed-up by 38% and adds $1,380 to your taxable income. The 50% GIS clawback on this $1,380 is $690. This is a 69% GIS clawback, which is reduced by 7% negative income tax on the dividend to get an effective tax rate of 62%.

In short, the government gets $620 of your $1,000 dividend.

If you can plan to have a lower income and keep some of the GIS, then you should avoid dividends entirely. However, if your income will be at least $25,000 without the dividends, then you can take advantage of the negative tax.

If your income is above $46,000, there is no real advantage of dividends. They are taxed about the same as an SWP up to $75,000 of income and then the dividend tax rate leaps to 30% if your income is over $75,000.

How Taxes And Rmds Affect Retirement Withdrawals

Money Monitor: Tax-efficient planning tips for retirement

Generally, your first stop for withdrawals should be RMDs from tax-deferred accounts or any account that requires a lifetime RMD. That’s because any RMD that hasn’t been withdrawn for the year could be subject to a 50% tax penalty.3 This is where donating to charity, in other words a qualified charitable distribution , can both satisfy the RMD and avoid a taxable event.

Next, consider withdrawing from accounts that are taxable to youregardless of whether you spend or reinvest those distributions. Examples include capital gains, dividends, and interest.

For most retirees, withdrawing more than the RMD from tax-deferred accounts generally should be the last choice. This is due to the way these accounts are taxedevery dollar withdrawn from tax-deferred accounts is taxed as ordinary income.

However, if you’re in a year in which your overall income is lower than normal, or if you feel your future tax rate will go up, you may want to think differently. Consider drawing from tax-deferred money up until the point that it would push you into the next marginal tax bracket.

Update for 2020: Because of the CARES Act, which was passed in late March 2020, you can choose not to take your RMD this year, leaving your funds invested longer instead of taking a withdrawal in a volatile market.

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Who Might Inherit Your Savings

You also may opt to draw from tax-deferred money for heirs likely to be in a high future tax bracket. It may benefit them to inherit taxable assets because those assets enjoy a step-up in basis. That means the capital gains tax on the assets are based on the value when inherited, not the original purchase price for the relative who bequeathed them. That can often result in a significant tax savings.

Five Principles For Tax

While there are many different approaches to withdrawal strategies in retirement, a handful of principles help guide these strategies.

Not every principle applies in every situation, but some of the most important tax-efficient principles to keep in mind are:

  • Minimize required minimum distributions
  • Defer Roths
  • Be careful of Social Security and Medicare thresholds
  • Consider charitable withdrawals from IRAs
  • Diversify your tax situation
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    Consider Charitable Withdrawals From Iras

    Qualified charitable distributions allow you to pay your RMDs straight to a charity, tax free.

    This is the most tax-efficient you can be. When you contribute money to an IRA, you receive a tax deduction, so you dont pay any taxes on amounts deposited into your IRA. Then, in retirement, the money goes out of the IRA and to the charity without any tax consequences. Tax free in, tax free out.

    But make sure to follow the QCD rules carefully because your payment wont be tax free if you dont.

    If you already donate money to charity, QCDs are an obvious choice. Even if you dont currently donate, the tax efficiency here should cause you to consider it.

    You dont have to itemize deductions to take advantage of a QCD. In fact, the amount that you give to the charity through the QCD isnt considered as income on your taxes.

    QCDs simplify the process of charitable giving and tax filing.

    Use Your Spouses Age To Calculate The Minimum Amount

    Journal Tax

    If your spouse or common-law partner is younger than you, you have the option of calculating the minimum RRIF withdrawal according to their age rather than your own when you begin the process to convert your RRSP to RRIF. This can be a good strategy if you dont need RRIF income immediately. You’ll need to inform your financial institution if this is the route you wish to take. Bear in mind, though, that you cant change your mind later.

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    Filling Lower Tax Brackets With Partial Roth Conversions

    While the strategy of taking partial distributions from an IRA earlier rather than later can be an effective means to enhance the longevity of the portfolio by reducing the average tax rate paid on the IRA, the one caveat to the strategy is that it still depletes a tax-preferenced account earlier than may have been necessary. In other words, the strategy faces a fundamental tension between the desire to take withdrawals earlier versus the desire to benefit from tax-deferred compounding growth .

    The resolution to this dilemma is to recognize that its possible to fill up the lower tax brackets in the early years from the IRA, without actually liquidating the tax-preferenced account. The solution is to engage in systematic partial Roth conversions in the early years, moving the dollars from the IRA to a Roth IRA, and generating the taxable income that fills the 15% tax bracket in the early years.

    Ultimately, the combination of taking advantage of lower tax brackets plus the additional tax-favored compounding in the traditional and Roth IRA accounts means that the partial Roth conversion strategy produces greater wealth than any of the other scenarios.

    Engaging The Right Withdrawal Strategy At Retirement

    Saving and investing for retirement is only part of the overall process of securing your later years. Having the right withdrawal strategy will allow you to maximize your gains while paying the lowest tax. Be sure to consult a wealth manager to put the right withdrawal strategy to work for your retirement.

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    Take Full Advantage Of Income Subject To Low Tax Rates

    Consider using your low tax bracket strategically by consistently filling up that bracket with ordinary income from tax-deferred account distributions, such as your Traditional IRA. If you need more than these withdrawals to support your lifestyle, you can sell taxable account investments or take money from your Roth accounts.

    As an example, assume a married couple:

    • Has $750,000 across their investment accounts: 60% tax-deferred, 30% Roth, and 10% taxable

    • Spends $65,000 each year

    • Collects $29,000 in Social Security benefits

    Using this approach, the couple supplements Social Security income each year with approximately $23,000 to $25,000 from tax-deferred accounts and $11,000 to $13,000 from taxable or Roth assets. By fully offsetting ordinary income with the standard deduction,1 they completely avoid federal income taxes and save $35,000 throughout retirement. This strategy adds nearly two years to the life of their portfolio compared with following the conventional wisdom of drawing on taxable accounts first, followed by tax-deferred accounts, and then tax-free accounts.

    Retirement Income Strategies Make a Difference

    Taxes From Large Purchases In Retirement

    How the sequence of retirement income withdrawals can impact income

    And you can see here their 2020 tax bill based on these assumptions.

    In total, because these IRA withdrawals are taxed like normal income, they would pay just over $15,000 in total taxes

    Then, the following year, they would pay much less in taxes because they have less in withdrawals without the car purchase.

    And in total over these 2 years, they are paying about $18,712 in taxes.

    Now we will get into a little bit more of the details in how these numbers are calculated later, and why just a $35,000 purchase can have such a large increase in total tax bill. But for now, just remember this $18,700 number

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