Avoiding unnecessary taxes is one of the best ways to stretch your retirement savings. Without an effective strategy, the IRS will take a bigger bite out of your investments. Join us as we explore how to reduce your tax liability by applying tax-efficient strategies to retirement account distributions.

Before we get into the weeds – and with a topic like this, there will be weeds – let’s take a step back and look at the big picture. The goal of any distribution strategy is to access your retirement savings in a tax-efficient manner. The name of the game is tax avoidance, not tax evasion. People go to jail for tax evasion. Tax avoidance is the implementation of strategies that help minimize your taxes, which is perfectly legal.

Terminology

Distribution: A sum of money withdrawn from an investment account.

Distribution Strategy: Also known as account sequencing, a plan to avoid taxes by structuring the timing of retirement account distributions.

Required Minimum Distributions: Also known by the acronym RMD, government-mandated withdrawals from pre-tax accounts beginning at 72 years of age.

Tax Bracket: A range of income which is taxed at a specific rate. 

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Types of Retirement Accounts

There are three basic types of retirement accounts:

• Pre-Tax: Also known as qualified plans, pre-tax investments are what most people think of when they hear “retirement account." Pre-tax investments include employer-sponsored plans such as a 401(k), 403(b), 457(b), and TSP. Another well-known constituent of pre-tax investments is the traditional individual retirement account, or IRA. Contributions to pre-tax accounts are tax-deductible and retirement distributions are taxed as ordinary income. Pre-tax accounts are subject to required minimum distributions and early withdrawal penalties. 
• After-Tax: A Roth IRA is the best example of an after-tax investment account. Others include a Roth 401(k), health savings accounts, and municipal bonds. Contributions to tax-free accounts are not tax-deductible and distributions are not taxed. Tax-free investments don’t feel very tax-free when you fund them, but they make up for it later. Distributions from tax-free accounts are not taxed, meaning there is no tax on investment earnings.
• Taxable: Non-qualified accounts are home to taxable investments such as stocks, bonds, mutual funds, and interest-bearing accounts like CDs and savings accounts. Investments held for more than one year qualify as capital gains, which means they receive preferential tax treatment. Taxable investments are purchased with after-tax dollars so they are not tax-deductible. Investment returns are taxed at the lower capital gains rate when distributions are taken.

Retirement Account Distribution Strategies

When it comes to retirement, it’s important to have a plan. You need to know when you can retire, when to start taking Social Security, and when to start tapping your investments.

With regard to retirement accounts, it’s not only a matter of when, but what order. Without a good strategy, you’re like a lamb being led to the slaughter.

Proportional

The proportional distribution strategy is the easiest to understand. Each year you take a distribution from each account in proportion to the account’s balance relative to your total investments. 

For example, suppose you are retired and one year you need a total distribution of $100,000 in order to make ends meet. The sum total of all your retirement savings is $1,000,000, comprised of $500,000 in a pre-tax account, $300,000 in an after-tax account, and $200,000 in a taxable account. Using the proportional strategy, you would withdraw $50,000 from the pre-tax account, $30,000 from the after-tax account, and $20,000 from the taxable account. 

The proportional strategy is best for those who want to keep things simple. One advantage is it spreads your taxable income out over your entire retirement period which serves to help smooth out your tax profile.

Traditional

The traditional distribution strategy has been around the longest and is the most commonly-used. With the traditional strategy, you draw down your investment accounts in sequence from worst to best. That is, you use up your worst investments first, allowing your best investments more time to grow.

After-tax accounts are the most tax-advantaged, second are pre-tax, and the worst are taxable investments. Based on that, the traditional strategy would have you use up all of your taxable investments first, followed by the pre-tax accounts, and finally the after-tax investments. 

The traditional strategy results in a tax profile that resembles a bell curve. When you are first retired, the bulk of your taxes will come from capital gains which helps keep your tax bill relatively low. About the time you run out of taxable investments, it’s likely you will be somewhere around 72 years of age. You remember what happens at 72, don’t you?

Required minimum distributions. At 72 years of age, RMDs take effect. RMDs combined with the switch from taxable to pre-tax investments results in a spike in taxes.

Finally, once the pre-tax accounts have been depleted, the after-tax accounts are accessed. This results in your taxes dropping to almost nothing. Another nice thing about after-tax investments is the fact that you can pass them on to your heirs tax-free. That’s good to know since you saved them for last.

Time is of the Essence

An important consideration is the fact that once we reach a certain age, changing course is challenging at best and impossible at worst. If you are reading this and jumping for joy because you’ve seen the light, it might be too late. 

The IRS sets limits on the amount that can be placed into tax-advantaged accounts each year. The annual limit is $23,500 for pre-tax accounts plus an additional $7,500 catch-up allowance for those age 50 and up. The limit for traditional pre-tax IRAs and after-tax Roth IRAs is $7,000 plus an additional $1,000 catch-up allowance for those age 50 and up. 

The point is, in order for these strategies to work, you need an appreciable portion of your savings in different types of accounts. A good place to start is 20 percent. That makes these strategies a young person’s game.

Let’s say you are 55 and you plan to retire in 10 years at the age of 65. You have $1,000,000 in retirement savings, so 20% would be $200,000. At the government’s maximum allowable rate of $8,000 per year, it would take 28 years for you to get $200,000 into a Roth account. Are you going to postpone retirement until you turn 83?

Unless you’ve already done it, only young people have enough years ahead of them to put a significant portion of their savings into Roth accounts. Ironically, young people are the least likely to do so because when we are young most of us are not concerned with such matters. A government conspiracy? Probably. 

Do not despair. If you cannot implement these strategies, you can pass this along to someone who can. One day they might thank you.

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