By Allyn Hughes, CFP®, ChFC®, CLU®, CAP®
The U.S. census indicates that about 10,000 baby boomers are turning 65 every day. Other surveys suggest that a relatively small percentage of these folks work with financial advisors. A smaller percentage work with financial advisors who can help retirees better understand how to spend down the money in their nest egg in such a way that they maintain as much as financial security as possible over what could be three decades of retirement.
We have found that most reasonably successful retirees have built their retirement nest eggs by investing in a variety of different accounts.
Some investment accounts are tax-deferred—like 401Ks, IRAs or to a lesser extent tax-deferred annuities. Ordinary income tax will be owed (at the marginal tax rate) when the retiree takes money out of these accounts.
Other accounts with capital gains or income are subject to current taxation. These are usually brokerage accounts and savings and money market accounts. Distributions from these accounts are taxed at either the marginal income tax rate for income from taxable bonds or real estate investment trusts, or at the long-term capital gains tax rate of 0 – 23.8% depending on the account holder’s income tax bracket.
The last group of accounts that many retirees have are tax-free accounts. These might include income from tax-free municipal bonds, some government bonds or from one or more Roth IRAs. No tax is due on any assets taken from these accounts if the retiree has met the rules for holding a Roth.
Virtually all new retirees will receive Socially Security. Relatively few receive pensions.
The trick for most retirees is to figure out how to best combine their Social Security and money from these three types of accounts so they can minimize taxes and maximize the amount left in their investments at any time.
A variety of decisions have to be made to maximize your income from all sources and minimize your taxes. The first decision is about Social Security. Do you and your spouse want or need to start it at age 62? Or, are you in a situation so that you can either continue to work or can afford to live on income from other assets until age 70 and can begin Social Security then with a maximized payment?
Another key event is beginning to withdraw money from tax-deferred retirement accounts. You must begin to take required minimum distributions (RMDs) based on the combined value of your tax deferred retirement accounts by April 1 after you turn age 70½. Starting then will give the balances in these accounts the longest time to grow tax deferred before the distributions must start. There is no reason that you can’t start taking withdrawals before age 70½, however, and often it is advantageous to do so.
The next decision you need to make is how much income you want to have (or will have) in each year of retirement. Your financial advisor can create a financial plan which will tell you how likely it will be that the plan will be successful based on your retirement income and spending goals. Understanding both these income goals and the tax character of your accounts and their withdrawal strategies will be an important tool for your long-term wealth planning.
Some techniques for tax efficiency and optimizing retirement income might include:
• Moving up or moving back your retirement date
• Moving up or moving back the date that you begin to take Social Security
• Closely monitoring your income and spending in retirement to keep from unintentionally increasing your Medicare premiums
• Converting some assets from IRAs (tax deferred) to Roth IRAs (tax free) to lower lifetime taxes
• Strategically balancing withdrawals from tax-deferred, taxable and tax-free accounts each year to fully use up each marginal tax bracket that you have
• Choosing to take more income in one year (and thus be in a higher tax bracket for that year) and then be in a much lower tax bracket the next
Working with a financial advisor can help you better understand these money relationships so you have more and pay less tax in retirement.