Tax Optimization

Tax Optimized Investment Strategies

Using a proper asset allocation between tax-advantaged and non-tax-advantaged accounts can help you optimize your tax situation before and during retirement.

 

Tax Deferred Accounts

These are among the earliest of the tax-advantaged accounts to be created and still the most common. For the majority of those nearing retirement, they tend to account for the majority of retirement savings. Because the full withdrawal amount is subject to ordinary income taxes and the nature of Required Minimum Distributions (RMDs), they can be the most expensive of tax-advantaged accounts. Therefore, it is important to strategically withdraw from these accounts as early as possible at lower tax brackets to avoid being forced to pay higher taxes later as the RMDs increase.
 

Roth Accounts

These post-tax accounts are generally the most preferable due to the fact that both growth and withdrawal are tax-free. Contribution limits for the Roth IRA usually restrict the size of these investments; however, Roth 401(k) accounts and Roth Conversions can help to substantially increase the amount of these contributions. Starting early is another key to maximizing Roth contributions.
 

Allocations for Tax Efficient Investing

The allocation of funds between tax-deferred, Roth, and taxable accounts can be optimized based on the individual's tax situation, retirement goals, and the expected growth of the accounts. Much of it depends on the limits and restrictions of each type of account, but here are some general guidelines:
  • Rebalance allocations through Roth Conversions when tax-deferred accounts are top heavy and could trigger higher RMDs in higher tax brackets later.
  • Consolidate tax-advantaged accounts for the best range of investment options with the lowest management fees and effort in managing portfolio assets.
  • Set up taxable accounts to help buffer expenses that might force you to withdraw more than desired from tax-deferred accounts and increase taxable income otherwise.
  • Invest in assets for value and long term growth since retirement will generally span decades and not just years.

Optimized Withdrawals

Withdrawing from different types of accounts during retirement in a tax-efficient way requires strategic planning to minimize your overall tax bill. The comparative rates of withdrawal and their timing depend on factors like your tax bracket, the growth potential of accounts, and tax laws. Here's how withdrawals can be optimized across tax-deferred accounts, Roth accounts, and non-tax-advantaged accounts.
 

General Order of Withdrawals

The following is a commonly recommended sequence for withdrawals, though it can vary based on personal circumstances:

  1. Taxable Accounts (Non-Tax-Advantaged) & Tax-Deferred Accounts (eg. Traditional IRA, 401(k)) - Start with an appropriate amount from both of these types of accounts especially if you are already receiving Social Security benefits. With taxable accounts, you only pay capital gains taxes (if applicable) on the growth realized as assets are sold and ordinary income taxes for any interest or dividends. Tax-deferred account withdrawals are taxed as ordinary income so they can trigger a higher tax burden. Withdraw only enough to keep your tax bracket low and reduce the risk of paying more taxes later with required minimum distributions (RMDs), which begin at age 73 (for those born in 1951 or later). Therefore, tax-deferred withdrawals may need to start earlier to avoid steep RMDs and moving into higher tax brackets. Supplementing necessary income using withdrawals from taxable accounts with those from tax-deferred accounts to avoid moving into a higher tax bracket is a common strategy.
  2. Roth Accounts - Withdraw from these accounts later if you believe you will be stuck with higher RMDs on traditional IRA and 401(k) accounts otherwise. They grow tax-free, and withdrawals are also tax-free. Roth accounts have no RMDs during the owner’s lifetime. This allows for maximum compounding of tax-free growth and withdrawals. Contribution limits and availability of Roth 401(k) accounts may result in a disproportionate amount of funds in tax-deferred retirement accounts. Executing Roth conversions over several years while in a lower tax bracket and at a measured pace may also help avoid massive RMDs and higher tax bills later.
 

Withdrawal Rates at Different Stages of Retirement

Withdrawal rates can and should vary throughout retirement to minimize taxes and optimize income.

  • Early Retirement (Before RMD Age) - Balance withdrawals between tax-deferred and non-tax-advantaged accounts to avoid higher tax brackets and RMDs. Again, consider Roth conversions to avoid higher RMDs. Converting part of a traditional IRA to a Roth IRA can reduce future RMDs while "filling up" a lower tax bracket for any given year.
  • Mid-Retirement (RMD Age, Typically 73–85) - RMDs from tax-deferred accounts are mandatory and may push you into a higher tax bracket. Use Roth accounts to cover large expenses without increasing taxable income.
  • Late Retirement (85 and Beyond) - Roth accounts are most advantageous in late retirement due to their tax-free nature. Taxable accounts may have minimal balances by now, simplifying tax management.
 

Key Considerations for Each Account Type

  • Taxable Accounts - Withdraw funds with the highest cost basis first to minimize capital gains taxes. This also allows higher performing funds to continue to grow with higher returns.
  • Tax-Deferred Accounts - Withdraw funds from tax-deferred accounts at a rate that will avoid higher tax brackets. Also, be mindful of Medicare premium surcharges, which can be triggered by higher modified adjusted gross income (MAGI).
  • Roth Accounts - Use these (or HSA funds when applicable) as a reserve for unexpected large expenses (e.g., healthcare costs). Defer withdrawals as long as possible to maximize tax-free growth.
 

Tools for Optimization

Besides the more general guidance regarding the different types of accounts, there are tools available to help you optimize your withdrawals even further.

  • Tax Bracket Management - Withdraw just enough from tax-deferred accounts to stay within a lower tax bracket.
  • Qualified Charitable Distributions (QCDs) - After age 70½, you can use RMDs to make tax-free charitable donations and reduce taxable income. It may be advantageous to even defer and contribute these donations as a lump sum for the years prior once you reach age 70½ if you normally make annual contributions to qualified organizations.
  • Capital Gains Harvesting - Sell investments in taxable accounts when in a lower tax bracket to minimize taxes on gains especially if you expect to see very high RMDs in later years.
  • Roth Conversions - Gradually convert funds from traditional IRAs to Roth IRAs when tax rates are favorable.
 

Example Scenario For an Early Retirement

Suppose a retiree and his spouse have $500,000 in taxable accounts, $750,000 in a traditional IRA, and $250,000 in a Roth IRA. Here's how withdrawals might look over time:

  • Ages 60–72 - Withdraw $40,000 annually from taxable accounts, another $40,000 from the IRA, and supplement with Roth conversions to fill a 12% tax bracket.
  • Ages 73–84 - Take RMDs plus funds to fill a 12% tax bracket from the IRA; withdraw additional income from the taxable account (e.g., 15% long term capital gains tax) and Roth if needed.
  • Ages 85 and Beyond - Withdraw proportionally more from IRA than Roth and even taxable accounts with 15% long term capital gains to perserve wealth for heirs if desired.

The key here is to strategically withdraw and convert tax-deferred funds to a Roth only at a rate that keeps you in a lower tax bracket.

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