Give yourself a big pat on the back if you have built up a nice retirement nest egg after years of scrimping and saving.
Congratulations, you're halfway there.
Many investorsare so focused onaccumulating wealth that theyneglect the second partof the equation –pulling out money so that you don't deplete it unnecessarily from poor tax decisions.
"We spend years or decades trying to put money into retirement plans," said Michael Kitces, a financial adviserat Kitces.com. "But how do you get the dollars out and do it in a tax-efficient manner?"
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That was the gistof a recent talk he gave to members of the American Instituteof Certified Public Accountants and the Chartered Institute of Management Accountants. Here are some highlights:
Realize you're not as rich as you think
Millions of Americans have watched their retirement accounts balloon in value in recent years. But if a good chunk of your assets are held in traditional Individual Retirement Accounts or workplace 401(k)-style plans, you eventually will have to pay taxes on the balances. Hence, you're not as wealthy as you might assume.
Kitces provided this simpleexample: Suppose you hold$750,000 in unsheltered brokerage accounts and $750,000 in a traditional IRA. When you withdraw money from the IRA, you will pay ordinary income taxon it. If you figure a middle-range 24% federal tax rate, you really have $570,000 in the IRA and $180,000 in deferred tax liabilities, he said. Corporations have to account for this on their balance sheets, but individuals typically don't think about itin this manner.
"Really, you wouldn't have a $1.5 million portfolio," he said.
In fact, assets in the brokerage account likely would incur taxes, too. Evenarelatively lowcapital-gain rate of 15% on withdrawalswould puta further dent in your wealth.
Plan withdrawals while you have time
You might be tempted to stash away cash in retirement plans and forget about it until you must take Required Minimum Distributions in your early 70s. That would give your account even more time to grow, after all.
But this might not be the bestway to go. If your account gets too big, you could trigger some nasty RMDs. You also would collectSocial Security by then, and largeretirement distributions could make some of your Social Security taxable.
Kitcessaid he often hears from upscale individualsthat they're getting killed by RMD taxes in their 70s. "There's not much you can do about it now," he said he tells them. "But 10 years ago, we could have helped you."
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People in their 60s have a golden opportunity to start drawing down retirement money while limiting the tax bite. This opportunity is enhanced if you're not earning much job income and haven't claimed Social Security yet. People in this age group also don't needto worry about the 10% penalty that typically applies on retirement withdrawals made before age 59½.
"The goal is to have smaller IRAs by your 70s by whittling them down in your 60s," Kitces said.
Think in terms of tax-bracket 'buckets'
If you have money in traditionalIRAs or 401(k) plans, you will pay taxeseventually. The goalis to pay those taxes at the lowest rates possible.
Americans currently pay federal incometax inseven brackets, where rates of10%, 12%, 22%, 24%, 32%, 35% and 37% apply. As you earn more, you're pushed into higher brackets.Along with job income and Social Security, retirement withdrawals can propelyou up the scale. But you might have some spare capacity each year at relatively low rates.
For example, the 12% bracket ends at $40,525 in taxable income (after deductions and so on) for singlesand $81,050 for married couples. Ideally, you'dwant to take retirement withdrawals up to the point where you stay in the 12% bracket. Or, ifyou're wealthier, you'd want to withdrawas long as you stay inthe 24% bracket. The next rate, 32%, starts at $164,926 in taxable income for singles and $329,851 for joint filers.
"The goal is to fill the lower-bracket buckets," without going over, Kitces said.
Kitces describes this strategy as an annual "use it or lose it opportunity" – and one that most people probably don'tthink about much.It's especially importantnot to jump from the 12% bracket to 22% or from 24% to 32%, as those are big increases, he noted.
State income taxes also can affect your withdrawal decisions, but federal taxes are the main concern.
Consider other taxstrategies, too
In addition to timing withdrawals from traditional IRAs and 401(k) plans– an optionmost appropriate for people in their 60s –other tax-shaving strategies are worth knowing. For example, younger adultsshould consider investing in Roth IRAs and Roth-401(k)s.With theseplans, withdrawals typically would come out tax-free, with no RMDs. The downsideis that you can't deduct the money you contribute.
Another strategy, useful in taxable accounts, is to harvest losses and perhaps even gains. Harvesting refers to realizing lossesor gainsearlier than you might otherwiseto minimize taxes. For example, you can harvestlosses to help offset any gains incurred in the same year. If your losses exceed your gains,you can deduct the excess up to $3,000 annually, carrying forward unusedamounts to future years.
You also might want to convert money from traditional IRAs to a Roth. You'd need to pay taxes now on the amount converted, but future withdrawals would come out tax-free. Again, you'd want to manage thisso that the increase in taxable income doesn't push you into a noticeably higher bracket.
"Should you convert everything to a Roth now? No," Kitces said. "You'd blast yourself to the topbracket."
Hold investments accordingly
It's worth noting that some assets are best held in certain types of accounts.
For example, Kitces said,investments with high growth potential that throw off little in the way of ongoing taxable distributions, such as index funds pegged to the Standard & Poors' 500 or non-dividend growth stocks, often work bestin unsheltered brokerage accounts. With these, it's possiblethe only taxes that mightapply would be on long-term capital gains.
Conversely, investments that areless tax-efficient often are best held in traditional IRAs. Thesemight include high-yield bond funds or emerging-market stockfunds that do a lot of internal trading (spinning off taxable gains or dividends along the way).
As forbonds, bond funds andmoney-market funds, Kitces argued that these can be held pretty much anywhere. This wasn't always the case, as most fixed-income investments are tax-inefficient, traditionally making them suitablefor sheltered accounts.
But after thedecades-long slumpin interest rates, fixed-income yields aren't high enough to compound significantly. "It doesn't matter much what account you put them in," he said.
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