So you’ve spent all of your working life diligently building up your nest egg in a tax-efficient manner by strategically allocating savings across a myriad of tax-favored and taxable investment accounts. By taking advantage of your company’s 401(k) plan, you were able to benefit from the up-front tax deduction and on-going tax-deferred growth. You were fortunate enough to have extra capacity to save and methodically maxed out your Roth IRA contributions every year; looking forward to the tax-free growth and distributions in retirement. When possible, you also funded a taxable investment account for which you were taxed each year on any dividends, interest, and realized gains produced. Now you’ve reached the end of a long and rewarding career that enabled you to build up a sizable balance across all your accounts of various tax structures.
At this point, many people think they’ve reached the end of creative tax-saving strategies and give way to the conventional methods of taking distributions in retirement. The common wisdom is to tap into taxable investment accounts first and then tax-deferred accounts later to allow the more tax-efficient assets to compound for a longer period of time. The problem with this strategy is that this can potentially cause future distributions from tax-deferred vehicles to be taxed at even higher rates as the large IRA distributions bump the retiree into a higher tax-bracket. This is because distributions from Traditional IRAs are taxed as ordinary income and large distributions can push retirees into higher tax brackets.
The most efficient strategy often involves funding cash flow needs with distributions from taxable accounts and then executing systematic Roth Conversions of tax-deferred assets to 'fill up' the lower tax brackets in the early years of retirement. Once the taxable accounts have been depleted, you now have a larger reserve of tax-exempt Roth assets to supplement distributions from tax-deferred assets. This has the dual benefit of helping the retiree avoid being bumped into a higher tax bracket in their later years due to large Required Minimum Distributions and continuing to benefit from the tax efficient growth of their Roth and Traditional IRAs.
While everyone’s situation is unique, this particular strategy can be a useful way to save on taxes and maximize the longevity of your portfolio. The following article dives deeper into this strategy and provides useful illustrations of the benefits it can provide:
https://www.kitces.com/blog/tax-efficient-retirement-withdrawal-strategies-to-fund-retirement-spending-needs/
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