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The Flawed But Common Advice That Can Dramatically Increase Your Tax Bill In Retirement

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A major problem as you approach retirement is deciding how to withdraw the money you have saved and invested over the years.

For instance, you might have two or three different retirement accounts, each with its own, distinct tax treatment.

Beyond taxes, retirees also must make sure that their spending today doesn’t impact their ability to withdraw money in the future. Separately, they worry about being able to leave money behind to children and their favorite charities — the more, the better.

The tax implications can be staggeringly complex, so complex that most financial advisors give up and offer their clients a “one size fits all” answer.

The simplistic plan favored by many advisors seems logical on the surface: Spend the most heavily taxed money first. Often, this means spending from accounts with required minimum distributions (RMDs), then from taxable accounts, then from tax-deferred accounts such as an IRA or 401(k), and finally from tax-free Roth IRA accounts.

Yet the easy answer, while appealing, can be very costly for some clients.

The simplistic plan favored by many advisors seems logical on the surface: Spend the most heavily taxed money first.

Often, this means spending from accounts with required minimum distributions (RMDs), then from taxable accounts, then from tax-deferred accounts such as an IRA or 401(k), and finally from tax-free Roth IRA accounts.

Nevertheless, Kirsten Cook, William Meyer and William Reichenstein, in a study published by the Financial Analysts Journal, found that using thoughtful, tax-efficient strategies can add three years to a portfolio’s longevity.

Consider for a moment what three more years of money could mean, especially to a surviving spouse!

The more robust strategy is the informed strategy, which takes the approach of deciding what tax bracket you want to fall into year by year. Based on that, you’re more likely to end up tapping all three types of retirement accounts each year.

What the “one size fits all” answer ignores is how much in taxes you will pay over your lifetime. You could be ignoring, for instance, that your brokerage has a step-up advantage if you plan to leave invested money to heirs.

A step-up means that heirs who receive your stock investments can eliminate long-term capital gains taxes. They get to “step up” the basis of the stock, the recorded purchase price, to the price on the date you died. That’s a huge tax break!

Second, the common advisor answer completely ignores what types of assets you have in your accounts. It can fail to balance paying taxes against your own longevity and your desire to give money to your kids.

The more robust strategy is the informed strategy, which takes the approach of deciding what tax bracket you want to fall into year by year. Based on that, you’re more likely to end up tapping all three types of retirement accounts each year.

Optimizing your withdrawals

The exact mathematical solution, of course, assumes full foresight into how the stock market will do every year in which you are invested — which nobody can know.

Yet the robust strategy should allow you to adjust to manage that market reality year by year. The data show there are situations where tapping into all of your accounts in any given year leads to better tax outcomes — and thus more money — over your lifetime.

There is no “one size fits all” solution, which is why the retirement withdrawal problem fascinates us at United Income. We’re developing on a robust algorithm that delivers actionable answers to this retirement question and others on an ongoing basis.

The goal is to attack the account-sequencing problem with a tool that will allow our clients the chance to optimize their retirement withdrawals in real time. Join us!