You Could Be Doing More to Limit Taxes in Retirement

A common approach to retirement income relies on withdrawing money from taxable accounts first, followed by 401(k)s and IRAs, and lastly, Roth accounts. Conventional wisdom holds that withdrawing money from taxable accounts first allows a retiree’s 401(k) assets to continue growing tax-deferred while also preserving Roth assets to potentially leave to heirs.

A financial advisor can help you plan for retirement and find a tax-efficient strategy for withdrawing your assets. Find a financial advisor today.

But this relatively simple and straight-forward approach for generating retirement income may result in tax bills you could otherwise avoid. In a 17-page study, T. Rowe Price explored alternative withdrawal strategies suited for retirees whose primary focus was on meeting spending needs, as well as those with considerable assets and a desire to leave an estate for their heirs.

By changing up the order in which assets are withdrawn from different accounts, specifically by tapping tax-deferred accounts earlier than what is conventionally recommended, a retiree can actually reduce his tax liability, extend the life of his portfolio and leave an estate for his heirs, T. Rowe Price found.

“When following conventional wisdom, you start by relying on Social Security and taxable account withdrawals,” Roger Young, a certified financial planner and director of thought leadership for T. Rowe Price, wrote in the report. “Since some of that cash flow is not taxed, you may find yourself paying little or no federal income tax early in retirement before required minimum distributions (RMDs). That sounds great – but you may be leaving some low-tax income ‘on the table.’ And then after RMDs kick in, you may be paying more tax than necessary.”

A Better Way to Meet Spending Needs and Reduce Taxes?

To illustrate how the conventional withdrawal strategy could cost you at tax time and ways to improve upon it, T. Rowe Price examined several hypothetical scenarios involving retired couples with both taxable accounts and tax-deferred accounts.

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In the first example, the firm looked at a married couple with relatively modest retirement income and an annual budget of $65,000. The couple collects $29,000 in Social Security benefits and has $750,000 in retirement savings, 60% of which is held in tax-deferred accounts and 30% in Roth accounts. The remaining 10% ($75,000) is kept in taxable accounts.

Following the conventional strategy of using withdrawals from taxable accounts to supplement Social Security benefits first, the couple preserves their Roth assets to be used later in retirement. However, they would incur a federal income tax bill of $2,400 in years 4 through 17 of a 30-year retirement as a result of relying too heavily on their tax-deferred assets, which are taxed as ordinary income.

“A better approach is to ‘fill up’ a low tax bracket with ordinary income from tax-deferred account distributions,” Young wrote. This income could fill the 0%, he noted, where income is less than deductions, or the 10% bracket.

“Any spending need above those distributions and Social Security can be met with taxable account liquidations, followed by Roth distributions,” Young added.

By spreading distributions from their tax-deferred accounts across more years (years 1 through 27) , the couple would eliminate their federal income tax liability altogether, according to the analysis. This alternative approach also relies on using Roth distributions earlier in retirement (year 8) as opposed to waiting until the 18th year of a 30-year retirement to begin taking these tax-free distributions.

The T. Rowe Price analysis shows that the couple’s portfolio lasts nearly two years longer (31.6 years) compared to the conventional method (29.8). “That’s an improvement of 6%. If both spouses die between ages 80 and 95, their heirs would receive between $19,000 and $63,000 more after-tax value than with the conventional method,” Young wrote.

Preserving Assets for Your Estate

While the first scenario looked at how a married couple with modest income and savings could optimize their withdrawal strategy to limit taxes and extend their portfolio, T. Rowe Price also examined how even wealthier retirees could preserve more of their assets to bequeath to heirs.

Since money withdrawn from Roth IRAs is not taxable, many people choose to limit or avoid taking distributions from Roth accounts while they’re still alive so they can leave those accounts to their heirs. This makes Roth IRAs powerful and popular components of estate plans. But a couple that expects to leave an estate may want to consider preserving taxable accounts for a bequest instead of Roth assets, according to Young.

“Under current tax law, the cost basis for inherited investments is the value at the owner’s death,” Young wrote. “This is known as a ‘step-up’ in basis, and it effectively makes gains during the original owner’s lifetime tax free for heirs. This can be a major benefit for people with wealth that won’t be spent in retirement.”

It’s important to note that President Joe Biden last year proposed closing this legal loophole. As part of his Build Back Better agenda, Biden proposed eliminating the step-up in basis on assets that exceed $1 million when a single taxpayer dies and $2.5 million for couples who file jointly. However, the provision did not have enough support on Capitol Hill and was dropped from the bill that eventually passed the House of Representatives.

Bottom Line

The conventional strategy for withdrawing retirement assets often starts with taking distributions from taxable accounts early in retirement so tax-deferred accounts can continue to grow. But research from T. Rowe Price shows that retirees with taxable accounts may want to consider alternative withdrawal tactics, including taking distributions from 401(k)s and other tax-deferred accounts earlier in retirement and spreading the money across more years.

Doing so may limit a retiree’s federal income tax bill on such distributions in a given year. Additionally, retirees who hope to leave an estate to heirs may consider preserving their taxable accounts deeper into retirement and passing them on to heirs instead of Roth IRA assets.

Retirement Planning Tips

• A financial advisor can help you sort through the many decisions you’ll need to make when it comes to your retirement plan, including a withdrawal strategy. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• Need help determining how much you’ll need to have saved for retirement? Fidelity’s 45% rule states that your retirement savings should generate about 45% of your pretax, pre-retirement income each year, with Social Security benefits covering the rest of your spending needs.

• SmartAsset’s retirement calculator can help you track the progress you’re making toward a savings goal. Meanwhile, estimate how much your Social Security benefits will be using our Social Security calculator.

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