Tax planning: A critical factor when investing in retirement

Q: I’ve recently retired and will be using money from my various investment accounts to pay my expenses going forward. I have IRAs, a 401(K) and brokerage accounts. How do I know where to take money from and what it will mean for me tax-wise?

A: Thanks for this question — and congratulations on your retirement. Managing taxes for maximum benefit in retirement requires careful planning. You’ll need to consider the tax implications of different investments. You’ll also want to think through how you make withdrawals from taxable and tax-deferred accounts. Following are a few key considerations for effective money management during your retirement years.

Less taxing investments

Municipal bonds, or “muni’s,” have long been used by retirees seeking a tax-advantaged investment. In general, the interest paid on municipal bonds is exempt from federal taxes and, in some cases, state and local taxes as well.1 Municipal bonds are issued by state or local municipalities, which may support general government needs or fund a variety of public-works projects, such as new roads, schools, bridges or hospitals. Therefore, in addition to providing federally tax-exempt earnings, municipals can be a good way to invest in the growth and development of your community.

Municipal bonds usually have a yield below the yield on corporate bonds of comparable maturity. This means that a municipal bond may potentially provide the same — or equivalent — after-tax yield as a taxable bond paying a higher interest rate. If you are in a high tax bracket, using municipal bonds in the fixed-income portion of your portfolio may be beneficial (see table for an illustration).1

Which accounts to tap first?

Another major decision facing retirees is when to liquidate various types of assets. The advantage of holding on to tax-deferred investments is that they compound on a before-tax basis and therefore may have greater earning potential than their taxable counterparts.

On the other hand, you’ll need to consider that qualified withdrawals from tax-deferred investments are generally taxed at ordinary federal income-tax rates of up to 39.6 percent, while long-term capital gains and qualified dividends from investments in taxable accounts are generally taxed at a maximum rate of 20 percent.2 (Capital gains on investments held for one year or less are generally taxed at ordinary income-tax rates.)

General investment wisdom states that it may be better to tap assets in taxable accounts first, allowing assets in Traditional IRAs and other tax-deferred retirement accounts to continue compounding as long as possible. However, in some instances, drawing down IRA assets first after retirement may make more sense if you’re in a lower tax bracket at that time. Remember that, with some exceptions, the IRS requires individuals to begin withdrawing money from tax-deferred accounts no later than age 70.5, at which point you may want to rethink your withdrawal strategy. When planning withdrawals from taxable accounts, try to hold these securities long enough to qualify for the more favorable long-term tax rates on capital gains and/or qualified dividends.

The ins and outs of RMDs

The IRS generally requires that you begin taking annual required minimum distributions (RMDs) from traditional IRAs and employer-sponsored retirement plans after you reach age 70.5. The premise behind the RMD rule is simple: The longer your life expectancy, the smaller the percentage the IRS requires you to withdraw (and pay taxes on) each year. Failure to take the RMD can result in a tax penalty equal to 50 percent of the required amount that wasn’t distributed.

Unlike traditional IRAs, Roth IRAs do not require that you begin taking distributions by age 70.5.3 In fact, you’re never required to take distributions from your own Roth IRA, and qualified withdrawals are tax free.3 For this reason, you may wish to liquidate investments in a Roth IRA after you’ve exhausted other sources of income. Be aware, however, that your beneficiaries will be required to take RMDs after your death.

Strategies for making the most of your money and reducing taxes are complex. Your best recourse? Plan ahead and consider meeting with a competent tax advisor and a financial professional to help you sort through your options.

1Municipal bonds are subject to availability and change in price. They are subject to market- and interest-rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Capital gains from municipal bonds are taxable and interest income may be subject to the alternative minimum tax. If sold prior to maturity, capital gains tax could apply.

2Income from investment assets may be subject to an additional 3.8-percent Medicare tax, applicable to single-filer taxpayers with modified adjusted-gross income of over $200,000, and $250,000 for joint filers.

3Withdrawals prior to age 59.5 may be subject to ordinary income taxes and a 10-percent additional tax.

This article was prepared with the assistance of DST Systems Inc. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Please consult me if you have any questions.

Because of the possibility of human or mechanical error by DST Systems Inc. or its sources, neither Wealth Management Systems Inc. nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall DST Systems Inc. be liable for any indirect, special or consequential damages in connection with subscribers’ or others’ use of the content.

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