A Three-Part Series on Making the Most of Your Retirement Dollars - Part III
So far, in this three-part series about stretching your retirement dollars, we’ve explored:
In Part I, we dove into what spending in retirement can look like, how much you could afford to comfortably spend, and how to maintain balance and flexibility within your spending.
In Part II, we broke down all of the different types of income you can expect to encounter in retirement and walked through how each type of Income is taxed and treated by the IRS.
And in this post, we’ll dive into asset location and how to be efficient about where you place your money while it grows, as well as the best way to get your money out and pay less in taxes.
Location, Location, Location
Psst: This Doesn’t Just Apply to Real Estate
Most of us are familiar with the concept of asset allocation and the role it plays in building out an appropriate and well-diversified portfolio. But far too often when it comes to building our portfolios, we forget about the role taxes play in our retirement and our investments.
In fact, taxes will be our single largest expense in retirement. So why pay more than you need to? I’m all for paying your fair share of taxes, but let’s not leave the IRS a tip!
One of my favorite tax sayings to share with investors is, “It’s not what you earn, but what you get to keep.” This phrase refers to the importance of a topic known as asset location. Asset location is the importance of knowing how each investment is taxed while it’s invested, and second, how it’s taxed when you decide to cash it out.
You may not be able to control how the stock market is going to perform, but you can control how much you’ll pay in taxes and where to take your first dollar from in retirement.
Therefore, it’s going to be important to know what types of investments (stocks, bonds, mutual funds, etc) go into each account. Each investment will perform differently and is also going to be taxed differently depending on the account you decide to place it in.
I know it can seem like there are a lot of moving pieces, but just like starting any new TV series, once you learn the characters and who’s who, it becomes a whole lot easier.
Knowing Your Main Characters
The Three Types of Investment Accounts
Many investors will have several different types of investment accounts. Each account will have its own specific goal, timeline, and risk attached to it. Some of the accounts will be subject to taxes each and every year, while others may defer taxes or be entirely tax-free.
Below are the three main types of investment account categories:
Taxable Brokerage Accounts: You can hold just about any type of investment you’d like with a taxable account such as stocks, bonds, mutual funds, and ETFs. Within this account, you will be taxed twice. The first is if your investment earns dividends or interest throughout the year. And the second type of taxation occurs only when you decide to sell your investments; that is assuming they’ve gone up in value.
Tax-Deferred Accounts: Common tax-deferred accounts include traditional 401k’s, 403b’s, Annuities, and IRAs. Some of these accounts will even lower your taxable income in the year you contribute to them. All of these accounts allow you to delay taxation until you withdraw your money. Here’s the catch though, upon taking your money out, all of your distributions will be taxed as ordinary income.
Tax-Free Accounts: My personal favorite and the undefeated champion of retirement income. These accounts include Roth IRAs, Roth 401k’s, and Roth 403b’s. Contributions to these accounts are made with after-tax dollars and do not provide any upfront tax deduction. However, within these accounts, every single dollar is considered exempt from taxes when you go to pull your money out. That’s right, no income taxes, no capital gains, nothing.
Note: There are limits to how much you can place into each account which prevents one from investing every dollar into a tax-free account such as a Roth IRA or Roth 401k. If you’d like to learn more about the contribution limits of each account, you can do so by clicking HERE.
Knowing Where to Place Your Investments
Now that you’re familiar with the different types of investment accounts, and how each of them handles taxation, it’s time to learn where to hold your investments.
For a refresher on the different types of taxation such as capital gains, qualified dividend income, ordinary income, etc, you can read more about it HERE in Part II’s blog post.
Let’s go back to our golden rule: It’s not what you earn, but what you get to keep. In an effort to minimize your taxes, and therefore maximize what you actually get to keep, you’re going to want to put your most tax-friendly investments in your taxable accounts and your least tax-efficient investments in your tax-deferred accounts.
Let’s take a look below to see how this could be structured:
Taxable Brokerage accounts are best to hold the following investments:
- Individual stocks, generally speaking, are tax-advantage if you hold them for longer than a year.
- Index Funds and ETFs with low turnover tend to be more tax-advantaged than actively managed funds.
- Stocks or Mutual Funds that pay qualified dividends
- Municipal Bonds
Tax-Deferred accounts are best to hold the following investments:
- Individual stocks that you plan to hold for less than a year
- Actively managed funds that generate short-term capital gains, frequent capital gain distributions, and have a higher turnover
- Taxable bond funds and REITS
Tax-Free accounts are best to hold the following investments:
- Your "Home Run" investments that you believe have the greatest change for the largest return
- Assets that are least tax efficient
Fidelity Investments has a great chart below citing the three different types of accounts we’ve spoken about and which investments are most appropriate to place into each of them.
Now For the Fun Part
How To Pay Less In Taxes and
Keep More of Your Hard-Earned Money
I want you to picture a grocery store conveyor belt.
Think of the last time you went shopping for the week ahead and were placing your groceries onto the belt.
What happened? The cashier scanned each item one by one as they moved their way down the belt, and eventually made their way into the bag.
Now let’s apply this conveyor belt analogy to your retirement and how you make the decision of which account to take your money from first.
Remember: Tax optimization helps us decide which dollar in retirement to pull off the “Conveyor Belt” first.
As you’ll soon find out, not every dollar is worth the same.
Credit: Getty Images*Let’s look at an example:
Bob, recently retired and is 64 years old. He has decided with his Financial Planner to delay taking Social Security. Therefore his only income comes from his part-time work at the local animal shelter.
Because he planned ahead and funded his taxable brokerage account years before retirement, he has decided to take money from his brokerage account FIRST in retirement. Doing this will allow him to be taxed at a much lower rate and keep more of his hard-earned money.
In fact, if Bob’s income is low enough, all of his capital gains distributions will be entirely tax-free as we explored in Part II of this blog post.
Your Secret Weapon Against Taxes in Retirement
The Taxable Brokerage Account
In addition to funding your retirement accounts, putting money into your Brokerage account during your working years will allow you to potentially:
Lower your Taxable Income in Retirement
Have the resources to choose to delay Social Security
Keep your Retirement assets growing uninterrupted
Create other favorable tax planning opportunities
It’s important to remember that retirement is not a one-size-fits-all approach and that each person’s retirement situation is going to look different. Therefore, if it makes sense for your specific situation, a common sequence of withdrawals in retirement occurs in the following order:
Brokerage account assets - Taxed at Capital Gains rates
Tax-deferred IRA and 401k assets - Taxed as Ordinary Income
Roth IRA assets - Exempt from Income Taxes
Your Tax Brackets Matter
Be Tax-Smart About Where (and How Much) You Decide to Withdraw
To the extent that you will need to rely on income from your portfolio in retirement, it's important to take taxes into consideration when you decide to sell investments and withdraw funds. We recommend that you begin working with a Financial Planner many years before your actual retirement date to create a tax-efficeint distribution game plan.
Though you may be tempted to consider taking all of your distributions from your taxable account during the first few years of retirement, you may want to consider strategically spreading out your retirement income distributions between your brokerage account and your tax-deferred IRA account. Why?
Well, rather than just taking all of your distributions from your taxable brokerage account, you’ll want to pay close attention to your marginal tax markets and do your best to fill up your respective bracket without tipping into the next one.
Doing this will help reduce your Required Minimum Distribution (RMD) one day in retirement.
Additional Techniques to reduce your RMD
Starting at Age 72, you will need to begin taking your Required Minimum Distribution (RMD) from your pre-tax IRA out each year. This amount is set by the IRS using their table guidelines and is based on your age and IRA account value. Unfortunately, this distribution is required each and every year, regardless of whether you need the money or not.
Below are a couple of common techniques used to reduce your Required Minimum Distribution.
Option 1: Begin converting your pre-tax IRAs into a Roth IRA through Roth Conversions
Note: Moving assets from an IRA to a Roth IRA is a taxable event and any amount converted is considered Income. Paying taxes at a higher rate to do the conversion isn’t likely the best idea, so you’ll want to run your numbers line up first before attempting.
The goal of a Roth IRA is to pay taxes today at a lower rate through the conversion and avoid having to pay taxes later on your distributions at a higher rate.
Helpful Pointer: In years when your income is low, it can help to take advantage of Roth Conversions before retirement and begin shifting your tax-deferred income from your Traditional IRA into a Roth IRA that will be exempt from taxes.
Option 2: Donating your RMD to charity through a Qualified Charitable Donations (QCD’s)
In addition to giving to charity, the amount of your Qualified Charitable Donation is excluded from your taxable income, which is unlike regular withdrawals from an IRA. Second, this donation amount is counted towards satisfying your RMD for the year. Specific rules and limits apply, to learn more read here.
Tying It All Together
Like most things in life, the sooner you get started, the more control you’ll have, and the better your outcome will likely be. Planning for retirement can be confusing or even at times overwhelming, and there are a lot of moving pieces to account for.
But as we discussed above, you actually have much more control over your retirement and tax situation than you know. That said, your path to retirement and the amount you’re able to save is an ongoing process. We know that your plan could shift, move and adjust as life and circumstances change. And when that happens, we’re here every step of the way to be your guide, teacher, resource, and educator.
Disclaimer: The views and opinions expressed are made as of the date of publication and are subject to change over time. The content of this website is for informational or educational purposes only. Website content is not intended as individualized investment advice, or as tax, accounting, or legal advice. It is not intended to be a recommendation or endorsement to buy or sell the specific investment. This information should not be relied upon as the sole factor in an investment-making decision. Website users are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.