Being tax-efficient in retirement

A crucial part of making the most of your retirement savings is making sure as much as possible goes to your retirement lifestyle instead of Uncle Sam. Tax-efficient withdrawals from your accounts can help make your savings go further and reduce the risk of running out of money.

Generally, ordinary income is taxed at the highest rate, ranging from 10% to 39.6% in 2015. This includes earned income, interest, nonqualified dividends, short-term capital gains, rent and royalty, pensions, and traditional IRA distributions. Qualified dividends and long-term capital gains are taxed at lower long-term capital gains rates which range from 0% to 20%. Finally, distributions from Roth IRAs, Roth 401(k)s, and life insurance proceeds aren’t usually taxed.

A general rule of thumb is that you should take withdrawals from your savings in this order:

  • First take the minimum required distributions (MRDs) from retirement accounts
  • Next, withdraw from taxable accounts
  • Tax-deferred retirement accounts, such as traditional IRAs and 401(k)s come next
  • Finally, tax-exempt retirement accounts, such as Roth IRAs or Roth 401(k)s

Taking the MRDs from retirement accounts, if you’re age 70 ½ or over, is important to avoid penalties. If you don’t take MRDs when you’re supposed to, you’ll likely face a penalty of half the amount you were supposed to withdraw.

After taking MRDs, you take withdrawals from your taxable accounts. If you sell your investments, you’ll have to pay capital gains taxes, which are generally lower than ordinary income tax rates. Tapping your taxable accounts first has two advantages. First, it allows the funds in your tax-deferred and tax-exempt accounts to continue to grow. Second, it reduces the taxes you pay from dividends and capital gains, since these are not taxed in your IRAs and 401(k)s.

Next, taking funds from tax-deferred retirement accounts forces you to pay ordinary income tax rates, but it allows your tax-exempt retirement funds to continue to grow. Additionally, if you need the tax-exempt funds later, such as for medical expenses, you can withdraw from a Roth IRA for this reason without taxes. Distributions from Roth IRAs are also usually nontaxable for your beneficiaries who inherit them.

Like all rules of thumb, there are some exceptions. For example, if you have significant income from a part-time job or rental income it might make sense to minimize your tax bill by withdrawing from your tax-exempt accounts first to supplement your income.

Since Social Security benefits are taxed as income, you might also consider delaying taking Social Security until you reach age 70, if you don’t need the additional income. This will reduce your tax bite and also increase the amount of your benefits when you do start receiving them.

It’s important to have a mix of different assets, such as U.S. and international stocks, bonds, and cash, and locating your assets in the right type of account can make a difference in your taxes.

Since interest from bonds is taxed as ordinary income, bonds are often less tax-efficient than stocks, so it might make sense to put your bonds in tax-deferred or tax-exempt accounts, and your equities in your taxable accounts. However, if you’re holding a stock with high dividend distributions, or a stock fund with high turnover, that might lead to more taxes than you expect.

While taxes are important, your investment and income goals and risk tolerance should be the overriding factor. You would not want to compromise your investment goals or take on more or less risk than you need, simply for the tax advantage.

You can use online simulations to estimate your tax bill under different scenarios. Here is an investment return calculator that takes taxes and inflation into account.

For further information

Listen as financial journalist Robert Powell interviews three leading experts in tax-efficient retirement.