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Elements of Retiree Tax Reduction Plan

Last update on: Nov 02 2017

Most retirees were misinformed about taxes. They were told that their income tax rates would decline in retirement. The unfortunate truth is that for many people, income tax rates stay the same or rise after retirement. In fact, retirees often face the highest marginal tax rates (the rate on the last dollar of income earned) in America.

Retirees and those nearing retirement can reduce their income tax burdens by adopting a plan. The elements of a good plan have been laid out in past issues of Retirement Watch and won’t be found in too many other sources.

Here is how to use these elements to put together a tax reduction plan.

Consider Roth IRAs. Money withdrawn from a Roth IRA is tax free in most situations. Tax-free income certainly reduces taxes in retirement.

In our September visit, and again this month, we discussed in some detail the benefits of converting a traditional IRA into a Roth. We also discussed who should consider a conversion and the best ways to do a conversion.

Key factors that determine whether a conversion makes sense are the differences between pre-retirement and retirement tax rates, the time money will compound in the Roth IRA after conversion, and whether or not the taxes can be paid from other sources. More details about conversions can be found in the Archive section of the members’ web site or in my book, The New Rules of Retirement (Wiley 2004), available on

Invest with tax efficiency. Most of us have several different types of investment accounts: taxable accounts at brokers or mutual funds, IRAs or 401(k)s, Roth IRAs, and perhaps annuities or other investments. Each has a different tax treatment. Considering the tax treatment of an account before deciding which investments to own in it can boost after-tax returns.

To invest tax efficiently, first decide on the asset allocation you want in your total portfolio. Then, determine which account is the best to hold each investment.

For example, sales of long-term holdings of capital gain assets such as stocks and equity mutual funds face a reduced tax rate when they are owned in taxable accounts. But when gains eventually are distributed from tax-deferred accounts, they are taxed as ordinary income, which means a top rate of 35%.

Here are some guidelines for efficiently investing your accounts in and for retirement:

If you are a tax-wise investor, hold long-term capital gain assets in taxable accounts. A tax-wise investor generally holds capital gain assets for longer than one year so that sales qualify for the long-term capital gain tax rate. Stocks that pay dividends that qualify for the 15% tax rate also should be held in taxable accounts.

The higher a tax wise investor’s ordinary income tax rate, the greater the benefit there is from holding capital gain assets outside of an IRA, annuity, or other tax-deferred account.

An investor who tends to sell stocks and equity mutual funds after less than one year usually should own them in tax deferred accounts.
Investments that primarily earn ordinary income generally should be owned in tax-deferred accounts. Such investments include bonds, high-yield bonds, and real estate investment trusts.

Of course, you are unlikely to be able to always own an asset in the ideal account. Develop your desired asset allocation first. Then, fit the assets in the ideal account to the extent you can.

Spending down accounts. The next part of the plan covers the distribution phase of retirement. Which accounts should be spent first?

The general rule is to spend taxable accounts first. Take advantage of the tax benefits of tax-deferred and tax-free accounts for as long as possible by letting income and gains compound in them. Another reason to spend taxable accounts first is that we do not know how long the 15% rate on long-term capital gains and dividends will last. Use it while it is here.

After spending taxable accounts, spend tax-deferred accounts next. Leave tax-free accounts such as Roth IRAs for last.

There are exceptions to these spending guidelines.

Sometimes it is a good idea to empty an IRA early. This might be a good idea for those whose other assets are sufficient to pay for their retirement needs. They plan to use their IRAs as emergency savings accounts and as something to leave for their heirs. Once required mandatory distributions begin, however they will exceed spending needs. The distributions will generate high, unnecessary taxes and deplete the IRAs. In addition, the heirs will pay income taxes on distributions they take from an inherited IRA. It might be better to pay taxes now and have future income and gains taxed outside the IRA.

On the other hand, if you plan to leave a significant amount of wealth charity, it makes a lot of sense to leave the IRA to charity instead of other assets. The charity will not owe income taxes on the distributions, and your heirs can inherit tax-advantaged assets.

It is unlikely that anyone can follow the perfect tax efficient investing and distribution strategy. To the extent you can follow these rules, however, your wealth will last longer for both you and your heirs.



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