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Leveraging the Tax Code to Make Your Nest Egg Last Years Longer

Last update on: Oct 24 2019

Would you like to make your nest egg last years longer during retirement?

Would you like to do that without worrying about the markets or searching for the hottest investments?

You can. Over the years my research, confirmed by others, found a nest egg will last years longer if you pay attention to a few tax rules to develop a smarter withdrawal strategy. Re- search from Vanguard concluded that a tax-efficient withdrawal strategy increases the value of the accounts by up to 0.70% annually.

More recent research shows you can do better. An even smarter withdrawal can make your nest egg last longer.

Adapting to the recent changes in the tax code, coordinating your withdraw- al strategy with the beginning of Social Security benefits and taking advantage of technology maximizes the life of your retirement assets.

Most people own different types of investment accounts: taxable accounts, tax-deferred accounts (traditional IRAs and 401(k)s, annuities) and tax-free accounts (Roth IRAs). The order in which you withdraw assets from these accounts matters.

Years ago, I was a leader in developing what now is the conventional wisdom for withdrawal strategies. With- draw money from the taxable accounts fi st. Then, take money from the tax-deferred accounts. Finally, spend down the tax-free accounts. In other words, let tax-advantaged accounts compound for as long as possible. Th s approach makes your money last three or more years longer than alternatives.

We updated and revised the strategy a few years ago to deal with Stealth Taxes, which became more numerous and began having a greater impact on retirees than in the past.

The Stealth Taxes increase your tax bill without pushing you into a higher bracket in the tax tables. They include the inclusion of Social Security benefits in gross income, the Medicare premium surtax, the alternative minimum tax, the reduction in personal exemptions, itemized expense deductions and more.

The key to most of the Stealth Taxes is adjusted gross income (AGI). As AGI rises, more of the Stealth Taxes are triggered.

AGI is the last line on the fi st page of Form 1040. It isn’t reduced by itemized expense deductions or many of the other strategies people traditionally use to reduce income taxes.

Now, to maximize the life of your retirement assets, you need to manage your tax bracket. Balance the with- drawals from the different accounts each year to stay in the 15% or 20% bracket each year.

When you withdraw money from taxable accounts, most of it is tax free. You’ll have some interest, dividends and capital gains. But for the most part, you’re withdrawing principal,  and that is tax free. The dividends and capital gains are tax-advantaged, with a maximum 20% rate.

So, under the original strategy, you’ll pay very little in taxes in each of the early years. But withdrawals from tax-deferred accounts, such as traditional IRAs, are ordinary income taxed at your regular tax rate. In the years when you’re primarily taking distributions from these accounts, your tax rate will be much higher. Then, when you take distributions from Roth IRAs or other tax-free accounts, those distributions are tax free and you’ll owe no taxes.

Under the traditional strategy, your marginal tax rate will fluctuate wildly during retirement, and you’ll be in a fairly high tax bracket in some years.

Managing your tax bracket reduces lifetime taxes and increases the life of your nest egg without changing your spending. Some examples of how to manage your tax bracket were in an article in the April 2015 issue of Financial Analysts Journal.

One strategy is to withdraw money from tax-deferred accounts each year until you’re pushed to the top of the 15% tax bracket. For someone age 65 or over in 2017, that’s $47,750, assuming the standard deduction and no itemized expenses. Any additional money needed for the year’s spending is taken from the taxable accounts. In later years, after the taxable accounts are exhausted, any additional money needed for annual spending is taken from the tax-free Roth accounts.

A variation is to take all spending from taxable accounts during the fi st years of retirement. At the same time, convert part of the traditional IRA to a Roth IRA each of these years. The converted amounts are included in gross income and taxed as ordinary income. So, convert just enough of the traditional IRA each year to keep you in the 15% tax bracket. You’re unlikely to convert all of the traditional IRA to a Roth before the taxable accounts are exhausted. After the taxable accounts

are exhausted, each year enough money is withdrawn from the traditional IRA to push you to the top of the 15% bracket. Any additional spending money is taken tax-free from the Roth IRA.

Each of these strategies makes the nest egg last at least one to two years longer than the conventional strategies.

You can take the strategy to the next level by coordinating the distributions with the timing of Social Security benefits and the taxation of those benefits.

For example, you can delay Social Security benefits until age 70. Before age 70, pay your expenses with distributions from the taxable account. At the same time, each year you convert enough of the traditional IRA to a Roth IRA to keep you in the 15% tax bracket. After the taxable account is exhausted, you take distributions from the traditional IRA until you reach the top of the 15% tax bracket. Additional spending comes from Roth IRA distributions, which are tax free.

Th s strategy has several effects. You maximize Social Security benefits. As with the previous strategy, it ensures you are in the 15% tax bracket for life. In addition, once Social Security benefits begin, it keeps your AGI low enough that you don’t trigger the inclusion of 85% of Social Security benefits in gross income. Instead, no more than 50% of benefits are taxed in any year.

The combination allows the nest egg to last about six years longer, according to research by William Reichenstein and William Meyer.

The government is your partner in retirement. It wants a share of your nest egg and Social Security benefits, but you can manage the share the partner receives. By thinking outside the box and taking advantage of the rules, you can increase the life expectancy of your retirement assets.

You probably won’t be able to apply these strategies exactly as described.

You’ll have some income that’s out of your control and will have to take

required minimum distributions from traditional IRAs after age 70½. You need to work the strategies within these limitations.

The strategies can become complicated, especially if you’re trying to find the optimal strategy and you’re part of a married couple with two Social Security benefit decisions. You can look for a local fi  ancial planner who uses a newly available tool, Income Solver. It’s software marketed to financial professionals at that costs over $1,500 annually. Or you can use the examples here as a guide and crunch the numbers to develop your custom plan. The keys are to have money in the different types of accounts and manage your tax bracket during retirement.

A smarter withdrawal strategy is a safer and surer path to extending the life of your retirement assets. It is easier than trying to increase investment returns and less painful than reducing spending



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