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5 Best Practices for Limiting Your Tax Burden in Retirement

Fri, 27 Feb 2015

A flexible withdrawal strategy, diversification across account types, and targeted Roth conversions can limit the tax drag for retirees, says Morningstar's Christine Benz.


Video Transcript

Note: This video is part of Morningstar's 2015 Tax Relief Week special report.

Jason Stipp: I'm Jason Stipp for Morningstar. Death and taxes may be inevitable, but with taxes you can exert some amount of control over what you pay. Here to offer some best practices for limiting your tax burden in retirement is Morningstar's Christine Benz.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: There are some ways that you can limit taxes in retirement. Some best practices, as you call them. The first one is to really bear in mind the withdrawal-sequencing rules that you should follow so that you're making tax-efficient withdrawals from your portfolios.

Benz: That's right. And I would call them guidelines rather than rules because, as we'll discuss, they can be bent at various points in time, and it might make sense to bend them. But I think it does make sense--as you're thinking about your retirement strategy and how you'll get distributions from your portfolio--it does makes sense to think about the overall logic behind these guidelines. The basic idea is that you want to preserve those vehicles that give you some sort of tax advantage. Hang on to those as long as you possibly can while spending those assets that have fewer tax benefits associated with them.

So, when we think about the standard withdrawal guidelines, you're certainly going to start with required minimum distributions, if you're subject to them. There is really no way around them. You've got to take them. So, that's step one. Then, taxable assets would be the next accounts to tap--again, no inherent tax-saving features, although capital gains rates are nice and low currently. Then, moving on to traditional tax-deferred vehicles. These would be Traditional IRA assets and traditional non-Roth company retirement plans.

Finally, you want to save those Roth assets for last. Not only are they the most attractive from a tax standpoint during your lifetime, but they will also tend to be the most attractive for your heirs to inherit from you. So, if there is money left over at the end of your lifetime, your heirs will be very grateful if it's in some sort of a Roth wrapper.

Stipp: And, of course, you'll never have to pay RMDs on Roth accounts.

Benz: That's right.

Stipp: Best practice number two, as you were saying, is remembering that rules are meant to be broken. So, some of those rules you just said, you may need to bend them depending on the context of situation. So, when should I be flexible with those rules?

Benz: One thing I've heard, certainly, from tax planners is that the last thing you want to do is rotely go through each of these account types and deplete them: Go through your taxable--spend it all down until it's gone. Then, move on to tax-deferred. Ideally, you want to keep some of these accounts alive throughout your lifetime, and the reason is that, at various points in time, it may be more or less advantageous for you to tap them.

A great example would be, even if your Roth assets are typically in the save-for-later pile, there may be years where you really need those tax-free withdrawals. Maybe you have very high RMDs because your Traditional IRA has performed really well. You need a little bit more money to live on. Taking those tax-free withdrawals can be a way that you can potentially keep yourself in a lower tax bracket. So, flexibility, maintaining assets in all three account types is a really valuable tool for retirees to have in their arsenals and, ideally, one for them to keep throughout their retirement years.

Stipp:  Best practice number three: If you are drawing from these different accounts at different times throughout retirement, you want to make sure that those accounts all have some degree of diversification in them.

Benz: That's right. Even though the withdrawal-sequencing guidelines would generally call for having your longest-term assets in the Roth accounts--because that's what you want to grow the most and you're getting big tax benefits and you won't pay taxes on those withdrawals--if you will periodically be maybe taking pieces out of that Roth account, you want to make sure that you are able to take some liquid assets. [You want to make sure] that you're not having to maybe tap an equity account when it's at low ebb because that won't make sense, even though it may be advantageous from a tax perspective. So, thinking about maintaining some asset diversification within each of those three major account types can be a valuable tool.

Stipp: Best practice number four has to do with what you call a sweet spot. It's an age range right when you start to retire but before you have to take RMDs in which you have maybe a little more flexibility and could do things like a Roth conversion.

Benz: Right. With people working longer, this is getting to be an increasingly compressed period of time; but the basic idea is that if you've retired, you're not earning a salary, you're just drawing from your portfolio, so that may be a good time to make those conversions because you are taking those RMDs, which could bump you up into a higher tax bracket. You may be able to keep yourself in a very low tax bracket during those years.

The tricky part is that we've sometimes heard about the go-go, slow-go, no-go cycle throughout retirement. This is oftentimes when people are feeling most active. They are feeling like doing some of expensive travel--where they would want to be drawing upon their portfolio. So, it's definitely a balance; many people in these years--say, between age 65 and age 70--really aren't feeling like short-shrifting themselves from a quality-of-life standpoint. So, you've got to find that right balance; but it is something to explore, particularly if you do have a lot of Traditional IRA or 401(k) assets that are going to be subject to RMDs.

Stipp: Best practice number five: Don't be afraid to ask for some help.

Benz: That's right. I think that this is all complicated stuff, and so I do think it's important for retirees to think about identifying a tax advisor or a financial advisor who is really well versed in tax matters to help you figure out this tax-efficient withdrawal sequencing--to help you determine how you can keep yourself in the lowest possible tax bracket. I think when you step back, you realize just how many moving parts are in the mix.

You've got RMDs; you've got deductions, which you may or may not be able to control. You potentially have subsidies under the Affordable Care Act that you may be eligible for. You've got Social Security and various elements of taxation that fall under that umbrella. So, a lot of moving parts. This is an area, I think, where an advisor can be very beneficial, even if you've been a dedicated do-it-yourselfer throughout your retirement years.

Stipp: Another big moving part, of course, is estate planning, which is also an important tax consideration at this time.

Benz: And it's an important place to get help. I think if you've got an estate-planning advisor, that person can really help you make sure that you have your beneficiary designations--that those all make sense. And that [estate-planning advisor can also help you answer the question], "Of these various pools of assets, which are going to be the most attractive for me to spend during my lifetime and which am I better off trying to leave to kids, grandkids, and other loved ones in my life?"

Stipp: Five great tax best practices for retirees. Christine, thanks for joining me.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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