Smart Moves with Tax-Deferred Retirement Accounts

This article was originally published in full on Tacoma’s The News Tribune on March 4, 2024. Gary Brooks has been a contributing author for the paper since 2008 and is also a Partner and Senior Wealth Advisor at Mission Wealth in Gig Harbor, WA.

Most people this time of year gather up their tax-related documents after filing their annual return and think about how they could possibly pay less tax for the next year. For some people, it is one of several personal finance topics where counter-intuitive opportunities might deviate from conventional wisdom.

There are circumstances – particularly for early 60s retirees with significant pre-tax account balances – where meaningful benefit might be gained by paying more tax now to pay less in lifetime taxation.

Commonly, people are opposed to accelerating any tax that could be postponed. However, if you can flip the script from conventional wisdom to maximize tax efficiency over time, you could potentially achieve one of two desirable outcomes:

• More money left over at the end of your life for heirs.
• A higher sustainable spending rate for your own lifestyle or charitable contributions throughout retirement

Conventional wisdom suggests that retirees should withdraw first from non-retirement accounts like brokerage or trust accounts, second from tax-deferred retirement accounts (IRA, 401k, etc.), and last from after-tax accounts (Roth IRA, Health Savings Account).

Revisit the Order of Withdrawal from Your Retirement Accounts

There are scenarios, however, where lifetime tax efficiency could be improved by engaging with your pre-tax accounts early in retirement. Careful orchestration of IRA withdrawals (including required minimum distributions that currently apply at age 73), Roth IRA conversions, Social Security taxation thresholds and income-based Medicare premium increases could lead to meaningful tax savings.

Rather than defer realizing taxable income as long as possible, it could be beneficial to fill up relatively low-tax brackets now, thus lowering total tax in future years. That requires proactive planning to model “what if?” scenarios and target windows of opportunity for a series of years between initial retirement and start dates for Social Security and IRA-required withdrawals.

For many people, the first 5-to-10 years of retirement present an opportunity that has an impact well beyond the first stage of retirement.

Retirement researcher Wade Pfau has modeled order-of-withdrawal sequences that project to the equivalent of improving after-tax investment returns by 0.10 percent to 0.40 percent per year. The larger after-tax improvements are gained by lower-income taxpayers who most need to keep every extra dollar they can. There is less percentage difference for wealthier people, but those small percentages apply to larger dollar amounts which could translate to significantly more absolute dollars of extra spending or generational wealth transfer.

Fractions of a percentage point might not seem like much, but, when applied consistently over perhaps a 30-year retirement, they might provide more build-up of your savings and more flexibility for you to increase your spending.

The order-of-withdrawal benefits are not the only way to increase after-tax investment returns. Several other tax-sensitive tactics apply, regardless of your age or income. That starts with optimal asset location.

Watch our video on the benefits of Asset Location

Why Asset Location is Equally Important

Which account types are used to hold investments with different tax characteristics is important.

Generally, you could reduce tax costs by holding tax-inefficient assets like income-paying investments (bonds, real estate, dividend stocks, actively managed mutual funds that pay out annual distributions) in tax-deferred accounts (IRA, 401k) while owning tax-efficient investments such as exchange-traded funds, index mutual funds, and municipal bonds in taxable brokerage accounts.

Aside from where you locate certain investments, utilizing tax-loss harvesting when available (selling investments that have declined in value to offset capital gains or income elsewhere) can increase your after-tax returns.

More adherence to tax-efficient income management requires time and effort by you, and possibly your accountant or financial advisor. It doesn’t take much extra return or reduced taxation to make it worthwhile.

Consider a hypothetical $1 million portfolio that has a $3,750 monthly withdrawal (4.4 percent of the initial balance plus a cost-of-living adjustment of 2 percent annually) and a 20 percent effective tax rate. Assume the conventional wisdom withdrawal approach and no special attention to tax-efficient investment management yields a 5.5 percent average annual return. There would be $147,171 remaining after 30 years. With some tax-efficient management, increasing the average after-tax return to 6.0 percent would boost the end total to $371,728. If dying with more isn’t your interest, you could alternatively spend roughly $220 more per month for 30 years under the more tax-efficient assumption.

Seek Tax-Efficient Investment Advice with Mission Wealth

Those are outcomes from the financial engineering laboratory but in practice could improve financial security. Not everyone will have the necessary mix of convenient timing and investment account flexibility to achieve those outcomes, but most people do have ways to manage tax impact over time.

Taxes have a variety of personal pivot points and changes from year to year that deserve attention. You might need to be careful when creating more current taxable income via IRA withdrawals or Roth conversions. Those activities could trigger net investment income tax, increased taxation of Social Security income, or higher health insurance premiums.

Contact Mission Wealth today for a free discovery consultation and receive your next steps to secure your best financial future.