A traditional approach of managing investments during retirement is to liquidate taxable investment accounts first before taking withdrawals from retirement accounts like IRAs and 401(k) plans. This retirement strategy allows retirees to spend the least tax-efficient portion of their investment portfolio by using interest, dividends, and potential capital gains – while preserving tax-deferral (and potential tax-deferred growth) as long as possible.
While many investment professionals focus on wealth accumulation strategies, a different approach is needed as individuals begin withdrawing funds from investment accounts to fund retirement needs. There are many strategies to consider for retirement income and making a mistake can be costly. A qualified financial planning professional can assist in evaluating retirement income strategies and help individuals craft an optimal retirement plan based on their specific circumstances.
Blending Withdrawals from IRAs and Taxable Accounts
While deferring IRA distributions can preserve tax-deferral and the potential benefit of tax-deferred growth, this distribution strategy can result in higher tax brackets after age 70 when IRA owners begin taking required minimum distributions (RMDs).
A withdrawal strategy to mitigate the potential impact of deferring IRA distributions until age 70 involves taking distributions from an IRA and taxable investment accounts along the way. By taking partial distributions from an IRA each year, distributions can occur at lower tax brackets without reaching the 24% tax bracket, and taxable investment accounts can last longer before being depleted and potentially avoid the point where a retiree must take distributions from the IRA because there’s no other money left.
By taking a blended-distribution approach, most of the IRA continues to benefit from tax-deferred growth for an extended period, and annual distributions can be managed to avoid hitting higher tax brackets.
Filling Lower Tax Brackets with Partial Roth Conversions
While taking partial distributions from an IRA before age 70 can be an effective means to enhance the longevity of a portfolio by reducing the average tax rate paid on IRA distributions, a caveat to this strategy is that it depletes a tax-preferenced account earlier than may have been necessary.
In other words, this distribution approach faces a fundamental tension between the desire to take more withdrawals early (to avoid “wasting” unused low tax brackets in the early years) versus the objective to benefit from tax-deferred compounding growth (by leaving the money in the IRA to compound tax-efficiently over time). A possible resolution to this dilemma is to “fill up” lower tax brackets from an IRA, without actually liquidating the tax-preferenced account.
Utilizing systematic partial Roth conversions before age 70 involves moving dollars from an IRA to a Roth IRA and generating taxable income that fills the 12% tax bracket in the early years of retirement. A potential result of this approach is the depletion of taxable investments during the first half of the retirement phase; however, a retiree’s tax rate isn’t driven up at that time because the newly-created Roth IRA can be used to supplement income on a tax-free basis.
Ultimately, a combination of taking advantage of lower tax brackets (and avoiding higher brackets) plus the tax-favored compounding in the traditional and Roth IRA accounts means that the partial Roth conversion strategy may produce a greater (net after-tax) wealth than other distribution strategies.
Optimizing Early Partial Roth Conversions and Avoiding Too Much Tax Deferral
An important concept to recognize in tax-efficient liquidation of retirement accounts is that there is such thing as “too much” tax deferral. An IRA or 401(k) that are allowed to compound long enough will eventually be so large that a retiree is driven into even higher tax brackets just trying to tap the account, whether to fund retirement spending or simply because distributions are “forced” out when RMDs begin.
Accordingly, the fundamental goal of spending from a portfolio in a more tax-efficient manner is to find constructive ways to whittle down a pre-tax account and stop it from growing too large, either by taking distributions outright at an earlier phase or by doing partial Roth conversions. Of course, if “too much” is withdrawn or converted in the early years, the retiree may drive up their tax rate now, which doesn’t help the situation either. In other words, the end goal is to find the balance point between the two.
Of course, where that balance point is will depend on the retiree’s overall income and wealth levels. For some, the balancing point may be to “just” fill up the 12% ordinary income tax bracket and try to avoid any rates that are 24% or higher. For those with more significant retirement accumulations, the sheer size of the family balance sheet may make it impossible to avoid being in at least the 22% bracket, and the goal will be to stay there and not drift up into the 24% or 32% brackets.
For those with very significant wealth, any tax bracket that’s less than the top 37% bracket may be appealing to fill with partial Roth conversions. Nonetheless, the strategy for tax-efficient spend-down of a retirement portfolio remains the same – to allow for maximum tax-preferenced growth in retirement accounts by spending from taxable brokerage accounts first, but not letting low tax brackets “go to waste” by filling them with partial Roth conversions along the way.
Reverse Dollar-Cost Averaging
Dollar-cost averaging is a technique of investing a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. Dollar-cost averaging can mitigate risk of market downturns by dividing up a lump sum and investing over time and taking advantage of market downturns. During wealth accumulation, dollar-cost averaging during market volatility can reduce average investment cost compared to funding investments with a lump sum.
During retirement, investors typically withdraw money on a regular basis and if investments are being sold on a regular basis to fund retirement, reverse dollar-cost averaging takes place which can force the sale of investments regardless of price. If share values are low, an investor will have to sell more shares to get a predetermined withdrawal amount compared to when share values are high. Since it’s important to buy when share values are low and sell when share values are high, selling regardless of market conditions is not wise.
During retirement, it’s important to be strategic with withdrawals and take advantage of certain market conditions. While timing the market isn’t generally recommended when putting money into investments, timing the market when withdrawing from investment accounts isn’t only helpful, it’s many times necessary. When an investor’s withdrawal rate remains the same, the price per share fluctuates and therefore requires selling a variable number of shares every month. Sometimes the price per share is high, other times, the price per share is low.
Withdrawing money on a regular basis during volatile and negative markets not only reduces the account value, but it also reduces the potential for recovery when markets improve due to the adverse impact of reverse dollar-cost averaging.
Emphasis on Investment Income with Growth Potential
An investment strategy focused on growing dividend income can provide an attractive alternative to relying on total return or high-income investments. By having a retirement portfolio focused on generating sufficient dividend income to cover retirement expenses, an investor can avoid having to liquidate investments during market downturns.
A strategy focused on growing dividend income should identify investment opportunities based on fundamental research that analyzes a company’s willingness and ability to pay an attractive dividend. An actively managed retirement portfolio may offer an effective way to navigate around some of the dividend declines seen in the broader market and passive index strategies.
Not only can dividend income contribute to funding retirement expenses, but also a well-managed portfolio may outpace inflation over time due to price appreciation.
Establishing a Strategic Liquidity Reserve
A strategic liquidity reserve can provide some control over the timing of withdrawals and offer an opportunity to reduce the impact of the short-term negative market performance. A strategic liquidity reserve can include savings account, money market account, or accessing home equity using a home equity line of credit (HELOC) or FHA home equity reverse mortgage (HECM) line of credit. The amount to hold in savings during retirement should consider monthly retirement spending with a goal of having at least six months of expenses in savings.
Benefits of a HELOC include low set up cost; however, this type of financing requires credit approval and lenders will consider income qualifications and home value in determining the credit amount. HELOCs require interest payments on the outstanding balance, the borrowing amount borrowed is static, and the revolving feature typically expires within ten years. Finally, HELOCs can be canceled by a lender which could create issues for the borrower.
To qualify for a HECM line of credit, homeowners need to be at least 62 years of age and demonstrate an ability to pay property tax and insurance on their home. The loan amount relies on the property value and borrower’s age. The available borrowing amount on a HECM line of credit increases each year due to an actuarial adjustment. Payments are not required on a HECM line of credit as long as the borrower lives in the house and pays the property tax and insurance, and the outstanding amount is not due until the borrower dies or moves out of the house.
HECMs are more expensive than HELOCs since a borrower is responsible for cost of a title policy, private mortgage insurance, as well as other fees including required credit counseling.
Using Qualified Charitable Contributions to Satisfy RMDs
Charitably inclined individuals over 70 should consider using qualified charitable distributions (“QCDs”) from their IRA to fund favored qualified charities. QCDs count toward meeting annual RMD requirements (up to $100,000 per year) while also reducing taxable income. Since the 2017 tax law doubled the standard deduction, QCDs can provide a tax benefit for individuals will no longer qualify for itemized deductions as a result of the doubling of the standard deduction as part of the 2017 tax law. Finally, lowering taxable income with the use of QCDs for charitable contributions may also result in lower Medicare Part B premiums since they are based on taxable income.
Since retirement assets may need to last for 30-years or more, having an optimal financial plan during retirement is critically important considering the limited ability to correct mistakes. A qualified financial planning professional can assist individuals to craft a plan to fund retirement in a tax-efficient manner and ensure achievement of retirement goals.
This article is for educational purposes only, and the information contained in this article is general and should not be considered legal or tax advice. Individuals should consult with an appropriate professional regarding their specific circumstances. The information contained herein is not intended to be used as the primary basis for investment decisions or construed as advice in meeting the particular needs of any investor. Please note that past performance does not guarantee future results.