Tax

Don’t overlook tax efficiency

People who are making financial preparations for retirement typically plan for expenses such as housing or health care…

People who are making financial preparations for retirement typically plan for expenses such as housing or health care but easily overlook one of the most significant categories that can affect their savings — taxes. Many neglect the fact that if the bulk of their retirement savings is in tax-deferred accounts, most or all of their distributions will be subject to ordinary income tax rates.

Investors often can stretch their retirement dollars further if they have the flexibility to manage distributions in a tax-efficient way. This is a process that must begin in the accumulation phase in order to create sufficient flexibility during retirement.

As investors accumulate retirement assets, they should consider diversifying their savings into three different buckets: one that’s tax-deferred, for workplace savings plans, traditional individual retirement accounts and annuities; one that’s tax-free, for Roth IRAs, cash value life insurance and municipal bonds; and one that’s taxable for savings and investments outside of tax-advantaged vehicles.

The biggest challenge tends to be directing enough money into tax-free accounts such as Roth IRAs. The earlier this process starts, the better, as a Roth conversion is not always a viable option.

Managing distributions from retirement savings to minimize taxes requires solutions that are personalized for each investor. The strategy also may need to change from year to year, depending on variations to the retiree’s income.

Managing distributions from tax-deferred accounts is a key consideration. Most of these dollars are subject to ordinary income tax rates and will increase the retiree’s taxable income. One strategy is to try to withdraw tax-deferred dollars without shifting the client into a higher tax bracket.

Consider a couple that needs income of $10,000 per month, or $120,000 annually, after taxes.

They receive annual pension income of $40,000 and after-tax Social Security income of $17,000, and have average deductions and exemptions of $30,000 per year. The combination of those elements results in a taxable income of $27,000. This is well within the 15% tax bracket for a married couple filing a joint return, which applies to taxable income of up to $68,000 (based on 2010 rates).

Any withdrawals from their workplace savings plans or traditional IRAs will also be taxed at the 15% rate to the extent that the taxable distributions don’t exceed $41,000. Staying within that limit, however, leaves an income gap. If they withdraw a larger sum from tax-deferred accounts, the federal income tax liability on additional distributions rises to 25% (based on 2010 rates), which would require additional distributions of nearly $40,000.

But there are better options.

Additional income needs can be filled using available taxable assets and savings from a tax-free Roth IRA. This will require considerably less than the $40,000 in tax-deferred distributions that would be needed to meet the remaining income goal.

The couple also should seek to offset any taxable gains incurred in that year by selling assets that would generate capital losses. Proceeds from those sales will fund part of the remaining income need — in this case, $19,000.

After all other sources are accounted for, the couple will still have a $10,000 income need, which can be met by taking distributions from the third tax bucket, their tax-free Roth IRA.

When you tally up all of the couple’s income sources, it looks like this: pension income, $40,000; Social Security, $20,000; withdrawals from tax-deferred accounts, $41,000; withdrawal from taxable accounts, $19,000; and withdrawals from tax-free accounts, $10,000. Their approximate tax on $68,000 of taxable income at the 15% rate will be $10,000, providing income of $120,000 to meet living expenses.

This case effectively demonstrates how tax diversification can add value to retirement savings. In this example, the couple’s effective federal income tax rate is 7.7%. Because they could manage their income effectively and avoid larger distributions subject to higher tax rates, the couple will realize additional benefits.

For example, they will qualify for lower premiums for Medicare Part B, potentially qualify for lower capital gains tax rates if the capital gains are also in the 15% bracket, and improve the potential to deduct some of their health insurance or long-term-care premiums.

By maintaining a tax-diversified retirement portfolio, investors have more flexibility to deal with unknowns, such as changing tax rates or the potential that Social Security and Medicare will be subject to means testing.

Craig Brimhall is vice president of retirement wealth strategies at Ameriprise Financial Inc.