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Creating a Tax-Efficient Withdrawal Strategy for Retirement

Many people spend their entire lives saving for retirement but don’t put very much thought into how they’ll convert that nest egg into an income once they take the leap. The truth is that putting together a well thought out withdrawal strategy can save you a lot of money over the course of your retirement, while still giving you the flexibility you need to live comfortably and check a few bucket-list items off of your list.

One of the primary considerations you have when putting together a withdrawal strategy is how your income in retirement will be taxed. Creating a tax-efficient plan can save you thousands of dollars each year when you file. This ultimately frees up your hard-earned savings to put it toward your ideal lifestyle.

Why Taxes Matter

Ultimately, when you retire, you’re able to pull retirement income from a few different types of accounts:

  1. Taxable. This could be an individual brokerage account.
  2. Tax-exempt. These accounts are usually Roth IRAs or Roth 401ks, where taxes have already been paid on the funds contributed.
  3. Tax-deferred. This would be a traditional IRA or 401k where contributions were made pre-tax.

Many investors end up funneling the largest portion of their retirement savings into a tax-deferred 401k or retirement plan offered through their employer. While this is useful for boosting savings, it can be problematic for investors whose income (and therefore retirement contributions) are significant. The higher your income tax bracket in retirement, the more those funds will be taxed when you tap them for income.

Let’s look at an example. If your income (married, filing jointly) is over $171,050 each year in retirement, you fall within the 24% tax bracket in 2020. However, if you’ve wisely planned ahead and performed a Roth Conversion to move funds to a Roth 401k or a Roth IRA before retirement, you’ve already paid taxes on those funds.

Any income you pull from your tax-exempt accounts isn’t taxable in retirement, which can significantly lower your tax bill. In fact, if all of your retirement income is coming from a tax-exempt account, you may only owe taxes on a small portion of your income from Social Security.

Ways You Can Diversify

If you’re still 5-10 years out from retirement, you have more flexibility in your ability to diversify your portfolio to create a tax-efficient retirement income plan. Speaking with an advisor to help you diversify your portfolio and boost your Roth 401k can help. If you’re further away from retirement, you may even be able to perform Roth conversions annually until you retire. This can help you transfer a large portion of your accumulated taxable retirement savings, and pay taxes on the funds during the conversion rather than waiting until you retire and need to take withdrawals to create an income.

By performing conversions to tax-exempt accounts before retirement, you’re also giving those funds a longer runway to grow tax-free. This could potentially mean a larger retirement nest egg that isn’t taxable, and the ability to encourage tax-free account growth throughout retirement.

Creating Your Own Flexibility in Retirement

In retirement, you have the power to create your own flexibility. One of the best ways to do this is to free up your cash flow as much as possible when entering retirement so that you can live the life you’ve always envisioned. By minimizing taxes in retirement, you give yourself the ability to:

  1. Continue investing to grow generational wealth.
  2. Check “bucket list” items off throughout retirement.
  3. Comfortably afford unexpected medical expenses.
  4. Pursue an “encore career” or launch a small business instead of retiring fully.

Saving as little as 8% in taxes in retirement can create a colossal impact, both on your wealth and personal fulfillment. Want to learn more about creating a tax-efficient strategy? Feel free to reach out. We’d love to hear from you!