WHEN DRAWING DOWN a portfolio in retirement, the standard advice is to start with your taxable account, next turn to traditional retirement accounts and, finally, tap any Roth accounts. That way, you let traditional retirement accounts grow tax-deferred for longer and allow your Roth accounts to grow tax-free for longer still.
While that’s generally good advice, you may want to tweak it. Retirement can prove surprisingly taxing, especially once you turn age 73 and start taking required minimum distributions from your retirement accounts. All withdrawals from 401(k) plans, IRAs and their ilk are typically taxed as ordinary income. Moreover, those withdrawals could, in turn, drive up your taxable income so that not only do you have to pay higher premiums for Medicare, but also up to 85% of your Social Security benefit is subject to taxes. The latter is sometimes referred to as the “tax torpedo.”
How can you avoid the torpedo? Two strategies may help. First, endeavor to pay off your mortgage by retirement. That way, you’ll avoid the need to draw down your retirement accounts to make mortgage payments. Those retirement account withdrawals could generate enough taxable income to trigger taxes on your Social Security benefit.
Second, you might use your early retirement years to trim the size of your retirement accounts by either drawing down those accounts or converting a portion to a Roth IRA. For instance, if you expect to be in the 22% federal tax bracket once you start required minimum distributions in your 70s, you might aim to generate enough income in your 60s to get to the top of the 12% bracket. To give yourself more room for maneuver, you could delay claiming Social Security until later in retirement—which, in any case, can be a smart thing to do. Strategies for claiming Social Security are discussed elsewhere.
You might also look to take extra-large retirement account withdrawals if you have a year with sizable itemized deductions, perhaps because of medical expenses. These itemized deductions could be offset against your taxable income, perhaps allowing you to tap your IRA at a relatively low tax cost. All this highlights a big advantage enjoyed by retirees: Unlike those in the workforce, you have a fair amount of control over your annual tax bill—and you can use that control to make your retirement more financially comfortable.
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Thank you for this discussion on taxes. It’s not about minimizing taxes in any given year. It’s about paying the lowest taxes over the long haul. In my situation, a Roth was not always available to me, especially in my 401k. After my divorce, I needed to minimize all of my expenses, including taxes. Now, the situation has changed. Tax rates have gone down, and I’m converting as much to Roth as possible, while also drawing on traditional assets. Then, when all of my income streams have started and it is time to draw RMDs, I hope not to be taxed out the whazoo just because my income is far more than I need. Makes me wish I’d heard this advice earlier. The lesson: diversify not only your investments, but also your taxability.