How to Keep More of Your Money by Reducing Taxes in Retirement

6 hours ago

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A woman ponders her retirement plan while sitting in a cafe. T. Rowe Price studied alternative withdrawal strategies suited for retirees with a primary focus on meeting their spending needs, as well as those with considerable assets and a desire to leave an estate for their heirs.
A woman ponders her retirement plan while sitting in a cafe. T. Rowe Price studied alternative withdrawal strategies suited for retirees with a primary focus on meeting their spending needs, as well as those with considerable assets and a desire to leave an estate for their heirs.

A common approach to retirement income relies on withdrawing money from taxable accounts first, followed by 401(k)s and IRAs, and lastly, Roth accounts. Conventional wisdom holds that withdrawing money from taxable accounts first allows a retiree’s 401(k) assets to continue growing tax-deferred while also preserving Roth assets to potentially leave to heirs.

A financial advisor can help you plan for retirement and find a tax-efficient strategy for withdrawing your assets. Find a financial advisor today.

But this relatively simple and straight-forward approach for generating retirement income may result in tax bills you could otherwise avoid. In a 17-page study, T. Rowe Price explored alternative withdrawal strategies suited for retirees whose primary focus was on meeting spending needs, as well as those with considerable assets and a desire to leave an estate for their heirs.

By changing up the order in which assets are withdrawn from different accounts, specifically by tapping tax-deferred accounts earlier than what is conventionally recommended, a retiree can actually reduce his tax liability, extend the life of his portfolio and leave an estate for his heirs, T. Rowe Price found.

“When following conventional wisdom, you start by relying on Social Security and taxable account withdrawals,” Roger Young, a certified financial planner and director of thought leadership for T. Rowe Price, wrote in the report. “Since some of that cash flow is not taxed, you may find yourself paying little or no federal income tax early in retirement before required minimum distributions (RMDs). That sounds great — but you may be leaving some low-tax income ‘on the table.’ And then after RMDs kick in, you may be paying more tax than necessary.”

A Better Way to Meet Spending Needs and Reduce Taxes?

Choosing which accounts to tap and when is critical to an effective withdrawal strategy. T. Rowe Price studied alternative withdrawal strategies suited for retirees with a primary focus on meeting their spending needs, as well as those with considerable assets and a desire to leave an estate for their heirs.
Choosing which accounts to tap and when is critical to an effective withdrawal strategy. T. Rowe Price studied alternative withdrawal strategies suited for retirees with a primary focus on meeting their spending needs, as well as those with considerable assets and a desire to leave an estate for their heirs.

To illustrate how the conventional withdrawal strategy could cost you at tax time and ways to improve upon it, T. Rowe Price examined several hypothetical scenarios involving retired couples with both taxable accounts and tax-deferred accounts.

In the first example, the firm looked at a married couple with relatively modest retirement income and an annual budget of $65,000. The couple collects $29,000 in Social Security benefits and has $750,000 in retirement savings, 60% of which is held in tax-deferred accounts and 30% in Roth accounts. The remaining 10% ($75,000) is kept in taxable accounts.

Following the conventional strategy of using withdrawals from taxable accounts to supplement Social Security benefits first, the couple preserves their Roth assets to be used later in retirement. However, they would incur a federal income tax bill of $2,400 in years 4 through 17 of a 30-year retirement as a result of relying too heavily on their tax-deferred assets, which are taxed as ordinary income.


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