Spokane Journal of Business

Staying tax efficient in retirement should be priority

Exposure can be minimized with right investments, plan

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For those approaching retirement with an established nest egg, the next challenge lies not just in continuing to grow your investments but in ensuring that the dollars you’ve put away last. Many factors should be taken into consideration, including the basic principles of managing your expenses and withdrawals efficiently, but one critical element is often overlooked: how to best minimize your tax exposure. 

Federal and state income taxes, including taxes on investment income and retirement distributions, all can be minimized with the right investment vehicles and planning. Tax minimization creates the potential for either larger withdrawals or an extension of the same withdrawal amount over a longer time period, thus hopefully leading to a more secure, stress-free, and enjoyable retirement. 

To prevent taxes from shortening the life span of your well-earned retirement, you need to be mindful of tax efficiencies as you craft every part of your retirement plan. Although it’s difficult to make recommendations that apply to every situation, there are many best practices that individuals can use as a guide to developing a tax-efficient retirement income strategy. 


Tax benefits

Most investors are aware of the different types of retirement accounts available to them. They know that any steps toward tax-efficient investing will likely involve some version of either a conventional tax-deferred retirement account in which contributions are pretax with taxable distributions—a traditional IRA or 401(k), for example—or a tax-exempt retirement investment that affords no immediate deduction upon contributing but from which appropriate withdrawals are tax free. The Roth IRA is a prime example. 

Investment accounts can be taxable, tax deferred, or tax exempt. Taxable accounts incur tax liabilities on income earned each year, whether or not the income is distributed to the owner, while tax-deferred accounts allow investors to defer tax obligations and shelter the investment from taxes until funds are withdrawn from the account. Deferring taxes creates significant advantages because you are able to let dollars that would have been spent on taxes continue to appreciate tax deferred. There are no immediate tax savings when funding a Roth IRA, but the funds in this account typically grow permanently income tax free.

Investors frequently debate whether taxable, tax-deferred, or tax-exempt accounts are better for their particular situation, and I encourage you to discuss which options are best for you with your investment and tax adviser. An early discussion is best, and continued periodic meetings can help make sure that your planning is keeping up with your goals and objectives.


Asset allocation

Asset allocation is a crucial aspect of developing any investment strategy, and it is especially important when considering retirement accounts—both during the accumulation phase and once distributions begin. 

Ideally, the asset allocation process includes a review of goals, risk tolerance, and other factors that guide an investor to finding the right balance of stocks, bonds, and other investment classes. While growth and preservation of wealth are, of course, important factors affecting these choices, any comprehensive financial plan should take tax vulnerability into consideration as well. 

Some investments are more appropriate for retirement accounts. Generally, investments that are highly taxed are best for tax-deferred or tax-exempt accounts. For example, it might make sense to have a mutual fund with high turnover in your retirement account. The rapid stock sales within the fund can increase an investor’s short-term capital gains, which are taxed at the individual’s maximum personal income tax rate. In contrast, a long-term buy-and-hold position or a mutual fund with low turnover and generally minimized short-term gains could be placed in a traditional investment account. 

Additionally, although no one typically buys an investment with the expectation of loss, a taxable investment account might be the best home for an investment that bears an unusual amount of downside risk. This is because there is no tax benefit for most losses in a retirement account. Investments with built-in tax benefits are also frequently better off in a taxable account, such as a master limited partnership investment, in which the distributions to owners are partially offset by depreciation or depletion.

Taxable bond investments may make sense for a retirement account as well, given that that interest income is taxed at ordinary income tax rates, as opposed to lower capital gains or qualified dividend rates. Consideration of the allocation of bonds and less heavily taxed investments between taxable and tax-deferred accounts is especially critical when retirement distributions are occurring. 

This is because every dollar coming out of a retirement account is taxed at the person’s maximum tax rate, while other investment income may be taxed at a lower rate. Obviously, municipal bonds or other investments that aren’t subject to tax don’t belong in a retirement account, given that there is no sense in sheltering these types of investments from taxes they aren’t subject to. 

In summary, highly taxed investments typically should be allocated to a tax-deferred or tax-exempt account, while lower-tax investments are placed in a traditional, taxable account. While the difference may seem minor initially, a tax-efficient choice can make a significant difference over a long time, increasing your total after-tax rate of return and making your retirement that much more enjoyable. 

Keep in contact with your investment and tax advisers on a regular basis, as the tax laws continue to evolve, and, as many people found out in 2013, the laws don’t always change in taxpayers’ favor. The elimination of some benefits related to qualified dividends and long-term capital gains, and the imposition of the punitive 3.8 percent Net Investment Income Tax, makes investment and tax planning all the more critical, especially when you are considering investment allocation between taxable and tax-deferred and tax-exempt accounts.


Taking distributions

Beyond looking at ways to invest tax efficiently and grow your portfolio, it’s also worth looking at how to best draw from your portfolio. You’ve put in all the work to create this wealth, and when you begin to rely on these assets, it’s even more important to be mindful of your earnings’ tax considerations. Broadly speaking, there is an optimal order in which you should withdraw from your accounts. Depending on your approach, you can help manage your marginal tax rate by using a tax-efficient strategy when taking distributions.

Typically it’s best to withdraw from traditional, taxable accounts first, taking advantage of low capital gains tax rates and managing any capital gains you incur while the funds in your tax-deferred and tax-exempt accounts continue to grow without being taxed. Next, it’s generally best to take distributions from tax-deferred accounts such as traditional IRAs and 401(k) plans. Lastly, look to tax-exempt accounts such as Roth IRAs. The income gained isn’t subject to tax, and unlike with traditional IRAs, investors aren’t required to take minimum distributions at age 70½. Also, a Roth IRA can be left to your beneficiaries without any income tax implications.

There are exceptions to the above approach, especially in regard to an investor’s marginal tax bracket. Depending on your income level, you may need to withdraw more to prevent required minimum distributions from pushing you into a higher marginal tax bracket. 

I would strongly encourage you to meet with your investment adviser and review your investment and distribution options, both now and periodically over the lifetime of your investments, to make sure that your plans remain current, that your goals are achievable, and that you are maximizing your retirement options. Over the long term, a tax-efficient investment and distribution strategy can significantly increase the funds available to you in retirement. Don’t leave that money on the table.

 Rob Blume is managing director and senior vice president of wealth management and advisory services for Spokane-based Washington Trust Bank.

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