Why it May be Advantageous to Diversify Retirement Savings

Although income may be lower than it was during working years, retirees may be surprised when their tax bracket is unchanged or even higher during the golden years. How can this be? Working professionals are able to reduce their taxable income in a number of ways: saving for retirement using a tax-deferred plan such as a 401(k), contributing to a health savings account, and deducting mortgage interest are a few common methods. However, once retired, many individuals are no longer eligible to utilize most of these methods. For retirees with at least one million in tax-deferred retirement accounts, this can be problematic when Required Minimum Distributions kick in at age 70 ½.

How are RMDs calculated?

To illustrate why RMDs may present tax planning challenges for those with a sizeable nest egg, we first need to explain how Required Minimum Distributions are calculated. Perhaps surprisingly, the RMD calculation is pretty simplistic. The IRS publishes a table called the Uniform Lifetime Table which those affected use to find their age and the corresponding life expectancy factor. Using the account balances as of December 31 of the prior year for all retirement plans and IRAs (except Roth IRAs); divide this sum by your life expectancy factor. (The exception to this is when a spouse is more than ten years younger and is also the only primary beneficiary – in this case the Joint Life and Last Survivor Expectancy Table is used.)

For retirees with large balances in tax-deferred accounts and other sources of income, Required Minimum Distributions may pose a few problems. The distribution will be taxable income, and if the sum is large enough, it can cause Social Security benefits to be taxed, raise Medicare Part B premiums, and phase out certain income-based tax deductions. In 2016, Social Security is at least in part taxable for individuals with provisional income of $25,000 or more and $32,000 for those that are married and filing jointly. If provisional income is greater than $34,000 for single filers and $44,000 for joint filers, it is likely that 85% of your benefits will be taxed. Medicare Part B premiums are increased for individuals who earn over $85,000 ($170,000 for joint filers). Although there is no way to predict future tax rates or legislative actions, by strategically diversifying the retirement portfolio, investors can give themselves more flexibility in retirement.

Portfolio Diversification Strategies

Most retirement plans provide tax-deferral, and there is a lot to be said for the benefits of tax-deferred growth on an investment portfolio. However, for investors who are able, it is wise to diversify retirement assets.

There are three main investment categories for retirement assets: taxable, tax-deferred, and tax-free. Examples of taxable accounts are mutual funds, brokerage and savings accounts, and CDs. These accounts are “taxable” because you will pay taxes on dividends and interest and capital gains taxes on realized investment gains annually. Tax-deferred accounts are the most common; Traditional IRAs and employer-sponsored retirement plans are two examples. Investors are able to deduct contributions from their taxable income but will pay regular income tax when they withdraw funds in retirement.

Tax-free accounts like a Roth IRA and Roth 401(k) are unique in that an investor will pay income tax on their contributions, but the account can then grow tax-free if held for at least five years.  Distributions in retirement are not taxable, and there are no RMDs.

Strategies to Withdraw Retirement Funds

Retirees should carefully consider the best course of action when it comes to withdrawing funds from their various accounts. The analysis will consider multiple factors such as total portfolio holdings, age, other assets, funds needed, and income tax bracket to help determine the optimal withdrawal strategy. As a general rule of thumb, retirees currently in a lower marginal tax bracket may want to tap tax-deferred accounts first. However those still working or in higher tax brackets could benefit from withdrawing funds from tax-free or taxable accounts. If you’re looking to pass along a legacy to heirs, using taxable assets last could be a good strategy for you.

Ultimately, every investor’s tax situation and financial picture is different so it is important to work closely with a financial advisor and tax professional to determine the most tax-efficient course. Of course, if all of your retirement assets are held in tax-deferred accounts the picture becomes much simpler – but you will also have far fewer options to reduce your tax exposure.

The material contained in this article is for general information only and should not be construed as the rendering of personalized investment, legal, accounting, or tax advice.

To learn more about Thomas McFarland, view his Paladin Registry profile.

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