Yellowstone Financial, Inc.

Use Tax Smarts to Hasten Retirement

As a client recently reminded me, retirement is an entirely different financial problem than saving for it. “I know how to save,” he told me. But he didn’t know how to generate a sustainable stream of withdrawals that would last throughout retirement. Moreover with pre-tax accounts like 401(k)s and traditional IRAs, taxable brokerage accounts, and tax-free Roth IRA accounts, he didn’t know when to pull funds from what accounts. If you add pensions, annuities, cash-value life insurance and Social Security to the mix it becomes a graduate-level case study to optimize your finances.

Looking at the conventional wisdom, many mutual fund companies advocate a certain order of withdrawals. The common advice is to first withdraw from your taxable accounts, which are funds held outside of retirement plans. Then you should shift to funding from tax-deferred accounts such as IRAs. Finally, the withdrawals should come from Roth IRAs and other tax-free sources.

A study of tax-efficient withdrawal strategies in the Financial Analysts Journal concluded that there were superior alternatives to the conventional wisdom, and that with some tweaks you could achieve a “portfolio longevity” increase of over three years. Given that there are many of you who would like to be financially independent as soon as possible, getting three years added to your retirement is no trivial matter!

So what’s the recipe for an additional three years of tax-fueled financial independence? The study uses retirees at age 65, but could work for those who reach financial independence at an earlier age. The first step is to move a regular amount of tax-deferred assets such as a traditional IRA every year into a Roth IRA over a period of years. The process is called a Roth conversion, and involves moving pre-tax assets to tax-free assets, while paying income taxes on the amount converted each year.

The key is to convert just enough to bring you to the top of the second lowest federal tax bracket, which is now 12 percent. This works for higher income levels than you may think because of the increased standard deduction, now $26,600 for married couples at least 65 years old. This means you could have $100,000 of income and still have that low marginal tax rate.

While you’re doing these Roth conversions, you should withdraw from your taxable account in a way to minimize taxes to pay your living expenses as well as your tax bill. You also need to take required minimum distributions from your tax-deferred accounts when turn 70 ½ years old.
After those initial years of Roth conversions, the investor shifts by withdrawing enough from their pre-tax accounts to put them in the top of the 12 percent bracket, and the remainder from the Roth tax-free account to cover living expenses.

There’s a lot of complexity and minutia in this recipe, so let’s make it simple. When you retire, regularly convert enough from your IRA or 401(k) to a Roth account for the first several years of retirement, as long as you stay in the 12 percent bracket. During this time, live on the proceeds from your taxable account. After you’ve executed this strategy for a few years, pull directly from both tax-deferred IRA type accounts and tax-free Roth type accounts in a way that still keep you in a low tax bracket.

In this way you optimize use of the new tax code and its very low 12 percent bracket, while still moving as much as you can to the tax-free Roth IRA. For many this will be a very technical undertaking on their own, but if it means retiring a few years early it could be a worthwhile endeavor.