Ever wonder how you’ll turn your retirement savings into retirement income? After a long career of saving and investing, you may be faced with this very question. It turns out the key is minimizing taxes on your investment income upon withdrawal so that you maximize your after-tax return.
Hopefully, you’ve accumulated retirement investments within these three types of accounts:
Taxable accounts are funded with after-tax savings, and they typically include individual and joint investment accounts, bank accounts and mutual funds.
Pre-tax accounts (also known as “tax-deferred” or “qualified” accounts) are funded with pre-tax savings (e.g., IRA, 401(k), 457, 403(b), SEP, SIMPLE). Withdrawals from pre-tax accounts are taxed as ordinary income in retirement, typically at your top marginal rate.
Tax-free accounts are funded according to tax laws so that the money can grow tax-free and withdrawn tax-free. Some tax-free accounts, such as Roth IRAs, are funded with after-tax savings. Some accounts, such as health savings accounts (HSAs), can be funded with pre-tax dollars.
The Strategies
There are two major strategies to minimizing taxes on your investment income in retirement: asset location and tax bracket management. First, let’s take a look at the asset location strategy. Stay tuned for Part II of this article, coming out in February 2020, to learn more about tax bracket management.
Asset location, the practice of holding differently taxed assets in different types of accounts, can help your retirement savings grow faster and last longer once you enter retirement and begin taking distributions.
You can minimize taxes by holding tax-efficient assets in taxable accounts, and tax-inefficient assets — assets that would typically generate large tax expenses — in pre-tax and tax-free accounts. The seminal publication in this area is “Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing,” Dammon et al., in The Journal of Finance, June 2004.
At a high level, tax-efficient assets such as stocks should be held in taxable accounts. Holding stocks in taxable accounts allows you to take advantage of capital gains tax treatment, balancing gains and losses, a step-up in basis for your heirs if they inherit the account, the ability to donate appreciated assets to charities and access to foreign tax credits.
Less tax-efficient assets such as alternatives, long-short strategies, commodities, traded REITs and fixed income should be held in pre-tax or tax-free accounts.
The chart below shows the type of investment, the tax treatment of the investment and the optimal type of account in which it may be held. Of course, personal situations will vary, so consult your financial advisor for advice specific to you.
© David O’Neill, JD, CWM®
In the end, positioning your tax-efficient investments in your taxable accounts and your tax-inefficient investments in your pre-tax and tax-free accounts can make your savings last longer in retirement. Of course, exactly how much longer will depend on your circumstances and the market returns of the assets in your portfolio.
If you’d like to continue the conversation, please reach out to schedule a time to speak with us. Be on the look out for Part II of “Turning Savings into Income During Retirement” in February, when we’ll cover tax bracket management.