

How to minimize taxes on retirement savings accounts

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Building retirement savings requires careful planning and so does drawing down those savings once you reach retirement.

The essence of the challenge is to draw your nest egg down carefully, so you don't spend your savings too soon. However, taxes can accelerate the burn rate of your assets. To some extent, you can reduce the tax impact by managing how you draw on your retirement savings account.

3 types of retirement savings and how they're taxed

From a tax standpoint, there are basically three types of savings vehicles:

  1. Ordinary savings, on which income and capital gains are fully taxable
  2. Tax-deferred savings, such as employer-sponsored retirement plans and traditional IRAs, on which taxes are not paid until the money is taken out
  3. Tax-exempt savings, such as a Roth individual retirement account (IRA), on which taxes were paid upfront so they can now grow tax-free with no further tax due upon withdrawal

Because of the tax advantages of numbers 2 and 3, financial planners often suggest drawing first from taxable savings in retirement, so you can hold on to assets with favorable tax treatment for a longer time. However, in an issue of the "Financial Analysts Journal," Kirsten A. Cook, William Meyer and William Reichenstein make the case that retirees might derive greater tax efficiency from a more complex approach. This strategy draws on both taxable and tax-advantaged vehicles throughout retirement.

How to reduce the impact of taxes on retirement accounts

To incorporate elements of this kind of approach, the following are six things you should think about in planning retirement withdrawals:

1. Coordinate asset allocation with taxable status

Investors generally own a mix of stocks, bonds, and cash equivalents. In planning where to put each asset class, keep in mind that income is taxed differently than capital gains, with the effective tax rate on income often higher for many taxpayers. If this is the case for you, it might be worthwhile to park fixed income holdings in tax-advantaged accounts, with a heavier concentration of stocks in your taxable accounts.

2. Plan a withdrawal strategy before making required minimum distributions

In most cases, you will pay a penalty if you withdraw money from a tax-deferred plan before reaching age 59 1/2. At age 70 1/2, you are required to start taking distributions from a tax-deferred plan, and paying any tax liability that results from those distributions. In between those ages of 59 1/2 and 70 1/2, you have the flexibility to draw on a tax-deferred plan at your discretion. Once you enter this window of time, you have the most latitude to alter your withdrawal strategy to manage your tax liability.

3. Don't confuse withdrawal schedule with spending rate

Keep in mind that in these discussions of withdrawals from tax-advantaged plans, those withdrawals do not necessarily mean you should be spending this money as it comes out. Sometimes, the withdrawal is simply a matter of shifting the money from a tax-advantaged to a taxable account, but you should still be preserving some of that money for later in retirement.

4. Look to Roth IRAs as a useful intermediate phase

As will be explained in the next two points, there are times when it makes sense to incur the tax liability of taking money out of a tax-deferred account. Since not all such withdrawals are meant to be spent immediately, having a Roth IRA to roll this money into can let you continue to enjoy tax-free growth after paying the tax on the initial distribution.

5. Consider gradual withdrawals to stay in a lower tax bracket

If you have little or no taxable income in retirement, you should be taking a little money out of your tax-deferred plans every year once you reach age 59 1/2. If you limit that amount to the total of your personal exemptions and standard deductions, you can essentially take the money out tax-free. In a progressive tax structure, it may also make sense to take out just short of an amount that would take you out of the lowest tax bracket. This way, you do not end up taking larger distributions that force you into a higher tax bracket once you turn 70 1/2.

6. Coordinate withdrawals with deductions

Beyond matching distributions from tax-deferred plans with personal exemptions and standard deductions, there is also another option to further limit your tax liability. You can make heavier distributions in years when you have large itemized deductions (such as for medical expenses).

Tax strategies often come down to the specifics of an individual's situation, so you can't always generalize about what works best. However, a more tax-efficient withdrawal approach demonstrates that it is always wise to do some scenario testing before making decisions that could affect your taxes.

More from MoneyRates.com:

10 savings accounts that come with sweet tax breaks

6 tax advantages you didn't know you get with savings accounts

IRA money market accounts to save for retirement

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