You have been working hard to slowly build up a retirement nest egg. You have been maximizing returns while mitigating risks. You have been dutifully paying government taxes and funding social security your entire working life. In a few years, you will be ready to say goodbye to the 9-to-5 grind and finally enjoy the retirement you have earned.
When you finally start making those well-deserved withdrawals from your retirement plan, how much of that withdrawal do you want to give to Uncle Sam? Almost everyone responds, “as little as possible”.
If you want to limit your tax bill, you need a retirement fund distribution strategy that is smart about taxes, to ensure you and your heirs keep as much of your hard-earned nest egg as possible.
The Two Retirement Distribution Tax Strategies
After you retire, there are generally two-income withdrawal strategies to consider, and each has tax benefits and drawbacks:
1. Pay your taxes in early retirement
This strategy calls for withdrawing from taxable investments first (such as a traditional IRA) and then let the tax-friendly investments (such as a Roth IRA) continue to grow.
Your nest egg may be at its maximum size on the day you retire; once you start taking withdrawals, your nest egg may start to shrink. So some people like to get those pesky taxes out of the way now. Your retirement income may be at its peak, so now may be the time when you can more easily absorb the tax burden.
Note some keywords in this strategy: Your retirement income is high and you are going to withdraw the highest taxed money first. As a result, you’ve just decided to hand Uncle Sam the maximum taxes possible. But, at the beginning of this article, didn’t you say you wanted to give Uncle Sam “as little as possible”?
The pay your taxes early strategy does not minimize your tax burden — it actually maximizes it.
2. Pay your taxes late in retirement
The second possible retirement income distribution strategy is the opposite of the first strategy — withdrawal from tax-friendly investments first and leave tax-unfriendly investments for later.
This strategy assumes that your nest egg will have shrunk by the time you get into your later years because you’ve been making generous withdrawals to fund your world travels. Or maybe by the time you hit your more golden years, you have downsized your life, enjoy spending more time at home, and you are simply withdrawing less than a decade prior.
Your retirement income is lower now than in prior years. Lower-income means lower tax rates. If you take the tax-unfriendly withdrawals in these later years, you will be paying a lower tax rate on the withdraws, and thus giving Uncle Sam less of your hard-earned nest egg
How to Decide? Talk to a Financial Advisor
So which strategy is the right one for you? Take the tax hit early in retirement when you can most afford to do so, or delay the tax hit and hope your tax rate is smaller in later years?
Unfortunately, that question cannot be answered via a blog post. Taxes are complicated and the strategy will depend on your individual situation, goals, and investment portfolio. Developing an effective tax strategy requires help from a qualified financial advisor.
V&E Wealth Management has been developing retirement and tax strategies for residents of the Detroit, Michigan area for over a decade. Contact us to schedule a consultation so we can begin to understand your situation and help you get on the best path towards your golden years.