Funding Your Retirement: Which Tax Buckets Are Right for Your Bucket List Years?

As many of our clients enter their retirement years, they experience a shift in thinking about their finances. These clients transition from many years of hard work and accumulation of assets into what the financial industry refers to as the “decumulation” phase. This is when retirees begin drawing from the assets they have accumulated over the course of their careers. Our job is to help develop a decumulation strategy to draw down assets as efficiently as possible.

A good place to start is to understand the different tax “buckets”, or investment vehicles, available from which to draw. Each bucket will have different tax ramifications when assets are distributed. Generally, the tax buckets can be divided into three categories: taxable, tax-deferred, and tax-exempt. An efficient decumulation strategy analyzes your spending requirements and draws from these available buckets to meet those needs in a tax-efficient manner. The timing of these distributions and the tax years to which they are attributed is also very important.

One thing that we have learned from our experience working with retirees is that it is helpful to have “tax diversity” among your assets. In other words, it is helpful to have assets in all three categories. Obviously, it would be ideal to draw the entirety of your retirement income tax-free; however, the IRS makes that difficult to achieve.  Also, sticking your whole “nest egg” into tax-free municipal bonds may not be the most prudent investment or tax strategy.  So, we need to plan and work toward accumulating assets into different buckets to achieve tax diversity. Having these different buckets available to us allows us to engage in pro-active tax planning to maximize the retirees after tax income. For example, we may choose to distribute funds from a taxable account for years in which a client will fall into a lower tax bracket.

In a taxable account, investors will have to pay tax on their investment income in the year it was received. While this can be seen as a disadvantage when compared to tax-deferred and tax-exempt accounts, there are some advantages to be considered. One major advantage of a taxable account is liquidity. An investor can withdraw from a taxable account at any time with no fear of incurring an “early withdrawal penalty.” Conversely, an investor is not forced to withdraw from these accounts (through IRS required minimum distributions) and can choose to leave their investment in these accounts in perpetuity.  Another advantage with taxable brokerage accounts is the ability to “harvest” losses when they arise due to market conditions.  Lastly, investments in taxable accounts may qualify for the lower capital gains tax rates.  A taxable account offers numerous planning strategies and can be a valuable tool to have come tax time.

Tax-deferred accounts, on the other hand, allow investment income to accumulate tax-free until the investor withdraws from this account. Common tax-deferred accounts include Traditional IRAs and 401(k) plans that allow an investor to accumulate earnings now and pay taxes later. Not having to pay taxes while your investments grow allows your funds to accumulate faster, as the money that would have been used to pay taxes is instead left in the account to potentially grow. Unlike a taxable account, these tax-deferred accounts have certain restrictions that can limit their flexibility. For example, tax-deferred accounts have contribution limitations. Unlike taxable accounts, there is a dollar limit that can be contributed to these accounts each year. For 2019, the maximum amount you can contribute to an IRA is $6,000.00, or $7,000.00 for those investors over 50 years of age, and $19,000.00 to a 401(k), or $25,000.00 if you’re over 50.  Also, if the funds in the tax-deferred accounts are contributed pre-tax, the withdrawals are classified as ordinary income, which may be subject to a higher tax rate versus capital gains.

Tax-exempt accounts, such as a Roth IRA, allow taxpayers to contribute after-tax money while all the earnings accumulate tax-free.  The ability to earn tax-free returns, compounded over several years, makes the Roth IRA one of the most advantageous investment vehicles available today. Much like tax-deferred accounts, certain restrictions apply regarding the funding of Roth IRAs. The contribution limits mirror those of the Traditional IRA. In addition to contribution limits, both Traditional IRAs and Roth IRAs have income thresholds that need to be taken into account before making a contribution.  We will go into more detail on funding Roth IRAs, such as the “backdoor Roth” strategy, in the next article in this series.

Having assets appropriately divided into each of these tax “buckets” is vital for taxpayers when it comes time to file their income tax return.  There are multiple strategies that can be implemented to ease the client’s tax burden. However, in addition to the caveats mentioned above, each of these types of investment vehicles offers unique opportunities as well as challenges. In deciding which are right for your needs, it’s important to consult the help of a trusted financial advisor and tax strategist.