By Kevin Theissen
Many people assume that when retirement rolls around, they should draw cash from their taxable accounts first.
Generally, this is a good idea, but not always. A fundamental of tax planning is to put off paying taxes for as long as possible. By investing money rather than turning it over immediately to the IRS, you can earn returns that are yours to keep. Tax deferral acts like a loan that pays interest to the borrower. This is why IRA rollovers are such a great idea as you can keep deferring the taxes on your retirement distributions and put that money to work in investments, rather than losing a chunk to current taxes. When deciding which retirement accounts you should access first, you’ll need to consider not just the character of the account itself— taxable, tax-deferred, or tax-free—but also the particular investments within each account.
The first item that everyone should consider is to create a cash bucket that contains anywhere from one to three years of living expenses in safe, liquid investments such as money market funds, treasury bills, short-term bonds, or CDs. If you know where your next few years of mortgage payments and groceries are coming from, you are far better equipped to tolerate the volatility that can go along with a diversified portfolio.
The downside of tax deferral as it relates to IRAs is that it can’t go on forever. Investors must start taking required minimum distributions at age 72 and the larger the account, the larger the distributions—and the tax—will be. If the account is large, the required distribution could throw you into a higher tax bracket.
It is possible to defer tax in a taxable account. One way is to buy growth stocks and hold them. So you could turn the taxable account into the tax-deferral vehicle and draw income from the IRA. If you had plenty of assets and won’t need to sell the growth stocks during your lifetime, your heirs will be happy, since they will receive a step-up in basis and owe no capital gains tax on the appreciation earned during your lifetime. If you are sitting on big gains in stocks you don’t want to sell, this could be a powerful reason to take income from the IRA.
Favoring the idea of withdrawing money out of an IRA account early doesn’t apply to the Roth IRA because they don’t have required minimum distributions at age 72. Since you never have to pay tax on Roth money, you’ll want to let it ride as long as possible, even into the next generation. Once a Roth IRA has been established, the only real reason to take money out is if you’ll need the income and have no other resources. T
here’s no absolute formula for planning retirement income. You must consider your income needs, tax situation, risk tolerance, life expectancy, and estate planning needs.
Kevin Theissen is the owner and principal of HWC Financial in Ludlow.
