Tax-smart Strategies for Retirement Income Distribution

November 17, 2011 | By Steven DiGregorio

The first wave of baby-boomers turns 65 this year, and that means millions of new retirees will begin to switch from accumulating a nest egg to drawing income from it. If you’re a boomer, it’s time to start thinking about how you’ll convert decades of savings into a lifetime stream of income, which accounts to tap first and how best to navigate. Different sources of income have different tax consequences. Withdrawing funds in the most tax-efficient way will not only minimize your tax bill but could also make your savings last longer.

Key Strategies for Retirement Income Distribution

Knowing which accounts to raid first can stretch your savings.

Generally, if you benefited from a tax deduction for contributing to an IRA or 401(k), every dollar you withdraw later will be taxed at your ordinary income-tax rate — currently as high as 35%. Each year, you’ll receive a Form 1099-R from your account custodian that documents the taxable distributions to report on your tax return.
 If you took a pass on the upfront deduction by contributing or converting funds to a Roth IRA, you’ll enjoy some tax-free income in retirement. Your annual Form 1099-R will note that you received a distribution from a Roth account, but it won’t specify whether any of the money is taxable (you’ll have to calculate that yourself on Form 8606, available at You may withdraw Roth IRA funds, up to the cumulative amount of your contributions, at any time tax-free and penalty-free. But you must wait until you are at least 59 1/2 years old and the account has been open at least five years before you can access the earnings tax-free (unless you use the money to buy a first home).

If you made nondeductible contributions to a traditional IRA, distributions are a little trickier.

Spread out the tax liability

Just as you should diversify your assets among various types of investments to minimize your risk, it’s a good idea to vary your tax liability.  The old assumption that you would be in a lower tax bracket in retirement is not only more questionable but hopefully for you, improbable!  The liklihood that future income tax rates will rise is greater now more than ever.  Hence, it makes sense not to put too many of your eggs in a single basket.

If you have been contributing to a 401(k), 403(b), 457 plan or a federal Thrift Savings Plan, have you avoided accumlating assets in taxable savings and investment accounts?   Reconsider, current tax laws could tax those assets at a lower rate than ordinary income from the retirement plans.  You may also want to contribute to or convert some retirement funds to a Roth account so that you will have more control over how much you pay in taxes in retirement.

First out: Taxable accounts

Conventional wisdom suggests that you should withdraw money from your taxable accounts, can benefit from lower capital-gains rates, before touching your retirement funds. Tapping taxable accounts first not only minimizes your tax bill but also allows your traditional IRAs and other tax-deferred accounts to continue to compound unfettered by taxes for as long as possible. The result: a bigger nest egg.

Of course, every rule has its exception.  Sometimes it pays to tap into your tax-deferred retirement accounts once you can — but before you are required to — so that your IRA doesn’t grow too big, which would result in large required minimum distributions each year after you turn 70 1/2, along with hefty tax bills.

If you have a brokerage account and sell assets that you’ve owned for more than a year, you’ll pay just 15% on your profits and, in some cases, no tax at all. Or, if you sell an asset in a taxable account at a loss, you can use it to offset investment gains, potentially wiping out any tax liability on your profits. Excess losses may be used to offset up to $3,000 of ordinary income per year and may be carried forward to offset income in future years.  You generally cannot claim tax-deductible losses in a retirement account.  Qualified dividends are also taxed at a maximum 15% rate or 0% for those who are eligible.  Although interest on your savings is taxed at your ordinary income-tax rate, the principal (the money you originally invested) is tax-free.

Next: Retirement accounts

After exhausting your taxable accounts, focus on your traditional retirement accounts, such as IRAs, 401(k)s and other employer-based retirement plans. You’ll pay taxes on your entire withdrawal at your ordinary income-tax rate (except for any after-tax contributions you made, which would be tax-free). If you need $20,000 per year in after-tax money, for example, and you’re in the 25% tax bracket, you’ll have to withdraw nearly $27,000 from your IRA.

You can start taking withdrawals from your traditional IRA penalty-free once you turn 59 1/2, but you’ll owe federal and possibly state income taxes on the distributions. You probably can’t invade your 401(k) or similar employer-based retirement account while you’re still working, unless your plan has an in-service distribution provision that allows you to take withdrawals once you reach the 59 1/2 milestone.  But if you leave your job when you are 55 or older, you can take penalty-free withdrawals (but still owe taxes). If you roll over your retirement funds to an IRA before age 59 1/2, you’ll lose this early-out option.

Once you turn 70 1/2, it’s time to reimburse Uncle Sam for all those years of tax-free growth. You must start tapping IRAs and other traditional retirement accounts by April 1 of the following year and take withdrawals by December 31 each year after that.  If you delay your first distribution until April 1, you’ll have to take a second distribution by the end of that same year which could result in a sizable tax bill.

Your required minimum distributions, known as RMDs, are based on your account balance at the end of the previous year divided by your life expectancy, as determined by IRS mortality tables. If you don’t take a distribution of at least the required amount, you’ll be hit with a stiff penalty: 50% of the amount you failed to withdraw. In most cases, you should save your tax-free Roth IRA distributions for last. Unlike traditional IRAs, Roth IRAs have no annual distribution requirement.   Should you have funds left over when you die, your heirs will thank you: Distributions from inherited Roth IRAs are tax-free; those from traditional IRAs are taxed at heirs’ ordinary income-tax rate.

Don’t be afraid to tap your Roth IRAs earlier as a way to increase your retirement income without being pushed into a higher tax bracket. The bottom line: Decide whose taxes you want to minimize — yours or your heirs’.

The information herein contained does not constitute tax advice.  Any final decisions or actions should not be made without first consulting a CPA or Accountant.

For more information contact us at 845.563.0537 or

The author of this blog, Steven M DiGregorio is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC a Federally Registered Investment Advisory Firm.  Securities offered through an affilliated company Spire Securities, LLC a Registered Broker/Dealer and member FINRA/SIPC.

Tags: 401(k), 403(b), 457, 55, 59 1/2, beneficiaries, beneficiary, distribution, income, investing, investment strategies, IRA, pension, portfolio, retirement, retirement distribution, retirement income, retirement plan, Retirement Planning, Rollover, rollover IRA, ROTH, social security, stocks, Taxes, thrift savings plan, TSP

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STEVEN M DIGREGORIO is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC.
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