When you're looking at the balances on your IRA or other tax-deferred retirement accounts, it's easy to forget that it's not all yours to keep. Once you start tapping those accounts, you'll likely need to pay taxes on those withdrawals.
The IRS allows penalty-free withdrawals from retirement accounts after age 59½. But starting at age 73, you must take an annual withdrawal from your traditional IRA and 401(k) accounts—known as a required minimum distributions or RMDs—even if you don't want or need the income. "At a certain age, tapping those accounts isn't a choice," says Mitch Pomerance, CFP®, CFA, vice president and financial consultant with Fidelity Investments, who often works with clients to help create a strategy around tax-efficient withdrawals. This guideLog In Required can help you learn when and how much you'll need to withdraw.
But those withdrawals, which are taxed at your ordinary income rate, can have significant consequences for your tax bill. The additional income from your RMDs can push you into a higher tax bracket, causing you to pay a higher effective rate. Having a higher income can also increase the amount of your investment income subject to the 3.8% net investment income tax (NIIT), an additional tax that only applies to high earners, and could increase the amount you pay for Medicare in the future.1
Proportional withdrawals: pros and cons
Some retirees who have multiple types of accounts in retirement may benefit from withdrawal strategies that pull from more than one account in a given year. That's because different account types can have different tax treatment; withdrawals from brokerage accounts may produce realized capital gains, for example, while Roth IRA and Roth 401(k)s as well as health savings accounts may offer tax-free withdrawal opportunities.2
One popular strategy involves taking proportional withdrawals by account balance across all accounts, spreading out taxable income generated from those withdrawals over the course of retirement. By taking some withdrawals from tax-deferred accounts earlier in retirement, you can reduce the "tax bump" that often occurs midway through retirement when typical income sources like Social Security and RMDs overlap.
However, this strategy tends to be less effective for retirees who have significant recurring income in retirement, or variable income rising suddenly in one year and dropping off in the next, notes Drew Bachman, senior analyst with Fidelity's financial solutions team. If that's your situation, you may benefit from a more tailored approach that manages income each year, even before withdrawals begin.
Detailed below are several other strategies that may make sense for retirees at various income levels. Since these strategies are complex, it's important to discuss them with your tax advisor or financial professional to determine the course of action that makes sense for your specific situation. "Ultimately, reducing taxes can prolong the life of your retirement income and may even open options to transfer wealth to your heirs," says Pomerance.
Gain from the gap
For retirees with higher balances in their IRAs, including rollover IRAs from former 401(k)s, a strategy to consider is making use of what Pomerance calls the "gap years"—that is, any years you may have between retirement and when you need to start taking RMDs—to potentially convert traditional IRA accounts to Roth IRAs. "If you can live off of cash held outside of retirement accounts or other untaxed assets for a couple of years, that can offer the opportunity to aggressively convert your tax-deferred accounts and open up flexibility down the road," Pomerance explains. That's because qualified withdrawals from Roth IRAs, unlike traditional IRAs, are tax-free.2
Roth IRAs can also be a vehicle for wealth transfer, since they have no required distributions during the life of the original owner. Due to the SECURE Act, assets inherited in retirement accounts must generally be distributed within 10 years. Since Roth withdrawals are not considered income, the distributions won't unintentionally push your heirs into a higher tax bracket.
Lock in losses
It's also possible to reduce taxes on realized capital gains with tax-loss harvesting. Any remaining losses can be used to offset $3,000 of income per year ($1,500 for married, filing separately), and unused losses can be carried forward for the life of the investor.
Done carefully, tax-loss harvesting won't make substantial changes to your asset mix, since you can sell investments that have lost value and replace them with reasonably similar investments, while still realizing the losses. "The end result is that less of your money goes to taxes and more may stay invested and working for you," says Christopher Fuse, an after-tax account portfolio manager with Strategic Advisers, LLC, which manages many client accounts.
Fuse cautions that tax-loss harvesting can be complex and should be done with the assistance of a financial professional. Among other considerations, investors need to be mindful of the wash sale rule, which disallows you from writing off losses if you buy the same or very similar security within 30 days of selling the loss-generating investment. For more detail on wash sales and other key details around tax-loss harvesting, read How to cut investment taxes.
Find the right location
Some assets are by nature more tax-efficient than others, Pomerance explains. Bonds and certain dividend-producing stocks, for example, generate interest income that is taxed at your ordinary income rate. "Those types of assets can often make sense to hold in an IRA," Pomerance says. By contrast, gains on stocks held for over a year and many types of dividends are typically taxed at lower long-term capital gains tax rates ranging from 0%–20%. (This can go as high as 23.8% for higher earners once the NIIT is applied). "If you can harvest losses from the asset, that should likely be held in a taxable account," explains Pomerance. For more on asset location, read Are you invested in the right kind of accounts?
Consider a QCD
Retirees who don't expect to need the income from their retirement accounts can preemptively donate funds from their IRA starting at age 70½ with a qualified charitable distribution, or QCD, in which gifts are directly transferred from their accounts to one or multiple charities. "QCDs can potentially help reduce IRA balances that would then reduce RMDs when reaching the age of 73," says Natasha O'Yang, regional vice president, Fidelity Charitable®.
QCDs can also be given in years when an RMD needs to be withdrawn. QCDs count toward the RMD amount, meaning less must be taken out as a taxable withdrawal in that year.
Investors considering a QCD need to be aware that there are a number of rules and limitations, O'Yang cautions. QCDs only apply to IRAs, and while there is no minimum amount a donor must give to qualify, there is maximum of $100,000 per individual per year. Moreover, the QCD must be done as a direct transfer; if the distribution check is payable to you, it can't be counted as a QCD and will instead be considered taxable income. QCD recipients also must be 501(c)(3) organizations and some charities, including private foundations and donor-advised funds, do not qualify.
"A QCD can be a great opportunity to lower your tax obligations. However, you always have to remember to balance the advantages of tax strategies with the overall health and composition of your portfolio," says O'Yang. "It's important to consult your financial professional and tax advisor before deciding to do a QCD."
Look at a Qualified Longevity Annuity Contract (QLAC)
The bottom line
Optimizing taxes in retirement is a complex process that is ideally started well before the end of your working years. But for those who can devote resources to planning ahead, there are a number of strategies available—with a payoff that can potentially extend even beyond your lifetime.