If you're like many people, you reach retirement with a mix of investments and accounts. After all, there were many tax-advantaged ways to tuck money away for retirement, such as a 401(k) or 403(b), a traditional or Roth IRA, or a deferred annuity.
So how do you transition what you've saved into an income-generating retirement portfolio that has the potential to last as long as you do?
Here are three steps to consider to help you do just that.
Step one: Establish guaranteed lifetime income.
We believe that most investors should strive to cover essential expenses with guaranteed income sources such as Social Security, pensions, and certain annuities. Because Social Security and pensions aren’t always enough, many people may need to purchase an annuity. Income annuities are one of the other ways to generate lifetime income.
If you’re looking to provide additional lifetime income, here’s a way to consider which savings to tap first. When purchasing an annuity, knowing how to fund it—and in what order—can potentially help minimize taxes and maximize your retirement savings:
- Annuitize an existing tax-deferred annuity.
If you've saved for retirement in a tax-deferred annuity, now may be the time to annuitize it, turning it into a steady stream of guaranteed1 income payments. You aren’t taxed when you do this. Instead, each annuity payment will be taxed appropriately.
- Tap tax-deferred accounts—401(k)s, 403(b)s, or traditional IRAs.
If you don’t own an annuity, you may want to consider rolling over the money from a traditional IRA, 401(k), or 403(b) to purchase one. You aren’t taxed on the amount you roll over (provided certain conditions are met). Instead each annuity payment will be considered taxable income and will be subject to ordinary income tax, assuming all contributions had been made pretax.
- Use taxable accounts—brokerage or bank.
After utilizing tax-deferred balances, you may want to consider turning to taxable bank or brokerage accounts. If you need to sell an investment from a taxable account, consider these suggestions, which have the potential to help minimize the tax impact:
- Consider selling investments that have lost value, and which can generally be used to offset capital gains and up to $3,000 a year in ordinary income. First, realize short-term capital losses to offset short-term capital gains, which are taxed at ordinary income tax rates. Then, realize long-term capital losses to offset long-term gains, which are taxed at lower capital gains rates.
- Use available cash.
- Realize long-term capital gains, which are taxed at lower capital gains rates.
- Realize short-term gains, which are taxed at higher ordinary income tax rates.
Consider working with a tax adviser before taking any of these steps.
- Tax-free accounts—Roth 401(k) and Roth IRA.
Typically, this would be the least favorable of the three for funding an annuity, because the funds in a Roth account can be used tax‐free for other purposes and can continue to grow on a tax‐free basis, if you don’t use them. But if you have exhausted the other three options, and you still want to set up an annuity, you could use savings in a Roth account to purchase an annuity. Thereafter, each annuity payment will be tax free.
|How to fund an annuity: a hierarchy|
|1. Annuitize tax-deferred anuity.||Transaction is tax free. Each annuity payment will be taxed appropriately.|
|2. Rollover from tax-deferred account.||Transaction is tax free (provided certain conditions are met). Each annuity payment will be taxed as ordinary income.|
|3. Use money from taxable account.||Transaction maybe taxable. Only a portion of each annuity payment will be tax free.|
|4. Use money from a tax-free account.||Transaction is tax free. Each annuity payment will be tax free.|
Be choosy, too: some annuities have high embedded fees, so you want to look for a low-cost annuity from a well-established and financially strong company. “Do a quality check,” says Roy Benjamin, vice president and actuary at Fidelity. “Consider the issuing insurance company. Ask yourself: Is the company in strong and stable financial health?”
Step two: Create an appropriate mix of investments.
In determining your asset allocation, don’t automatically assume that you should invest conservatively just because you’re retired. Today’s 65-year-old retirees may need their portfolio to last 25 years or more. Plus, if your essential expenses are covered by Social Security, pensions, and annuities that provide lifetime income, you may be able to take on some additional risk with your remaining assets.
As you can see in the illustration below, a growth portfolio (70% stocks, 25% bonds, and 5% short-term investments) would have lasted 39 years in an average market, versus only 32 years for a balanced portfolio (50% stocks, 40% bonds, and 10% short-term) and 24 years for a conservative one (20% stocks, 50% bonds, and 30% short-term). In an extended down market, the growth portfolio would have lasted 17 years; the balanced, 18 years; and the conservative, 19 years.
Of course, you’ll need to be comfortable with fluctuation in the value of your portfolio, and this is just an example. You’ll need to decide on an appropriate mix of investments and level of risk for your situation.
There’s another companion strategy that many investors often overlook. Known as “asset location,” it involves strategically positioning investments in taxable, tax-deferred, or tax-free accounts to potentially help minimize the overall tax hit to your portfolio.
For example, most taxable bonds generate interest, which is taxed at ordinary income rates. So, you may want to consider holding such bonds in traditional IRAs or 401(k)s, where interest income is tax deferred, or in Roth-type accounts, where interest is federally tax free, if certain conditions are met. By contrast, stocks that you plan to own long term are often better held in taxable accounts, because gains are taxed at long-term capital gains rates, which are generally lower than ordinary income tax rates.
For a quick summary of which assets to put in which accounts for tax efficiency, see the table below. But don’t let the tax tail wag the investment dog; maintaining an appropriate asset mix should still take precedence.
Of course, if you need to reposition your investments, you’ll want to do it tax efficiently. For example, you may want to offset gains with losses where possible. Consider working with a tax adviser to understand your current tax situation before taking any steps.
Also, give some thought to what type of investor you may be in retirement. Do you still want to choose investments and manage your portfolio? Even if you were a hands-on investor in your savings years, you might want help from a financial professional in retirement.
Step three: Take taxes on withdrawals into consideration.
Consider building a withdrawal plan around your current tax rate and your general expectations of future effective tax rates (combined federal, state, and local income rates), particularly if you expect your tax rates to rise in retirement.
After you have made annuity purchases, you may need additional income, which may come from the remaining portion of your portfolio. When making withdrawals in retirement, it may make sense to use money from your taxable accounts first. This is because long-term capital gains are taxed at significantly lower rates than the ordinary income tax rates you’d pay on withdrawals from traditional tax-deferred retirement accounts. What’s more, using your taxable assets for retirement withdrawals leaves the money in your tax-advantaged accounts in place, where it has the potential to grow tax deferred or tax free.
If you’ve depleted your taxable accounts, next consider starting to take distributions from tax-deferred accounts, such as traditional IRAs and 401(k)s. You’ll pay income tax on these withdrawals, but it may leave more money in tax-free accounts such as a Roth IRA or a Roth 401(k), which can have significant benefits. In general, you must begin withdrawing money from a traditional 401(k) or IRA by April 1 of the year following the year in which you turn 70½ anyway.
Lastly, consider tapping investments in Roth IRA or 401(k) accounts where neither withdrawals nor any earnings are taxed.3 Again, the longer you keep assets in these accounts, the longer they can potentially grow tax free. And if you’re planning to leave money to others, inherited Roth IRAs are not subject to federal income taxes, provided certain conditions are met.
|Withdrawals from an investment portfolio: a hierarchy|
|1. Taxable: Brokerage, bank.||Cash withdrawals are tax free. Long-term capital gains are taxed at relatively low rates, and can potentially be offset with capital loses.|
|2. Tax-deferred: Traditional IRA, 401(k), 403(b), or governmental 457(b).||Taxable portion of withdrawals are taxed as ordinary income. If no after-tax contributions are made, then withdrawal is 100% taxable as ordinary income.|
|3. Tax free: Roth IRA, Roth 401(k).||Earnings and withdrawals are tax free, provided certain conditions are met. The longer you keep assets in these accounts the longer they have the potential to grow tax free and/or be tapped for unexpected expenses, or be left to heirs.|
|4. Tax-deferred Annuity.||For annuities funded with non-qualified investments, withdrawals are treated as earnings and taxed at ordinary income tax rates until all earnings have been withdrawn. After all earnings have been withdrawn, withdrawals of principal are tax free. Withdrawals from annuities funded with tax-deferred or tax-free investments are subject to the tax provisions outlined above.|
You may also take withdrawals from more than one type of account at the same time to strategically manage the impact on your taxable income, and potentially avoid being pushed into a higher marginal income tax bracket (see tax rate table above). For instance, you may want to consider withdrawing an amount from tax-deferred retirement accounts, taxed as ordinary income, up to the next tax bracket. Then, if you need more income, consider withdrawing from a taxable or tax-free account, because it isn’t taxed as ordinary income, and won’t move you into a higher bracket.
Here’s a hypothetical example. Sal is 63 years old and files his taxes jointly with his wife, Sarah. He anticipates that his federal taxable income will be $61,700 in 2013. However, he needs to withdraw an additional $14,000 after tax during the year for expenses. He has both a traditional IRA, funded with pretax dollars, and a Roth IRA, eligible for qualified tax-free distributions. He’d need to take $17,227 from his traditional IRA to meet his need, owing $3,227 in taxes to get a net amount after tax of $14,000. The first $10,800 of his withdrawal would be taxed at 15% and the next $6,427 at 25%.
Instead, he could withdraw $10,800 from his traditional IRA, which would be subject to income taxes at a 15% rate so that after tax he’d have $9,180, and then withdraw $4,820 from the Roth IRA to reach his $14,000 after-tax target. Because this is not counted as taxable income, he avoids paying taxes at the higher 25% effective rate. In this case, his total tax on the withdrawals would be $1,620 ($10,800 at 15%) for a potential tax savings of $1,607. This strategy is more complex, so you may want to work with a tax professional before implementing it.
Transitioning a portfolio to retirement: a hypothetical example
Let’s take a look at a transition strategy for a hypothetical couple, using the Fidelity Income Strategy EvaluatorSM 4 tool. Marsha and Charles Wilson are both age 63 and retired. They have $600,000 in savings invested in a balanced portfolio of 50% stocks, 40% bonds, and 10% short-term investments. Their monthly expenses add up to $4,200, of which $3,000 are essential and $1,200 are discretionary. Social Security and income from pensions put $2,635 in their pocket after taxes (they have a 15% effective income tax rate), so they’ll need $1,565 more a month from their savings, of which $365 is for essential expenses. They would like this income stream to last until the end of their plan (in 31 years).
Based on the Wilsons’ situation, the Evaluator suggested a Fidelity Target Income Mix® with an investment component and a guaranteed component (a fixed income annuity and a variable annuity).5 Based on the Evaluator’s analysis, this approach was estimated to provide enough income to meet their $1,565 need, including more than enough guaranteed income to meet their gap for essential expenses. It also estimated it would leave them with $122,084 for emergencies or other purposes. View the details (PDF) on the income payments over 31 years for the fixed and variable annuities and withdrawals from the investment portfolio in this hypothetical example.
How could the Wilsons transition their portfolio to this suggested Target Income Mix model should they decide to? The Evaluator assumed they could use $238,958 from tax-deferred sources like Charles’s 401(k) to roll it over to purchase the two suggested annuities; this would help ensure that they can pay all their essential expenses. It would also give that income some potential to grow (through the variable annuity). Then they can continue to invest the remainder of their portfolio ($238,958) in a balanced allocation (50% stocks, 40% bonds, and 10% short-term investments) in their tax-deferred accounts, from which they can withdraw for discretionary expenses. Continuing to have investments in taxable, tax-deferred, and tax-free accounts can enable them to better manage the potential tax impact of withdrawals.
There is much to consider when transitioning your life savings into an income-generating portfolio. We’re here to help you devise and implement a strategy. Just as we provided guidance for saving for retirement, we can assist you in making the most of what you’ve saved.
- Develop and explore income strategies with the Fidelity Income Strategy EvaluatorSM 4 (login required.)
- Learn more about investing for income in the Fidelity Guide to Retirement Income Investing.
- Speak to a Fidelity Retirement Representative at 800-343-3548.
- Attend our Tax Efficient Investing seminar.