Strategize to minimize taxes on nest eggs
You've got many ways to save for retirement. You've also got
many ways to get taxed on your retirement savings. The question: How can you get
the most from your retirement savings and pay the least in taxes?
Experts generally recommend that you defer taxes as long as possible. If you
have a choice between paying taxes this year or next, you should choose next
For that reason, you should start by tapping any accounts that throw off taxable
gains or income, according to a study by the T. Rowe Price funds. Your first
target: mutual funds that are not in tax-deferred retirement accounts, the
Baltimore-based fund company says.
Funds make annual distributions of income and capital gains. Some income
distributions are taxed at your maximum tax bracket, which can run as high as
35%. Qualified dividend distributions are taxed at capital gains rates, at a top
rate of 15%. You must pay taxes on those distributions each year, so it makes
sense to spend down those accounts first.
Next in line: appreciated stocks in a taxable account. When you sell them,
you'll owe taxes on the capital gains.
Once your taxable assets are exhausted, move on to tax-deferred retirement
accounts, such as 401(k) plans and traditional individual retirement accounts.
You'll pay taxes on your withdrawals at ordinary income tax rates. The main
advantage of these accounts is the deferral of taxes. The longer you can go
without tapping them, the greater the advantage. You do have to start taking
minimum withdrawals at age 70.
Finally, tap your Roth IRAs. These accounts are tax-free, provided you're at
least 59 1/2 years old and have held the accounts for five years or more. They
aren't subject to minimum withdrawal rules. Furthermore, you can pass a Roth on
to your heirs. They can spread out their withdrawals over their lifetimes, which
will give their inheritance years to grow, tax-free.
T. Rowe Price studied taking withdrawals over a 20-year period from a portfolio
of taxable funds, appreciated stocks, tax-deferred retirement accounts and Roth
IRAs. Taking withdrawals in the above order generated the most after-tax income.
One reason: The Roth IRA had the longest to grow, and withdrawals were
completely tax-free. By tapping the Roth last, you get the most tax-free income.
Stuart Ritter, a financial planner at T. Rowe Price, says that if you plan to
leave money to your heirs, you might want to hold onto appreciated stock as long
as possible. If you pass on the stock to your heirs, you'll sidestep the tax
entirely. When they sell the stock, they will calculate the cost of the stock as
of when they inherited it — not when you bought it.
As important as taxes are, though, the amount you withdraw is the most
significant factor in your retirement plan. If you want to bump up your
withdrawals for inflation, your initial annual withdrawal shouldn't be much more
than 4% of your savings, Ritter says. Otherwise, you could run out of money.