To maximize retirement income, it’s important to leverage current tax law to your advantage. The coordinated use of taxable, tax deferred, and tax free retirement accounts – including Health Savings Accounts – is critical to your success and requires intentional planning. Big picture, the less you pay Uncle Sam, the more you keep for yourself.
Strategy 1: Tax advantages of long term investments
Everyone should keep some savings in a taxable checking, saving, or investment account, for everyday spending. Keeping at least three months of regular expenses is a good start. The income generated by assets held in such accounts is subject to ordinary income tax, but gains on investments in a taxable investment account held more than one year are subject to a favorable long-term capital gains rate, currently 15% for most people.
The greater your income, the more you should consider municipal bond funds, which are not subject to federal income tax on the interest received. Additionally, you’re allowed to bequeath any highly appreciated assets held in a taxable account to an heir who will receive the asset with a “step-up” in cost basis, i.e., the value at your death, for purposes of calculating their long-term capital gains.
Strategy 2: Use employer sponsored plans
Saving for retirement in an employer-sponsored retirement plan, like a 40l(k), is the next priority especially if your employer offers to match your contribution. If your employer does not sponsor a retirement savings program, then an Individual Retirement Account (IRA) offers essentially the same tax benefits and nearly as much legal protection against creditors while the maximum allowable annual contribution is lower.
The key is determining the type of retirement plan or IRA account to fund. A traditional tax deferred account allows you to deduct your contribution from your taxable income, which makes the most sense if you’re in a higher tax bracket when you contribute. However, the distributions in retirement are taxed as ordinary income. On the other hand, a Roth account provides no deduction for contributing, but everything you accumulate in the account is withdrawn tax free in retirement.
The question of which type of retirement account is best is answered by comparing your pre-retirement and post-retirement tax brackets. Theoretically, if you invest the tax savings received from contributing to a traditional account, then the issue is moot. However, most are not disciplined enough to invest their tax savings. Therefore, the Roth account, in which you invest after tax money and withdraw principal and earnings tax free, ends up netting the typical saver the most spendable income in retirement.
Other benefits of a Roth account include the avoidance of required minimum distributions (RMDs) in your 70s, tax free inheritance for your heirs, and the emotional benefit of knowing you aren’t compounding your future tax bill to the government.
Strategy 3: Advantages of Health Savings Accounts
After contributing to your retirement, the next consideration should be a Health Savings Account. These accounts allow you to save for current or future medical expenses with the most robust tax advantages of any account available. Not everyone can open an HSA, but if you participate in a high deductible (at least $1,600 for individuals) health insurance plan, there’s a good chance you qualify.
HSAs allow you to deduct the amount contributed, up to $4,150 for
individuals and $8,300 for families this year, from your taxable income. Your contributions grow tax free and if used to cover any related medical expense, withdrawals are tax free as well. It’s the trifecta of tax savings, and a great way to save for future needs while minimizing your taxes.
Strategy 4: Plan how you will spend assets
When planning your retirement income, carefully consider the order in which you liquidate and spend your retirement savings between assets held in taxable, traditional tax deferred, and Roth accounts.
Generally, any excess of your three months in expenses in your taxable investment accounts should be spent first, tax deferred assets second, and save your Roth assets for last. The longer assets stay in a Roth account, the more you benefit from their tax free compounding. For some, Roth assets can also come in handy keeping taxable income in retirement under the necessary level to protect Social Security benefits from taxation.
Once you reach retirement age, the IRS requires distributions from your traditional IRA and 401(k) accounts. The amount you’re required to withdraw is approximately 4% of the account balance and gradually increases annually to around 8% by age 90. The IRS levies a substantial penalty for failure to comply. If you donate to charity, another distribution strategy is to utilize a Qualified Charitable Distribution from a traditional IRA. The IRS allows you to donate directly from an IRA to satisfy your annual distribution and not pay income tax on the amount.
In the final analysis, your tax planning strategy may be more complex than your contribution strategy, but both require careful planning and execution to maximize your retirement income.
Michael J. Francis, is President of Francis LLC, a registered investment adviser with offices in Milwaukee, Minneapolis, and St. Louis. Francis can be reached at michael.francis@francisway.com. The information contained herein is provided for informational purposes only. The information provided is from sources we believe to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Francis LLC does not offer personal legal advice.
