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Making smart tax decisions can have a big impact on the amount of money someone has in retirement.
Investing and withdrawing retirement funds in a tax-efficient way is among the top ways financial advisors can boost returns for clients, according to an analysis published by researchers at Morningstar.
Doing so can boost retirement income by more than 4%, they found. In other words, a retiree could have an extra $4 for every $100 of income if certain tax strategies are implemented.
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The gains may be even larger for individuals with Roth accounts, according to the researchers, who in a 2013 paper first quantified the value financial advisors offer via specific services.
“It’s something that should always be in the back of your mind when you’re planning a retirement strategy,” said David Blanchett, the head of retirement research at Morningstar Investment Management and one of the co-authors.
Here are some ways financial advisors and consumers can be smarter about taxes.
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Financial advisors generally encourage account diversification among clients — meaning, having some savings in a taxable account, a traditional (pre-tax) 401(k) or individual retirement account, and a Roth 401(k) or IRA.
That gives investors flexibility when withdrawing funds. (More on that later.)
Investors can maximize their tax savings by holding certain investments and funds in the appropriate type of account. This is called “asset location,” which boosts an investor’s after-tax rate of return.
For example, investors should generally consider holding stocks and stock funds in taxable accounts. These investments are more “tax-efficient” — meaning most of their return is from capital gains taxed at a rate that’s less than ordinary income.
On the other hand, investors should generally hold bonds and bond funds in retirement accounts. These investments are less tax-efficient, since most of their returns are dividends taxed as ordinary income.
Let’s say an investor has $1,000 in a taxable account and $1,000 in a 401(k), and wants a 50-50 stock-to-bond allocation.
Holding $1,000 of stocks in the taxable account and $1,000 of bonds in the retirement account (instead of doing a 50-50 stock-bond split in each account type) would generally be the most tax-efficient approach, according to Wade Pfau, a professor of retirement income at the American College of Financial Services.
Sequencing withdrawals efficiently from different piles of savings can lead to a lower tax bill in the long run.
The prevailing wisdom is to pull money from taxable accounts first. Then, retirees can draw down tax-deferred 401(k) accounts and IRAs. Roth accounts should generally be tapped last.
“That’s a pretty good rule for the vast majority of people out there,” Blanchett said.
However, there are instances in which investors (and their advisors) can be more strategic. It requires paying attention to the marginal income tax rates.
For example, single taxpayers will jump from a 12% to a 22% tax rate after surpassing $40,525 of taxable income in 2021.
An individual who has withdrawn $40,525 from taxable or tax-deferred accounts in retirement would be able to withdraw any additional funds for the year from Roth accounts to prevent jumping into the higher, 22% tax bracket.
Since investors have already paid taxes on Roth savings, their taxable income wouldn’t increase as a result of those Roth withdrawals and they would remain in the 12% tax bracket.
(Of course, investors must also contend with annual required minimum distributions, which require them to withdraw a minimum amount of money from tax-deferred accounts each year after age 72.)
The same type of Roth-withdrawal strategy can be used to reduce annual Medicare premiums and taxes on Social Security benefits.
For example, single taxpayers with income over $25,000 must pay taxes on their Social Security benefits. That tax is applied to 50% of benefits if income is between $25,000 and $34,000. The government taxes up to 85% of benefits if income exceeds $34,000. (The income thresholds are different for married couples.)
Likewise, Medicare premiums increase as taxpayers hit different income thresholds.
Strategic withdrawals from Roth accounts can help retirees from creeping over income thresholds that cause these higher taxes and premiums.