Know How Not To Give It All Away In Taxes – Part II

Good Morning Relaxing Retirement Subscriber,

**This is the first of a two-part excerpt from Chapter 6 of THE RELAXING RETIREMENT FORMULA on The Tax Reduction Decision Tree

Where You Withdraw From – The Tax Reduction Decision Tree

Because they’ve done all the work in the previous chapters, Bill and Rose now know exactly how much they need to withdraw from their Retirement Bucket to support their ideal lifestyle. They know what they own, where they own it, and how much they paid for it.

Now, when they’re ready to begin withdrawing funds, they can determine which accounts they should tap, when, and in what order to reduce what they pay in taxes. They do this through a series of If-Then forks on the tax reduction decision tree which we’ll walk through with them, one branch at a time.

The First Fork: One Or More Worlds?


If Bill and Rose’s entire Retirement Bucket is inside the world of tax-deferred retirement accounts such as 401(k)s and IRAs, then the only variable they can control is time. A strategy sometimes referred to as Tax Year Straddling may let them push some of one year’s tax burden into the next year.

How It Works

If, near the end of the year, they temporarily tap and later pay off a home equity line of credit to buy time, or withdraw only a portion of what they need and wait for the rest until 12:01 the morning of January first, they may be able to pay a lower tax rate by shifting the taxable income to next year where the rest of their taxable income may be less. Otherwise, the first fork ends here.

More than One

If their Retirement Bucket is distributed between worlds, Bill and Rose can reduce their taxes by accessing funds held outside of IRAs which are subject to capital gains tax rates rather than those on which they would pay ordinary income tax rates. Additionally, if they have any realized capital losses either from this year or carried over from previous years, they can use those to offset gains, further reducing what they pay— sometimes to zero! To see how it works, we need to progress down the second fork.

The Second Fork: Over or Under 70½?

Under 70 ½

If Bill and Rose are not yet 70½, they are not legally required to withdraw funds from their IRAs. If possible, they should access funds exclusively outside that world, leaving their IRAs to continue growing tax-deferred since anything they withdraw from them would be subject to ordinary income tax rates as high as 37 percent.

How It Works

To keep things simple, let’s imagine when Bill and Rose did the work of the previous chapters, they arrived at numbers identical to Bob and Linda’s. They’ve subtracted their predictable retirement income from their lifestyle cost estimate, and determined their level of Retirement Bucket Dependence. They know they need to free up $78,000 this year and next to cover their expenses, with an additional $75,000 in that second year when their youngest daughter gets married.

They inventoried all their savings as the third step of Know How Much Is Enough. Additionally, in Know How To Make Your Money Last, they separated their savings housed in the tax deferred world from the rest. They determined they had $1,500,000 in 401(k)s and IRAs in the former, and another $1,000,000 in the latter split between the sub-worlds of fixed income and equity holdings.

They know that they want to fund the entirety of the $78,000 they need over and above their social security and pensions from the $1,000,000 they hold in that second world because that’s where they’ll pay capital gains tax rates, or none at all.

Their first step down the Under 70 ½ fork is to determine how much that $1,000,000 will have automatically generated for them. Let’s say they’ll earn $12,000 per year in dividends, so they’ll need the other $66,000 to come from somewhere. But where?

To determine the most cost-effective answer to that question, Bill and Rose start with the unrealized gains and losses information they have in hand for all funds they hold outside of IRAs. If they sell any of their funds which have increased in value over their purchase price, they’ll pay the lower capital gains tax rate on the profits. That’s a great option to free up some of the $66,000 they need over and above what they’ve already positioned in money markets to support their cash flow.

Additionally, out of nostalgia, Bill has held onto some remaining shares in the first stock he bought, and these have lost value, as have two of the asset class funds Bill and Rose they purchased last year. While initially, this seems like a painful loss, if handled wisely, these funds can still be of significant value to Bill and Rose. Selling these out-of-favor positions would generate a capital loss which the couple can use to offset the capital gains on which they’ll have to pay taxes.

In the first year of their retirement, Bill and Rose sold off a targeted selection of shares which balanced losses against gains, and freed up the additional $66,000 they needed in a very tax-efficient manner.

Over 70 ½

If, at the second fork in the Tax Reduction Decision Tree, Bill and Rose were over 70½ years old, the path toward their goal of lowering their legally required taxes looks a little different. At this point, the rules of the first, tax-deferred retirement savings world change.

The IRS allows you to defer the taxes on everything you contribute and hold in this world until you turn 70½, at which point it requires you to begin withdrawing a calculated amount each year. You’ll pay the higher, ordinary income tax rate on the amount you withdraw, but if you don’t take that required minimum distribution, you’ll incur a 50 percent penalty in addition to the taxes you owe. Ouch!

Because they did the work of Know How To Make Your Money Last, Bill and Rose know their required minimum distribution will be $55,000 this year. They also know they need to free up $78,000. Sadly, this doesn’t mean they’ll need to fund only $23,000 from their non-tax-deferred retirement savings world.

Assuming their combined federal and state income tax rate on their IRA required minimum distribution is 29 percent, after taxes, the net amount of spendable money Bill and Rose have coming in from their $55,000 IRA distribution is about $39,000.

From here, the Over 70½ fork proceeds along the same path which the Under 70½ fork took. With their initial need for $78,000 halved by the $39,000 that’s left of their IRA required minimum distribution after taxes, they take the same $12,000 that’s coming in dividends, leaving them $27,000 to fund using the same method of balancing capital losses and gains.

COACH’S CORNER: Where you withdraw funds from makes a big difference in the amount of taxes you pay and how long your money lasts.  Take the time to strategically plan for tax efficient withdrawals each year.

The End of the Tree

Once you know what you own, where to own it, and have followed the Tax Reduction Decision Tree to determine from what accounts and in which order you should withdraw funds from your Retirement Bucket, you’re almost ready to confidently start spending what you’ve saved and living the life you’ve earned.

The final thing you need to consider is your targeted investment allocation. In reality, this consideration will be managed simultaneously as you progress through the decision tree, but for simplicity’s sake, we’ve separated it out here.

While evaluating what to buy and sell in order to free up the funds necessary to support their lifestyle, Bill and Rose can see their carefully designed target allocation will now be out of balance. They aren’t planning to sell a little bit of everything after all. They’re making their decisions based on what will allow them to reduce their taxes.

They’ll need to make readjustments within the tax-deferred retirement savings world for the same reason. Inside this world, they can rebalance their holdings to bring them into alignment with their predetermined strategic mix without having to pay capital gains taxes.

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)