The before-tax contributions allowed for government-regulated retirement plans (such as 401(k)s and IRAs) entice many people to invest and grow a large fraction of their retirement savings within those plans. But money you eventually withdraw from them is taxed at ordinary income rates – a potentially high rate. And their required minimum distributions (RMDs) begin after you turn 701/2. How can you minimize taxation of your savings in retirement?
Generally people have two categories of accounts that hold their savings: (regular) taxable accounts (like bank and brokerage accounts) and government-regulated retirement accounts (like their IRA). The taxation of investments in each of these is fundamentally different.
All investment earnings and gains within deductible IRA-type accounts grow tax-deferred. But everything – earnings, capital gains and principal (contributions) – is taxed at ordinary income tax rates when you withdraw from them.
On the other for taxable accounts, principal (i.e. the amount you contributed or purchased to that investment) is their tax basis since you got no deduction for it: it’s never taxed. But annual earnings such as dividends or interest are taxed annually. Any growth in value (capital) is taxed only on its increase, but only when it’s sold, and, then, at the low capital gains tax rates if held over 1 year.
Retirees with large IRA-type savings probably have them invested in both capital growth investments and annual income-based investments. And, they also often hold CDs and other income-based investments in their taxable accounts which generate earnings taxed as ordinary income too.
When retirees must begin their IRA-type withdrawals from government savings’ plans, their RMDs will be taxed at income tax rates. If their yearly income needs from savings can be met by their RMD withdrawals, it’s a pity to have their taxable accounts also producing income investment-type earnings that are taxed at ordinary income rates too -and therefore pushing them possibly into higher income tax rates.
*Reposition your investments to save taxes:
Retirees can minimize this unnecessary earnings taxation in their taxable account by switching much of their CD-type investments to growth investments that carry little or no annual income earnings. Then they’ll be taxed on their expected growth only when they sell them – and then only on their capital gains at their low tax rates.
At the same time, they can comparably reduce the amount of growth investments in their IRA-type accounts in favor of income investments – like those CD-type investments they had, and seek higher income-based earnings investments. Doing so, will maintain their investment ‘allocations’ between income and growth investments, but reduce unnecessary taxation of their taxable accounts. That way, their taxable accounts will last longer and, hopefully, grow faster.
They should maintain at least a portion of their emergency funds within the taxable accounts so they can access them – if necessary – without incurring excess taxation of ‘principal’.
