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Taxes and Retirement Part 3 of 4

Income Management and Tax Diversification

An important step in managing your income in retirement is determining the amount of income that you will need to support your desired lifestyle in retirement.

Most advisers will give you a blank monthly budget sheet and ask you to complete it to determine your expenses. At Financial Coach, we go through a face to face, customized process with a new client or one approaching retirement to estimate what they think will be required for their first year in retirement. We know that this is a difficult task as you are facing a new phase in your life and can only estimate what your needs will be. However, it is essential to build a realistic expense estimate based on the client\’s needs and desires. We then create a contingency plan to deal with any unknowns that you may run into. In addition, Financial Coach sets up multiple touch points for our clients as they enter the first years of retirement to continuously evaluate their income needs and adjust their plan accordingly. From this basis, we are able to create a tax effective tactical income plan.

The next step is to look at the sources of income and the appropriate time to initiate them. When should I start my pension? When should I take Social Security? How much will I get from any other non-investment sources? How much will I need from my investments: Qualified assets (traditional IRA, 401K, 403B) and non-Qualified investments?

From a tax standpoint, we start with the sources of income that one must take in retirement. That would include social security and any pension and deferred compensation income as the base. All or the vast majority of this income (up to 85% of Social Security) is taxable and will set the starting point to look at your tax bracket and effective tax rates in retirement.

You must then determine the amount of additional income needed to support your retirement lifestyle and the potential investment sources of that income. This provides you with the alternatives that will allow an effective management of withdrawals to minimize taxes.

Start with understanding the proportion of assets in Qualified accounts. If the bulk or a large portion of investments are in IRA/401K/403B types of accounts, every dollar withdrawn will be subject to Federal income tax. In addition, when we reach 70 1/2, the government forces us to start taking an annual Required Minimum Withdrawal (RMD) whether we need it to support our lifestyle or not. And this RMD increases every year. Adding this increasingly larger withdrawal from retirement accounts to our Social Security/pension income base could have a significant and negative impact on our federal tax bill.

Conventional wisdom has always said that we should save our tax deferred assets as the last asset to tap for income. However, due to uncertainty about future tax rates, the certainty of increasingly larger RMD\’s and the mix of Qualified investments to non-Qualified, it may be more appropriate to start taking income from your IRA/401K/403B assets earlier in your retirement life rather than later when you are forced to take withdrawals.

Earlier withdrawals from qualified investments can allow us to more effectively manage our levels of income to minimize our current effective tax rates. It can also allow us to reduce the future size of our Qualified investments subject to RMD. And, by withdrawing dollars from Qualified accounts and repositioning that money into non-Qualified or Roth IRA accounts, we can better diversify our assets from a tax standpoint. This will help to minimize the risk from potential future tax increases.

The conversation with your Financial Planner should be about more tax efficient management within your plan.  If you are not having that discussion, call the Financial Coach and Start the Conversation toward creating a more comprehensive and tax effective retirement plan for your household.

This information is not intended to be a substitute for specific individualized tax advice. You should consider discussing your specific tax issues with a qualified tax advisor.