You’ve spent a lifetime of smart saving and investing, but, as you age, it is just as important to protect your money as it was to accumulate it. Use these asset preservation strategies and you will have a very good chance of not outliving your money. Indeed, you should have a good chance of leaving a pretty penny to your loved ones.
Delay paying taxes on tax-deferred retirement accounts as much as possible and it could ensure long-term financial security. Pay taxes sooner than needed and that could increase the chances of running out of money in retirement.
That’s according to financial advisers. They say qualified investments—investments that have deferred taxation provisions—can be golden for retirees and those saving for retirement. Taking maximum advantage of these retirement accounts is a big part of attaining and preserving wealth.
“Accessing qualified assets last is right on the mark. It is the smart thing to do,” according to Charles Hughes, a certified financial planner in Bay Shore, New York. “We tend to delay the use of retirement assets as long as possible,” adds Steve Branton, a San Francisco-based adviser.
What Are Qualified Investments?
Qualified investments, commonly called retirement accounts, are savings vehicles that “qualify” for special, or reduced, taxation under the tax code. These tax breaks can have several features that put money in your pocket or delays taking it out of your pocket.
A qualified retirement plan is a plan recognized by the IRS as qualifying for special tax treatment. Some include Individual Retirement Accounts (IRAs), pension, 401k) s and Keogh plans. Most retirement plans offered at work are qualified plans. The tax advantages over many years can be considerable, especially when compared to regular investments.
For instance, if you buy a mutual fund and earn dividends or capital gains on it over the course of a year, normally you must pay taxes on the gains each year. However, in most qualified accounts, one contributes to a retirement account and pays no taxes on the gains until one starts withdrawing in retirement. Then, in many cases, one is in a lower tax bracket.
Getting a Tax Break
Many qualified accounts also provide a tax deduction in the same year one contributes to a plan. For example, say you made $50,000 in a year, but contribute $6,000 to a qualified plan. You get a tax break. You are only taxed on $44,000 of your income. These breaks can be critical in building a healthy retirement stash.
Why?
A retirement account is often a retiree’s primary income.
For pre-retirees and retirees, it is important not only to understand how to build retirement accounts, but also how you draw down assets effectively. Qualified accounts have rules for withdrawals. One can avoid a boatload of taxes over the course of a lifetime through a smart withdrawal strategy.
“Distribution strategies actually start long before retirement,” says Melissa Brennan, an adviser in Plano, Texas. “The goal should be to lower the client’s lifetime tax burden by triggering taxes mindfully.”
How you choose to access retirement money is a key issue for millions of Americans, who have some $28 trillion in various retirement accounts, according to the Investment Company Institute, the trade group for the mutual fund industry.
You Can, but Should You?
In most cases, one can start spending your qualified money without penalty beginning at age 59.5. But you are not required to do so. The decision is important. You can wait until between ages 70 and 72 to begin collecting from qualified accounts. Many advisers say, depending on your circumstances, wait the extra 11 years or so.
“As a general principle, with some exceptions, one should defer qualified assets as long as possible,” says Boyan Doytchinov, an adviser in Medford, New York. “That is a good starting point in retirement planning.”
The reason is that you will be letting your qualified retirement accounts, with their tax advantages, grow for the maximum period. Generally, the longer this compounding can take place, the better it is for your final retirement balance. Use taxable assets first and let deferred taxation grow as long as possible, as the advice of most financial professionals.
How you take withdrawals may seem a minor point. It is not. Understanding how to maximize qualified accounts is vital.
A Million-Dollar Difference
The strategy of spending taxable assets first in retirement and letting qualified assets continue to grow as long as possible is important in several respects.
Advisers say that by delaying the use of these qualified accounts, and later only taking a minimum distribution each year, you extend the compounding process. Compounding is a vital element in the creation of wealth. This is true whether you are trying to build a retirement nest egg or preserve it as long as possible.
For instance, say you have $922,000 in a qualified retirement account after putting $500 a month into the account and earning 9% a year on average over the course of 30 years. However, say you don’t access your money at age 59.5 when you can without penalties for early withdrawal. You leave it to compound another 10 years or so. In fact, you build an online side-income and continue to contribute $500 a month to your qualified account.
You let it continue to grow, perhaps at the historic long-term return of the stock market, about 9% a year.
That extra decade was incredibly important to the compounding process. It will show up in your final balance. Ten years later, you have about 150% more in your qualified account than if you started collecting at age 59. It comes to some $1.3 million more in qualified money for a total of about $2.2 million. That’s because you didn’t do what some people mistakenly do: You didn’t start taking distributions at age 59.5 and start paying taxes. You actually let the compounding continue longer and added to it.
The Roth Option
By the way, in the case of another qualified account, a Roth IRA, there is a different type of tax bargain. It offers no upfront tax breaks. You can’t take off on taxes on yearly earnings.
However, your balance could accumulate without investment taxes seemingly forever. You never have to take a distribution and, as long as you have earned income each year, you can keep adding to the account. Say you don’t entirely quit work. Say you have an online side-hustle in which you make $7,000 a year.
Then you can contribute all of it to your Roth account and never have to pay investment taxes. You can also take as much or as little from it tax free.
I have a Roth account among my four retirement accounts. It has grown a lot over the past seven years since I quit full-time work and just continued to freelance for various publications (Editing and writing services available here. Just write GregoryBresiger.com).
The Roth account is growing both because I put the maximum $7,000 in each year and because the investment has done well, healthy compounding is continuing.
Keep an Account Going Forever
Using any of these strategies in delaying the use of your qualified accounts can make a great difference, according to a New York advisor. “That can mean an enormous increase in your retirement savings,” says Andrew Schwartz, an adviser in White Plains, New York. Another strategy is taking minimum or little more than minimum required distributions.
The IRS requires anyone using most of these accounts to take somewhere between the required minimum or required maximum distributions based on a lifespan formula.
Keeping distributions to the minimum or just a little more allows you to maintain the value of your accounts. Let’s say you have $330,000 in a qualified account and your minimum distribution in one year is about $12,000.
But say you want a little more. You take an additional 150% more than the minimum distribution, for a total of about $30,000, and have to pay taxes on it. However, you still have $300,000 remaining in the qualified account that is still not being taxed.
And, if it is a good year and you earn 10% on the remaining balance, then, at the end of the year, you once again have $330,000 and had the benefit of the $30,000 (minus taxes). With some luck, smart management and decent markets, your qualified accounts might never run out.
Taxes on these accounts can depend on where you live, how much earned and investment income you have. But the key issue is what is your tax bracket. The lower the tax bracket, the less you will pay.
Also Have Other Assets
Of course, these qualified distribution strategies only work if you also have taxable assets to access in retirement and are not completely dependent on the qualified assets. It’s important to have both kinds of assets—taxable and tax deferred—but clearly the latter are very valuable. Often, they are the most important element in achieving financial independence before or during retirement.
Indeed, Hughes, the Bay Shore, New York advisor, thinks it is a critical factor in retirement planning.
“I tell my clients taking distributions each year to wait until December to take the required distribution. Then, he adds, “you have let the compounding process go on a little longer.”
Still, almost any good idea can be misused.
The Wrong Way to Use Qualified Assets
Working at a financial publication 30 years ago, a young woman I knew at another business publication—who was actually a financial journalist—decided to break into her qualified account so she could buy a car. By the way, she lived in Manhattan and really didn’t need a car. She had about $30,000 in her qualified account. Not only was the account lost, along with employer matching contributions and tax breaks, so were years of compounding.
However, since she was using the account before age 59.5 and since there were no exceptional circumstances, the government penalized her breaking into her account early. It also required that she pay all the investment taxes before she received what was left of her qualified account, which was drastically reduced by the taxes and penalties. She immediately triggered a 10 percent early withdrawal penalty.
That meant $3,000 disappeared. She also incurred delayed investment taxes on the gains she had enjoyed over the years. Her retirement account was nuked and she received something less than $20,000. The compounding process, on the way to making her rich, was destroyed.
There Are Always Exceptions
A Long Island adviser cites an exception to the general rule of protecting your qualified assets. “I have asked clients sometimes to consider using qualified funds in the first couple of years of retirement so that they can defer taking Social Security until a later age. Each year they wait between 62 and normal retirement age, their Social Security benefit increases by 8%,” says John Carbonara of Jericho, New York. Waiting until age 70 to collect Social Security increases monthly payments by about 25%.
Brian Behl, an adviser in Waukesha, Wisconsin, identifies another exception. Say someone is in a low tax bracket in his or her 60s, but will be in a higher tax bracket after taking Social Security and required distributions from qualified accounts. “If that is the case,” he says, “it can be beneficial to pull income forward through IRA distributions or Roth conversions to maximize lower tax brackets now at a lower rate than is assumed to be paid later.”
The distribution from Roth IRAs, unlike traditional IRAs, aren’t counted in taxation. The best strategy, he says, depends on each person’s tax situation. But he adds “for many people the best strategy is to spend taxable accounts first, then tax deferred accounts (like 401(k)s and IRAs), and lastly tax-free accounts like Roth IRAs,” he says.
Boyan, the Medford, New York-based adviser, similarly emphasizes that “there are no cookie cutter approaches to retirement planning that work every time” and says sometimes it “makes sense to take money from a Roth IRA early in retirement because it can keep you in a lower tax bracket.”
Advisors underscore that all retirement planning, no matter how good, can blow up because all plans are based on certain assumptions that can change.
Assumptions, Assumptions
Ultimately, financial planning in retirement is not an exact science.
For example, you never know exactly how long retirement savings will need to last because you don’t know the exact number of years you will be retired. Moreover, part of constructing an effective plan depends on a correct assumption of the inflation rate. Over the past century, the inflation rate has been about 3% a year on average. But there have been periods of high inflation such as in the 1970s when inflation was sometimes in the double digits.
Another assumption of a retirement plan is the projected returns on your portfolio. Many younger retirees have a large part of their portfolios in stocks. That’s because stocks tend to provide the highest long-term rate of return of most investment categories. But, in exchange for the higher returns, they can be volatile investments. In the first decade of the century, stocks underperformed. In the last decade they were strong. But then for much of this year, the markets have been in turmoil due to the coronavirus.
Considering all the variables that must be taken into account, how can you determine if you have enough saved to retire comfortably? “That’s the $64,000 question,” writes attorney and certified public accountant James Lange in his book “Retire Secure. Pay Taxes Later.”
Lange, a longtime adviser in Pittsburgh, adds that, since there are many retirement variables, no plan can be 100% secure. But he adds that one strategy can dramatically improve a retiree’s odds of never running out of money: trying to reduce what is for most people their biggest or close to biggest cost over the course of a lifetime: “Take action to drastically reduce your taxes,” he says.
Lange argues the buildup and protection of qualified assets through accessing these accounts as late as possible. He believes most retirees should only take the minimum required distribution. By delaying the payment of taxes, he says, “you are giving your accounts more time to add capital gains, interest and dividends, instead of interrupting the buildup of the account.”
