Save Early, Save Often, and Save Tax Efficiently

When planning for retirement, many people focus on maximizing investment perfor­mance and saving enough money to sustain their lifestyle. While these consid­er­a­tions are important, retirees should also look at how tax efficiency can impact how long their money will last.

Compare someone who has all their savings in a tax-deferred account (tradi­tional IRA or a 401(k)) with someone whose savings are entirely after-tax. The first individual might need to have a third more saved to equal the after-tax income of the second individual.

We recently read an article in the Journal of Financial Planning that looked at this very topic—the impact of tax efficiency on the sustain­ability of withdrawals from retirement accounts.¹ The study, conducted in March 2021, looked at retirees with savings across three different sources: a taxable account, a Roth IRA, and a tax-deferred 401(k). Was there a sequence of withdrawing funds from these sources that would extend the life of the funds by minimizing taxes?

The study found that, yes, the most tax-efficient sequence could extend the portfolio by seven and a half years over the least tax-efficient sequence.

So how can you start to think about saving in a tax-efficient way?

Diver­si­fying your retirement savings is the first step, and our New Three-Legged Stool™ strategy explains why this is so important. When thinking about how to allocate invest­ments, follow these basic principles:

• The most tax-efficient invest­ments, such as municipal bonds, non-dividend-paying stocks, growth-oriented passive mutual funds, and exchange-traded funds, should usually be held in taxable accounts.
• The least tax-efficient invest­ments, such as corporate bonds, real estate investment trusts, and income-oriented mutual funds, should usually be held in tax-deferred accounts.
• Tax-free accounts, such as Roth IRAs and Roth 401(k)s, can be used to balance out your asset allocation.

In addition to these principles, there are more advanced techniques for minimizing taxes in the future. Think of it as oppor­tunistic tax planning.

Control capital gains

Whereas short-term capital gains are taxed at higher ordinary income rates, long-term capital gains are taxed at signif­i­cantly lower rates. Currently, realized gains on appre­ciated securities held for one year or more qualify for favorable tax treatment. So before selling a security, be sure to check when it was purchased. Delaying the sale could result in a consid­erable tax savings.

A taxpayer in the 12% bracket, for example, might consider realizing long-term capital gains until they reach the top of their tax bracket (where the tax rate is still zero).²

Tax-filing Status	Single	Married, Filing Jointly	Married, Filing Separately	Head of Household
0%	$0 to $40,400	$0 to $80,800	$0 to $40,400	$0 to $54,100
15%	$40,401 to $445,850	$80,801 to $501,600	$40,401 to $250,800	$54,101 to $473,750
20%	$445,851 or more	$501,601 or more	$250,801 or more	$473,751 or more

If you live in a state that taxes capital gains, be sure to consider your state’s tax treatment before imple­menting this strategy.

A second part of this strategy is to review currently held security positions that are trading below their original cost. This situation is called an unrealized loss. Unrealized losses aren’t tax-deductible, and you need to sell a position in order to create a realized loss for tax purposes. This technique is called tax-loss harvesting. The federal tax code says that capital losses can offset capital gains. If your losses exceed your gains, you can take a $3,000 loss against other income (and carry any excess loss into future tax years).

Convert a traditional IRA to a Roth

When you convert a tradi­tional IRA to a Roth IRA, the tax on the converted amount is due in the year of conversion. This means you can consider Roth conver­sions in tax years when income from other taxable sources will be low. Partial conver­sions can also help maximize tax savings. Over time, well-planned Roth conver­sions can minimize required minimum distri­b­u­tions at age 72 and provide a tax-free source of funds when needed for large purchases.

In 2020, the bear market caused by the COVID pandemic may have been the perfect oppor­tunity for a Roth conversion. A conversion would be taxable, but what better time to pay these taxes than when the market and account value are down? Then, account holders would realize the advantage of this strategy when the market recovers, and the growth from the recovery would be tax-free (once the funds had been held for five years and the account owner reached age 59 ½).

While the savings you can achieve through tax efficiency can be signif­icant, taking advantage of oppor­tunistic tax planning can extend the life of your portfolio even further. Tax planning should be a long-term strategy that also considers the timing of Social Security benefits and pensions. This approach is essential to help ensure retirees have the savings they need to sustain their retirement.

Rick’s Insights:

• A March 2021 journal article shows that the most tax-efficient sequence of withdrawals could extend a portfolio by seven and a half years over the least tax-efficient sequence.
• Before selling a security, verify that it has been held for at least 12 months. Delaying the sale could result in a consid­erable tax savings.
• Well-planned Roth conver­sions can minimize required minimum distri­b­u­tions at age 72.

Origi­nally Posted: July 14, 2015