How the New Three-Legged Stool™ Strategy Helps Reduce Taxes in Retirement - Rodgers & Associates
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How the New Three-Legged Stool™ Strategy Helps Reduce Taxes in Retirement

See Part 1 and Part 2 in this series.

Even novice investors have probably learned that diver­si­fi­cation is an important tool for lowering risk. The main concept is to avoid concen­trating assets in one position to prevent serious harm if an investment doesn’t work out. This includes diver­si­fying among investment classes—and diver­si­fying within the investment classes themselves—to reduce volatility.

Diver­si­fi­cation is just as important to taxability as it is to investing. Simply put, tax diver­si­fi­cation involves allocating investment assets across accounts and investment vehicles that are taxed in different ways—taxable, tax-deferred, and tax-free. We call these three types of accounts the New Three-Legged Stool™ of tax-efficient retirement planning. A sound tax diver­si­fi­cation plan follows these three techniques:

1. Allocate assets by tax treatment.

To determine what type of invest­ments to prior­itize within your retirement planning, consider how the returns are taxed. The return from equity invest­ments, for example, is generated in the form of dividends and capital gains, which are currently taxed at a maximum rate of 20%. Therefore, you’ll may want to keep a more signif­icant percentage of equity holdings outside of your retirement accounts. Focus on keeping a larger percentage of fixed-income holdings in your retirement accounts, because the return is taxed as ordinary income.

2. Use tax-free bonds when holding fixed income in taxable accounts.

It is not always practical to hold all fixed income in retirement accounts and all equities in non-retirement accounts. When fixed income must be kept in non-retirement accounts, consider using municipal bonds, which are free from federal, and in some cases, state and local income taxes. For this reason, these bonds can be partic­u­larly advan­ta­geous for investors in the highest tax brackets. Tax-free bonds may even be attractive to those in lower tax brackets because their yields can be equal to, and in some cases exceed, the long-term average versus compa­rable taxable fixed income securities. When equities must be held in retirement accounts, consider invest­ments with higher dividend payments, such as real estate investment trusts.

3. Find ways to fund a Roth regularly.

Consider investing in a Roth IRA or Roth 401(k) account based on your tax bracket each year. You may want to put only enough money in these tradi­tional tax-deferred accounts to stay in the 12% tax bracket. This will require estimating taxable income to determine when you have reached the optimum tax deferral, and then saving additional funds in a Roth. Use this chart to check taxable income:

2021 Tax Brackets
Single FilersMarried Individuals
Filing Joint Returns
Std Deduction
Under 65
$12,550$25,100
Std Deduction
Over 65
$14,250$26,450
($27,800 if both over 65)
Tax RateTaxable Income
10%$0 to $9,950$0 to $19,900
12%$9,951 to $40,525$19,901 to $81,050
22%$40,526 to $86,375$81,051 to $172,750
24%$86,376 to $164,925$172,751 to $329,850
32%$164,926 to $209,425$329,851 to $418,850
35%$209,426 to $523,600$418,851 to $628,300
37%$523,601 or more$628,301 or more
Source: IRS​.gov

You might consider converting part of your IRA to a Roth in a year when you know taxable income will be in the 12% tax bracket. For example, a couple filing jointly that estimates their taxable income will be $70,000 may consider converting $10,000 of their IRA to a Roth IRA

The financial press often advises retirees to take money from their accounts in the following order:

  1. Taxable
  2. Tax-deferred
  3. Tax-free

The reasoning is to preserve tax-deferred assets for as long as possible thus delaying payment of the Not without merit, this reasoning is to preserve tax-deferred assets for as long as possible, thus delaying tax payment. However, depending on an individ­ual’s tax situation, this order may not be the best course of action. Consider the following chart:

Tax-Efficient Withdrawals
Retirement Circum­stanceConsider the Following
10% to 12% tax bracketDraw from tax-deferred accounts to maximum
taxable income for 12% bracket. This should help
reduce required minimum distri­b­u­tions at age 72.
22% or higher tax bracketUse a combi­nation of tax-free Roth distri­b­u­tions,
withdrawals from taxable accounts, and
withdrawals from tax-deferred accounts to
minimize taxable income.
Signif­icant capital gains in taxable
account
Avoid withdrawals from tax-deferred accounts in
years gain is realized. Those with chari­table goals
should gift appre­ciated assets instead of giving
cash.
Wages or self-employment incomeCould trigger penalties on Social Security benefits
if under full retirement age. Consider suspending
benefits if income is signif­icant.

Anyone with signif­icant unrealized capital gains in taxable accounts may want to withdraw funds from tax-deferred accounts first. Appre­ciated assets will get a “stepped-up” cost basis when passed on to heirs, but tax-deferred accounts are fully taxable to heirs when the assets are withdrawn.

It is essential to actively estimate taxable income each year. You can adjust distri­b­u­tions from tax-deferred accounts to maximize the 12% tax bracket. When income is low, it may be best to take more from tax-deferred accounts, especially in the years before you reach age 72. Consider Roth conver­sions if you do not need the income for living expenses. This way, taxable income may be realized in a low tax year. The funds can be withdrawn tax-free from the Roth in a later year when the income is needed but your tax situation may not be as favorable.

Maintaining a lifestyle through 30 years of retirement is a challenging goal. Start with a sound investment strategy and be sure to prior­itize tax efficiency when imple­menting the plan. A tax-efficient portfolio may require smaller distri­b­u­tions to maintain spendable income. This could make the difference between having plenty of money to pass on to heirs or coming up short.

See Part 1 and Part 2 in this series.

Rick’s Insights

  • Diver­si­fying invest­ments can reduce investment risk. Diver­si­fying savings using the New Three-Legged Stool™ strategy may minimize income taxes
  • Waiting to withdraw retirement income from tax-deferred accounts is not neces­sarily the best strategy. Let your tax circum­stances each year determine the order of withdrawing.
  • Allocate assets by tax treatment to capitalize on the preferred tax status of long-term capital gains and qualified dividends.

Origi­nally Posted: September 6, 2012