In this three-part blog series, we’re exploring how to preserve your income stream throughout retirement. An effective retirement strategy should, after all, be designed to provide increasing income over life expectancy, allowing retirees to maintain their lifestyles.
In Part 1 of this series, we established three fundamentals for the investment side of this strategy:
- Ensure growth through equities.
- Establish an asset allocation strategy to take advantage of market volatility.
- Set a sustainable withdrawal rate.
The next step to building an effective retirement income strategy is to optimize your portfolio to protect it from avoidable income taxes. There are three main ways to achieve tax efficiency:
- Use all three legs of the New Three-Legged Stool™ strategy: taxable accounts, tax-deferred accounts, and tax-free accounts.
- Properly diversify your asset allocation across these three legs.
- Take tax-smart distributions that will vary based on market conditions and your individual circumstances.
For many individuals, one key challenge to pursuing proper tax diversification is that a large percentage of their overall savings lies in tax-deferred retirement accounts. Traditional IRAs, 401(k) plans, and pensions are great to have when you’re working, but when it comes time to make withdrawals, distributions are fully taxable at ordinary income rates.
According to a study from the Employee Benefit Research Institute, for families with assets in tax-deferred accounts, these resources accounted for a median of 68.3% of total financial assets.1 Roth IRA accounts, which are funded with after-tax dollars and can produce tax-free distributions in retirement, comprised just 5% of all tax-deferred assets.
Tax Treatment of Various Types of Retirement Income
|Type of Income/Account||Tax Treatment|
|Tax-deferred accounts — 401(k), 403(b), 457 plans, thrift savings, traditional IRA, annuities||Taxable at ordinary income rates upon distribution. 10% to 37% in 2021.|
|Pensions||Taxed at ordinary income rates.|
|Roth IRAs and Roth 401(k)s||Distributions are non-taxable if owner is age 59 1/2 and the account is at least five years old.|
|After-tax investment accounts||Long-term capital gains and qualified dividends: taxed at a maximum of 20% in 2021. Other income: taxed at ordinary income rates.|
|Social Security||May be partially taxable at ordinary income rates.|
From Don’t Retire Broke: An Indispensable Guide to Tax-Efficient Retirement Planning and Financial Freedom
Unfortunately, retirement savings have been building up in tax-deferred accounts at a time when personal income tax rates have declined to historically low levels. Historically, tax brackets have only been at current levels 14% of the time. Congress is currently trying to reduce budget deficits in the trillions of dollars, which means the $21.9 trillion of pre-tax assets now sitting in retirement accounts could look very appealing.2 Retirees who have most of their assets in traditional accounts and anticipate lower tax rates in retirement could be in for an unpleasant surprise.
A historical analysis of different tax scenarios shows the survivability of a diversified portfolio of equities, fixed income, and cash over various time periods when taxed at different rates. Not surprisingly, the portfolio with the highest tax bracket had the shortest survivability.
Historical Success Rate
Following the New Three-Legged Stool™ strategy for retirement offers several benefits:
- Flexibility: You can draw income from three different account sources depending on your year-to-year tax situation.
- Sustainability: A lower tax rate may help your portfolio last longer.
- Protection: While no one knows what will happen with the tax code in the future, diversifying your savings is one way to hedge against tax changes that could affect you.
The final part of this series looks at specific techniques for achieving tax efficiency.
See Part 1 and Part 3 in this series.
- Holding all retirement savings in a tax-deferred account provides few opportunities to minimize taxes during retirement.
- Research shows that lower tax rates can increase the survivability of your portfolio over life expectancy.
- If Congress could figure out a way to tax just one-fifth of retirement assets, it could eliminate the current budget deficit.
Originally Posted September 19, 2012
- The Status of American Families’ Accumulations in Individual Account Retirement Plans and Differences by Race/Ethnicity, By Craig Copeland, Ph.D., Employee Benefit Research Institute, March 11, 2021.
- Source: Board of Governors of the Federal Reserve System. Financial Accounts of the United States: Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts 1992–2019, Tables L.118.b/c and L.227.
- This hypothetical illustration is based on rolling historical time period analysis and does not represent the performance of any specific mutual fund, which will fluctuate. This illustration uses the historical rolling periods from 1926 to 2020 and a portfolio composed of 60% equities (as represented by an S&P 500 composite), 30% fixed income (as represented by a 20-year long-term government bond (50%), and a 20-year corporate bond (50%)), and 10% cash (as represented by U.S. 30-day T bills) to determine how long a portfolio would have lasted given a 5% initial withdrawal rate adjusted each year for inflation. A one-year rolling average is used to calculate the performance of the 20-year bonds. Past performance is not a guarantee of future results. The S&P 500 Index is an unmanaged index of common stock performance, and you cannot invest directly in an index.