It’s Time for the Tax Talk

(Couple examines IRS forms.)


Most of the time when people come to see a financial professional, they want to talk about investments and returns. And as they get closer to retirement, much of that discussion is centered around risk: Are they taking too much, or possibly not enough?

It can be tough to turn the conversation in any other direction, but — especially in retirement — it’s important that we talk about taxes.

Investors tend to overlook the role taxes play in their long-range plans, often because they’ve been told that their income — and as a result, their income taxes — will go down in retirement. But that isn’t always the case. Sometimes their income actually will increase, at least at first, because they want to be spending more on hobbies, travel or other things they want to enjoy. To cover those costs, they take withdrawals from their retirement accounts without considering the tax implications. And this comes at a time when they might be losing some of the deductions they had when they had mortgage payments, children at home or business expenses.

For some, taxes can have as much of an impact on their future as market volatility. And if they reallocate the assets in their portfolio to lower their risk tolerance, the impact may be more substantial.

So it’s important to break down your various income streams based on how they’ll be taxed and manage them accordingly. We look at it as though there are four tax buckets:


This is income that is taxed on an ongoing basis, such as the interest on certificates of deposits or the gains in a brokerage account. Even if it’s money you aren’t using — dividends that are reinvested, for example — you’re still going to pay taxes on it. Your Social Security income also may be taxable, depending on your provisional income.


For many people, this is the bulk of their retirement savings — a traditional 401(k), 403(b) or traditional IRA. You can reduce your taxable income for years by contributing to these qualified accounts, and that’s a big draw. But once you retire, you’ll have to pay taxes on any withdrawals from those accounts, and you must take required minimum distributions (RMDs) when you turn 70A1/2 (with very few exceptions).

Income tax-free, estate taxable

These are things like Roth IRAs, Roth 401(k)s and municipal bonds. A Roth IRA or Roth 401(k) contribution won’t reduce your taxable income the year you make it, but you can withdraw your contributions tax-free and there are no taxes on any future earnings as long as you hold the account for five years and are age 59A1/2 or older when you make a withdrawal. If you think your tax rate will be the same or higher in retirement, that can make a big difference.

Another big benefit of Roths: There are no RMDs from a Roth IRA during the lifetime of the original account owner. When the original account owner dies, a non-spouse beneficiary can choose to take the Roth funds in an income tax-free lump sum (as long as the owner of the Roth had owned the account for at least five years — if not, then you could be taxed on any earnings), or roll them into an Inherited Roth IRA. An Inherited Roth IRA will still grow tax-free, but under the most popular method of inheritance, the account owner will need to begin making RMDs by Dec. 31 of the year after the original account holder’s death. Or you can withdraw all of the money in the account within five years.

A spouse who inherits a Roth has the added option of rolling the assets directly into their own Roth, without having to take RMDs.

However, Roth IRAs and Roth 401(k)s are considered part of the estate for estate tax purposes. Therefore, if the estate is greater than federal estate tax exemption, currently $5.49 million for a single person, the excess will be taxed at the federal estate tax rate, which is currently 40%. Depending on the state, the Roth IRA or Roth 401(k) might also be subject to an inheritance or state estate tax, too.

Income tax-free, estate tax-free

This fourth tax bucket comes into play at the completion of retirement, when you die. Using specific trusts such as an irrevocable life insurance trust (ILIT) or a charitable trust, if properly structured, will enable your loved ones to receive proceeds free of estate tax and income-tax. You want to be sure the money you’re leaving your loved ones or favorite charity gets to them with the least amount of tax impact.

A diverse portfolio can help guard against not only market risk but also tax risk, and each of these buckets should have a place in your plan.

If tax efficiency isn’t built into your retirement plan, it isn’t complete. Talk to your adviser about building a strategy designed to keep more of the money you worked so hard for in your pocket, not Uncle Sam’s.