Type the words “safe withdrawal rate” into Google, and it’ll return more than a million results. I’m not surprised by this. People debate about practically everything in personal finance, but the debate around this question is particularly intense. For at least twenty-five years, the conventional wisdom has been that it’s safe for retirees to base portfolio withdrawals on the “4% rule.” But not everyone agrees. Some feel that percentage should be higher, while others feel it should be lower. This debate is ongoing, as evidenced by the number of Google results.
While this question is an important topic in retirement planning, it gets so much attention that it sometimes feels like it’s the only question. In reality, it’s just one piece of the puzzle. Managing taxes is, in my opinion, at least as important. And for many high net worth families, it’s much more important. As you plan for retirement—or if you’re already there—below are some key tax concepts to keep in mind.
First, think long term. Because taxes are levied on a year-by-year basis, most of us tend to think about taxes on that same year-by-year basis. But when you’re making a retirement plan, you want to think about it differently. Instead of trying to minimize your bill in any given year, make decisions with an eye toward minimizing your total lifetime tax bill. This is a theme that runs through many retirement income strategies, including those described below.
Required minimum distributions (RMDs) are a perfect example of why it’s useful to take a multi-year perspective. Under current rules, mandatory withdrawals from tax-deferred accounts must start at age 72. These withdrawals start at a seemingly modest 3.9% of the value of your tax-deferred savings. But if you have substantial savings, that can translate into a big dollar figure. And that percentage increases each year as you get older. This can be a challenge because every dollar that comes out of a tax-deferred account is taxable as ordinary income. As a result, some retirees find themselves back in the same neighborhood of high tax brackets they thought they’d left behind. This isn’t true for everyone, though. It depends on the size of your account. So the first step I recommend is to assess your future RMDs. The key question you want to ask is: Will my future RMDs be less than or greater than my living expenses? The IRS provides a complete RMD table, but a shorthand way to think about it is to use 5% as a litmus test. If you think your living expenses will be less than 5% of the value of your tax-deferred accounts, then RMDs likely won’t be a problem.
But if it looks like your RMDs will substantially exceed your living expenses—in other words, if your RMDs will result in unnecessary taxable income—then these four strategies might help you keep a lid on them:
RMD solution #1: Keep working, at least a little. One little-known route around RMDs is to continue working—even part-time—at a company that offers a 401(k) plan. Provided you don’t own more than 5% of the company, any assets in that 401(k) won’t be subject to RMDs as long as you’re still working there. Note that this won’t exempt you from RMDs on other tax-deferred accounts, but you might be able to consolidate assets from those other accounts into your employer 401(k) if you wanted to shield more of your savings from RMDs.
RMD solution #2: Early withdrawals. Suppose you have both a taxable account and a tax-deferred account. Conventional wisdom dictates that you shouldn’t take withdrawals from your tax-deferred account until you’re required to. But research has shown that it’s more nuanced than that. Suppose, for example, you retire at 65 and defer Social Security until 70. That means your tax rate will probably be quite low for the first five to seven years of retirement—before Social Security and RMDs start. In situations like that, high income people can see their tax rates drop to surprisingly low levels. After a lifetime of contending with high rates, you might relish that newly low rate, but this is a good example of when you’d want to take a longer term perspective. Counterintuitive as it might seem, it might be worthwhile to take withdrawals from your tax-deferred accounts during these very low-income years even though you’re not required to. Yes, you would be intentionally driving up your tax rate in those early years. But it could be worth it because it might help lower your rate later on.
A further note on this: Even if you don’t expect to have an RMD problem, it’s worth considering taking distributions before you’re required to. That’s because the key principle here is to try to even out, as much as possible, your tax rate during retirement. And remember that your tax bracket is just one part of the tax burden facing retirees. Medicare’s IRMAA surcharges aren’t called taxes, but for all intents and purposes, they are. They can add up to more than $5,000 per year for those with high incomes—and twice that if you’re married. This is another reason to try to keep your tax rate as steady as possible in retirement.
RMD solution #3: Roth conversions. As I described back in May, Roth conversions carry many benefits. Among them is the potential to lower RMDs.
RMD solution #4 Charitable gifts: If you have charitable intentions, you can avoid taking your RMD—or part of it—by sending it directly to a charity. This is called a qualified charitable distribution (QCD). You won’t receive a tax deduction for this kind of donation, but it will satisfy your required minimum distribution (up to a cap of $100,000 per year).
If this all sounds complicated, I don’t blame you. But as the old saying goes, don’t let the perfect be the enemy of the good. What I recommend is to sketch out a long-term plan then revisit it each year. For Roth conversions and early withdrawals in particular, I recommend sharpening your pencil in October or November of each year. That’s when you’ll have a good sense of your other income and can decide how much to convert or withdraw to hit your tax target that year.
What does this all mean if you’re currently in your working years? Conventional wisdom says that you should do everything you can to look for tax breaks during your peak earning years. I mostly agree with this, but as we all know, Congress can change the rules any time. In fact, they’re debating another round of tax changes right now. For that reason, I think it’s a good idea to try to balance your savings among taxable, tax-deferred and Roth accounts. In other words, don’t bend over backwards to cram every last dollar into a tax-deferred account. Sure, this means you might pay a little more tax this year, but in return, you might gain valuable flexibility down the road.