High Net Worth Withdrawal Strategies
Which account should I use first to fund my retirement?
This is the not-so-simple question every retiree has to answer. Most either don’t bother to answer it or use a rule of thumb which calls for taxable and tax exempt (Roth IRA) accounts first and tax deferred accounts (Traditional IRAs and 401ks) last. While this may work for some, it could be costing you thousands in taxes and reducing the life of your portfolio by 2 to 7 years. Greatly reducing your retirement lifestyle or the amount of inheritance you can leave to your heirs.
I recently watched a webinar on High Net Worth Withdrawal strategies and it was such great info I had to share the secrets that I learned. Below is a summary:
Exploit your Lower Tax Brackets First - This strategy attempts to take advantage of the lower income you may experience during the first few years of retirement. If you are a high-net worth individual but your income dips right after you leave your job there is a window where you can draw from your IRA and pay the taxes at the lowest marginal tax rate. This is generally ideal before you start drawing social security. Added bonus - with significant assets you should be able to delay social security to maximize your benefit and save overall on taxes using this withdrawal strategy.
Practice Proper Asset Location – You may have heard of Asset Allocation which is choosing the correct mix of assets like stocks and bonds in your portfolio. Well now try Asset Location. This is choosing which accounts are best suited to hold your investments. For example, bonds produce income taxed at ordinary income rates. Therefore, you should hold bonds in a tax shielded IRA account. Although, considering the current low interest rate environment, a taxable account may be the best location at this time. By placing certain assets in various accounts you can better plan for withdrawals. The absolute best place to take out money during retirement is from a taxable account and selling an asset with a loss. You not only receive the full selling price of the asset (no tax) but you create a capital loss that can offset other gains. This allows you to unload some other investments with gains at zero tax as well. Example: Sell an asset at $100 that you purchased for $120. You get $100 and also have a $20 loss to offset other gains.
Borrowing Money
This is the most efficient way to get money. The presenter used the example of Warren Buffet using his Berkshire Hathaway stock – He will borrow against his Berkshire Hathaway stock which means not only does he get a dollar for every dollar he borrows but he also creates an expense which he can deduct. While this isn't the best example it does illustrate the point. The problem with this is it also creates more risk. Just because something is tax efficient doesn't mean it’s worth the risk! You should consult with your financial advisor before implementing this type of strategy. A reverse mortgage is an example of this on the real estate side. Currently there are not many good ways to do this on the portfolio side. Although, collateralizing a bond portfolio is not unheard of but should only be done with a risk management plan in place.
Save some Assets for Later in Life – Medical expenses only tend to go up over time. These are deductible on your taxes, so make sure you save some of your IRA/401k money for later in life. These medical expenses may allow you to remove this money at a lower tax bracket or possibly tax free.
Reclassify Income – If you rely on income from your portfolio, you should take a look at where you are receiving that income. Qualified Dividends receive a favorable tax rate as compared to corporate bond interest. And Municipal bond interest is tax-free (depending on circumstances) but will count as income when determining the taxation of social security benefits. This strategy goes hand in hand with asset location. Certain bonds and stocks should be held in different accounts from a tax efficiency standpoint.
IRA Conversions and Recharacterization – One of the more complicated strategies is converting assets from an IRA to a Roth IRA (called a Roth Conversion). You have to pay taxes on any assets that are converted, however, now the money can be withdrawn tax free at a later date. This can be combined with an IRA Recharacterization, which converts Roth IRA money back to a traditional IRA. You convert different assets types to the Roth account then if the market goes down after your conversion you can recharacterize those assets back to a Traditional IRA which removes the tax liability that resulted from the conversion.
What are tax rates going to do?
We can't know for certain (although most people think they will be up in the future) so you need to make sure your analysis considers a change in marginal tax rates. If taxes go up then your tax deferred money has less value (because it will be more heavily taxed when it comes out of the account) . This then affects your withdrawal strategy. It is important that your tax advisor and financial planner are talking because these strategies cross disciplines. (Or in the case of Phillip James – Your financial advisor is your tax advisor).
As you near retirement a little planning goes a long way in extending the life of your portfolio. The best planning should be done years ahead, but even if you are already in retirement and withdrawing money these strategy’s can help keep more of your money for yourself (and heirs) and out of the hands of the IRS. Contact a Phillip James Professional to see how you can implement some of these strategies for your own portfolio.