Retirement is an exciting time, filled with opportunities to enjoy the fruits of your labor. However, if you’re not careful, taxes can erode a significant portion of your retirement savings. That’s why it’s crucial to review your financial strategy and make sure you’re not leaving any money on the table due to inefficient tax planning.
Today, we’ll use Elizabeth and Joe’s situation as a case study to explore how three essential tax strategies can dramatically impact your financial health in retirement. The strategies we’ll cover—asset location, withdrawal sequencing, and Roth conversion—are particularly important for retirees with substantial savings, as small changes can result in significant long-term benefits.
Meet Elizabeth and Joe
Elizabeth and Joe are approaching retirement with a combined net worth of approximately $4.2 million. They have $2.2 million in investments, including taxable accounts, IRAs, 401(k)s, and Roth IRAs. They also own a primary residence worth $1 million and a lake house valued at $1.2 million, with a small remaining mortgage.
Elizabeth, 53, is already retired, and Joe, 51, plans to retire in four years at 55. Their goal is to live comfortably, spending about $8,000 per month, which covers their living expenses, taxes, and mortgage payments. They also need to account for healthcare costs, which will rise once Joe retires and loses his employer-sponsored health insurance.
The couple is understandably concerned about taxes. With retirement savings spread across taxable, tax-deferred, and tax-free accounts, they’re unsure how to draw down these funds efficiently. Their primary question: Can they retire on their current assets without overpaying in taxes?
Let’s dive into the three key strategies that can help them—and you—make retirement as tax-efficient as possible.
1. Asset Location Strategy
Asset location refers to how you distribute your investments across different account types—taxable, tax-deferred, and tax-free. The goal is to minimize taxes by placing tax-efficient investments in taxable accounts and high-growth or tax-inefficient investments in tax-advantaged accounts.
In Elizabeth and Joe’s case, their overall portfolio is allocated about 78% to stocks and 22% to bonds. However, this allocation is spread evenly across their taxable accounts, IRAs, and Roth IRAs. This approach may not be the most tax-efficient.
By rethinking their asset location, they can optimize their portfolio for tax efficiency. For example, it makes sense to place high-growth investments like stocks in their Roth IRA, where they’ll grow tax-free. Conversely, bonds, which generate more taxable income, can be placed in tax-deferred accounts like IRAs and 401(k)s.
By being more intentional about where their investments are held, Elizabeth and Joe can potentially reduce their future tax liability and increase the growth of their portfolio. This simple change can lead to significant tax savings over the course of their retirement.
2. Withdrawal Strategy
Your withdrawal strategy—how and when you take money from various accounts—can greatly impact your tax burden in retirement. Many retirees, like Elizabeth and Joe, consider withdrawing funds from their accounts on a pro-rata basis. In other words, they take distributions proportionately from their taxable, tax-deferred, and tax-free accounts.
While this approach may seem logical, it’s rarely the most tax-efficient. Instead, a more effective strategy is to draw down from taxable accounts first, allowing tax-advantaged accounts (like IRAs and Roth IRAs) to grow longer. This method lowers taxable income in the early years of retirement, creating a “tax planning window” where they can take advantage of lower tax brackets.
For Elizabeth and Joe, this means starting with withdrawals from their taxable brokerage account, which will keep their taxable income low. By doing so, they preserve their IRA and Roth IRA balances for later years, when tax rates may be higher.
This approach also allows them to strategically convert some of their traditional IRA funds to a Roth IRA during these lower-income years—setting them up for even greater tax savings down the road.
3. Roth Conversion Strategy
The third strategy, Roth conversions, is a powerful tool to help retirees reduce taxes in the long term. A Roth conversion involves moving funds from a traditional IRA or 401(k) into a Roth IRA, where future growth and withdrawals are tax-free.
By timing Roth conversions during lower-income years—such as the gap between retiring and starting Social Security or other income streams—retirees can lock in lower tax rates on these conversions. For Elizabeth and Joe, this strategy makes perfect sense. Once Joe retires at 55, they’ll have several years before their Social Security benefits kick in and push them into a higher tax bracket. This window provides an ideal opportunity to convert a portion of their traditional IRA to a Roth IRA, potentially saving them significant taxes later in life.
In their case, converting up to the 10% tax bracket allows them to move funds at a low cost, reducing their future required minimum distributions (RMDs) from tax-deferred accounts, which can push retirees into higher tax brackets in their 70s.
The result? More of their savings can grow tax-free, giving them greater flexibility to manage taxes as they age.
Putting It All Together: A More Tax-Efficient Retirement
By implementing these three strategies—asset location, an optimized withdrawal sequence, and well-timed Roth conversions—Elizabeth and Joe can potentially save hundreds of thousands of dollars in taxes over the course of their retirement.
For example, by starting withdrawals from their taxable accounts and delaying IRA withdrawals until later, they can create a tax-efficient “glide path” that smooths out their tax liability over time. This approach minimizes taxes in high-income years and avoids unnecessary jumps into higher tax brackets.
Additionally, by converting traditional IRA funds to a Roth IRA during lower-income years, they can reduce future RMDs and ensure that a larger portion of their assets grows tax-free. The result is a more stable and predictable tax situation, allowing them to enjoy their retirement with peace of mind.
What This Means for You
While Elizabeth and Joe’s situation is unique, the principles of asset location, withdrawal sequencing, and Roth conversions apply to every retiree. By taking the time to review your retirement tax strategy, you can ensure that you’re making the most of your hard-earned savings.
Here are three questions to consider as you evaluate your own retirement plan:
- Where are your assets located? Are you taking advantage of tax-efficient placement in your taxable, tax-deferred, and tax-free accounts?
- What’s your withdrawal strategy? Are you pulling funds from accounts in the most tax-efficient manner, or are you following a pro-rata approach that could cost you more in taxes?
- Have you considered Roth conversions? Do you have a window of opportunity in early retirement to convert funds at a lower tax rate, reducing your future tax burden?
The answers to these questions could mean the difference between paying more than necessary in taxes or enjoying a more comfortable and financially secure retirement.
Tax planning is an essential part of any successful retirement strategy, especially for those with substantial assets like Elizabeth and Joe. By optimizing your asset location, withdrawal sequence, and considering Roth conversions, you can reduce your tax liability and ensure that your savings last longer. The sooner you begin planning for tax efficiency, the more opportunities you’ll have to maximize your wealth in retirement.
Don’t let taxes eat away at the savings you’ve worked so hard to build. Take control of your retirement with a strategic approach, and you’ll enjoy the financial freedom to live out your retirement dreams.
