How to Create a Tax Efficient Income Plan

In my early days as a financial advisor, I remember meeting a retired couple, anxious and confused about their retirement savings. As we sat in my office one spring afternoon, they looked at me earnestly and asked, "Leibel, where should we start spending our money first in retirement?" This question has stuck with me through the years, and I've realized how complex the answer can be.

You see, when it comes to managing finances, especially for retirement, there are two kinds of people. Some folks see the big picture, while others excel in the nitty-gritty details. But in retirement, you really need to be a bit of both. It's like playing a chess game where you're thinking several moves ahead while also focusing on the intricate play-by-play.

Let's say you've got a 401K and an IRA. Your 401K is just sitting there, safely tucked away in cash or cash equivalents. But your IRA? It's a wild stallion, aggressively investing and growing at an exponential rate. So, which do you touch first? Well, it's not always about the specific account. It's more about what you're trying to achieve.

Let's circle back to that couple in my office. They had a substantial 401k, but it was mostly in cash. Their IRA, on the other hand, was considerably smaller but invested aggressively. In their case, the IRA was growing rapidly, while their 401K was essentially idle. So, we decided to spend from the 401K first, allowing the IRA to continue its growth trajectory.

RMDs Are The Real Enemy

The government has a say in all this, too. You see, Uncle Sam is pretty hands-off with your 401K and traditional IRA until you hit a certain age. Then, they want their cut, and you have to start taking required minimum distributions (RMDs). It's like a ticking tax time bomb.

Say you've been diligently saving, and now you're sitting on a significant retirement account balance. By the time you're in your eighties, the RMDs could be 20, 30, even 40% of your account balance. That could mean shelling out hundreds of thousands just in taxes. You might find yourself in a higher tax bracket in retirement than you ever were while working, with the largest beneficiary of your hard-earned savings being Congress, not your family.

So, what's the best way to avoid this? Keep a close eye on your retirement account balance and your potential RMDs. If you project your RMDs to be significantly higher than your annual income in retirement, you might need to spend down your retirement accounts or consider Roth conversions.

What Are RMDs?

Required Minimum Distributions, or RMDs, are essentially the tax bill coming due on the money you've saved in your retirement accounts. You see, when you were working, you got a tax break for contributing to these accounts. This allowed you to save more and pay less in taxes at the time. But the government wants its share eventually, and that's where RMDs come in.

Once you hit 73 or 75, depending on when you were born, Congress insists you start withdrawing a specified amount from these accounts each year. It's like they're saying, "Hey, we know you've been saving diligently, and maybe you feel comfortable with your Social Security and pension. But we want our share, and we're going to make sure you pay up."

And if you're thinking, "Well, I'll just leave it to my kids when I pass," think again. The government will require your beneficiaries to drain the account within ten years of inheriting it, often bumping them into a higher tax bracket.

So, how do they calculate your RMD? The IRS gives you a number based on your account balance as of December 31st. You multiply your balance by this number, and that's your RMD. If you don't take it out, you'll face a tax penalty, which could be as high as 25% with the new Secure 2.0 Act.

Generally, there's no reason not to take out your RMDs unless it would push you into an unusually high tax bracket. In the end, Congress wants you to start drawing down that money. For a clearer idea of what your RMD might look like, you can look up the Uniform Life Expectancy Table or use an online RMD calculator. Just remember, Uncle Sam is waiting for his share!

As a rule of thumb, I usually suggest prioritizing retirement accounts first, then taxable accounts, and finally Roth accounts for distributions. But remember, your situation might call for a different strategy. So, just like that couple in my office years ago, don't be afraid to ask questions and seek advice tailored to your needs.

Where Does Social Security Fit In?

For the majority of retirees, Social Security forms a vital part of their income. Even if your annual expenses go beyond what you receive from Social Security, it's a safety net. It ensures you've got a roof over your head, food on your plate, and gas in your car.

But the question that often stirs up a debate is - when should you start taking Social Security? At 62, because life is unpredictable? Or wait until 70 to receive a larger check? The answer is not one-size-fits-all. It depends on your lifestyle and your retirement accounts.

I recall a couple who came to me without much in terms of retirement savings. Their Social Security check wasn't large either. But taking a reduced check at 62, though it might seem counterintuitive, allowed their retirement savings to grow, and it significantly impacted their retirement lifestyle. That early, smaller check was the difference between them running out of money and being able to live comfortably and leave something for their beneficiaries.

On the flip side, for some people, delaying Social Security until 70 is essential. Imagine a scenario where a large chunk of your income comes from Social Security, and then the higher-earning spouse passes away. The surviving spouse only receives the higher-earning spouse's benefits, leaving a deficit of 30-40% of their income. If they don't have the savings to cover that difference, it's a precarious situation.

So, when considering Social Security, Roth conversions, RMDs, or which accounts to spend down first, remember - these pieces interlock. Adjusting when you take Social Security can significantly impact other aspects of your retirement plan.

Here's my advice: plot these numbers out side by side. Run a few scenarios. What if you delay Social Security by a year? What if you take it a year earlier? Or what if the first year or two of your retirement, you have a negative balance instead of a positive one? Visualize what these changes do to your retirement account balance over 20, 30, or even 40 years.

Yes, it may feel like looking too far into the future, but here's a sobering fact - about 10% of Social Security beneficiaries are over 100. While you or your spouse may not live that long, you don't want to risk ending up in a low-cost Medicaid nursing home because you didn't plan well. It's about doing the hard work and asking the difficult questions now so that you can reap the benefits later. Trust me, future you will thank you for it.