This article was recently UPDATED in 2020 due to the SECURE ACT!
For most, I think having a completely tax efficient retirement portfolio would be an ideal scenario. It could allow for flexibility and many planning opportunities. Not to mention knowing that you won't have worry about tax planning issues when taking withdrawals. It would simply make life so much easier! Unfortunately this isn't the situation for most retirees.
Many retirees we see are in the exact opposite situation, and have portfolios that are fully-taxable. For those of you serious about your wealth planning, I want to share the strategy we employ with some of our clients' retirement portfolios, which allows them to be tax efficient throughout a 20 to 30 year retirement. If you are in the distribution phase of retirement, or simply planning ahead for an upcoming retirement, this strategy is definitely worth considering. Before I get into the actual strategy, we need to have at least a basic understanding of a few things. They are as follows:
Pre-Tax Retirement Dollars
The most widely held retirement accounts are those funded with pre-tax dollars such as the IRA, 401(k), 403(b), and 457(b) plans to name a few. The tax-deferred nature of these types retirement accounts can make them great savings vehicles since they allow contributions and any potential earnings to compound in a tax-deferred environment (meaning you won't pay taxes on the amounts you earn year-to-year) until withdrawn, vs. an account .where earnings are taxed each year.
For example: You can have $100 invested in a pre-tax account that earns 5%, or you can have $80 (same $100 after it is taxed at 20%) after-tax earning 5%. Assuming identical one time investments, the account with the pre-tax money will be larger than the after-tax account measured over identical time periods. This is the true power of tax-deferred retirement accounts.
One other advantage of tax-deferred accounts is that they can be good candidates for certain investments that have "unfavorable tax treatment". I am referring to the fact that some types of investments such as bonds and certain real estate investments distribute interest or dividend payments that do not receive favorable capital gains treatment of 0% to 23.8%. Even though these types of investments aren't the most tax efficient, they can offer tremendous diversification to a retirement portfolio.
Why are they good candidates? The key rule to understand is that all pre-tax contributions and earnings distributed from retirement accounts will be taxed at the owner's ordinary income tax rate at the time of distribution (and possibly a 10% early withdrawal penalty if withdrawn before age 59 1/2). Therefore there is no need to seek out the most tax-efficient investments or asset classes because in the end it won't matter, you're paying full boat. Is there a way to mitigate the tax bill? There sure is - Let's talk about the power of the Roth IRA.
The Roth IRA
Roth IRAs can be a fantastic investment vehicle if you are eligible to contribute to one. Essentially they are tax-deferred retirement accounts that you fund with after-tax dollars, and any potential earnings/interest can grow tax-free and penalty-free if certain requirements are met. These accounts are especially advantageous if you think that you will be in a higher tax bracket (or tax rates simply increase) by the time you need the funds later in life (after 59 1/2). That being said, they allow for tremendous opportunity and flexibility in retirement income and distribution planning.
Let's review the requirements since they are important to satisfy if you are to consider using the strategy I will be discussing:
Requirements for tax-free AND penalty-free withdrawals (aka qualified distribution):
There are two separate 5-year clocks, one for contributions and one for conversions.
For contributions, the 5-year rule determines whether or not earnings are tax-free.
For conversions, the clock determines whether or not the principal is penalty-free - The principal in this case would be the ENTIRE amount you converted from the pre-tax account since upon conversion you pay the taxes due on the entire amount.
2: You must be over age 59 1/2.
If you are over 59 1/2 but have not met the 5-year rule, you will not pay a 10% penalty on the earnings withdrawn but will pay income tax on them.
If you are over age 59 1/2 and have met the 5-year rule, you're home free - no penalties, no taxes due.
If you are over age 59 1/2 and have converted funds to a Roth IRA, the 5-year clock for conversions will not affect you - no penalties, no taxes due.
A distribution is made due to death, disability, or under the first-time home-buyer rules.
Required Minimum Distributions or "RMD"
A required minimum distribution is essentially a minimum amount that a retirement account owner must withdrawal from their accounts when they reach age 72 (previously 70 1/2 pre Jan, 2020). This rule applies to retirement accounts such as those mentioned previously. What happens when you take the distribution? You pay income tax on it!
If you fail to take an RMD, the IRS penalty is currently 50% of the amount that you should have taken. My advice? Don't give the IRS more of your hard-earned dollars. This leads to the rationale behind why such a rule exists - After 72 years of waiting, the IRS wants to be paid!
NOTE: Roth IRAs do not have Required Minimum Distributions! That is one of their huge advantages! However, Roth 401(k) accounts do have Required Minimum Distributions. In this case the Roth 401(k) distribution would not be taxed but you still have to take a minimum amount out while it's earning interest tax-free! - go figure.
RMDs are required for all eligible retirement accounts you hold. Therefore if you are over age 72, have an old 401(k) at a previous employer and have an IRA, there is an RMD that applies to both. If you do have multiple retirement accounts subject to RMDs, you can usually choose to take your entire aggregated RMD distribution from just one of the accounts.Make sure to coordinate this with your advisor or the custodian of your accounts - this can make record-keeping much easier on you.
One additional caveat to some 401(k), profit-sharing, 403(b), or other defined contribution plans, is that you do not have to take your RMD at age 72 if you are still working for the employer sponsoring that plan. This will depend on your plan's specific terms, as some may still require you to take them at 72.
Example: If you have a 401(k) plan with your employer, attain age 72 and are still working, you do not have to take the RMD for that 401(k) account. However if you have other old 401(k)s or IRAs, you will have to take the RMDs from those. This can present additional planning opportunities. If this is you, we suggest you consult an advisor.
One more thing, if you are a more than 5% owner of the company (the company sponsoring the retirement plan), you will have to take RMDs starting at age 72. In this case you can delay taking the RMD from that account until April 1st of the year following the year you terminate employment- confused yet?1
The Problem With Required Minimum Distributions
Required Minimum Distributions are not your friend. As I mentioned, most retirees who have saved on their own for a lifetime end up having relatively large pre-tax accounts compared to tax-free or partially-taxable accounts (if any). These pre-tax retirement accounts are not known to be the most tax-efficient vehicles later in life because everything is taxed at ordinary income rates when taken out - when you start to take RMDs! There really is no way to get around this in pre-tax retirement accounts, someone will pay taxes eventually.
However, you can structure your overall retirement portfolio strategically to give you more options when it comes to taking distributions. With a little creative planning you might even be able control the amount of taxes you pay! When we say "overall retirement portfolio" we mean to consider all of your retirement accounts as one portfolio, even though each account could be invested differently and have different "rules".
If you and/or your spouse have accumulated a good sized nest-egg in pre-tax retirement accounts, RMDs will require you to start taking money out at age 72 and you will be taxed on all of it (assuming you are no longer working for an employer with a retirement plan and not making Qualified Charitable Distributions). Often times, many retirees do not necessarily need that money yet and/or are looking for ways to minimize their tax liability.
This can be for a multitude of reasons, whether it be because the retiree and their spouse receive a lifetime pension and can live comfortably on that, or maybe they are able to live comfortably off of Social Security and income from rental properties for example. It may even be the case where the retiree does need to take withdrawals to supplement their retirement income, but the RMD amount is far greater than what is actually needed as a supplement!
In the case where a high amount of income from other sources is involved, adding RMDs from one or both spouses' accounts could potentially launch them into higher tax brackets. Not only can this subject them to higher income tax rates but can also trigger IRMAA Medicare surcharges, and the Net Investment Income Tax (aka 3.8% Medicare Tax) as well! As you can see, RMDs can become a major disruption to your wealth preservation plan! So how can we reduce RMDs while maintaining an efficient portfolio?
Tax Efficient Retirement Portfolio: Barbell Strategy
In comes my barbell strategy. The goal is to mitigate RMDs as much as possible over the remainder of your lifetime, thus mitigating potential tax liability. If you remember from earlier, Roth IRAs do not have RMDs. Therefore one way to reduce RMDs would be to consider converting some or eventually all of your pre-tax retirement dollars to a Roth IRA. If you have a Roth 401(k) balance, you may want to consider rolling it to a Roth IRA in order to avoid RMDs. This strategy won't work if the Roth money is left in the 401(k). You may also want to consider rolling your pre-tax 401(k) dollars to a Rollover IRA for ease of record keeping and future Roth conversions.
When you convert pre-tax dollars in an IRA to a Roth IRA, you will pay ordinary income tax on the entire amount you convert in the year you convert it. The amount and timing in which you decide to convert is up to you and requires careful planning. Some convert all of their pre-tax dollars at once, but most convert smaller portions over a number of years due to tax liability or tripping IRMAA Medicare premium surcharges. This strategy works primarily for those who plan on converting over a number of years. The end-goal is to have a Roth IRA that can serve as one side of the barbell portfolio.
The other side of the barbell is your larger pre-tax retirement account (IRA, SEP IRA, 401(k), etc.). When your RMDs on this account(s) are calculated each year, they will be based on your age that year (age-factor from an IRS provided table) and your retirement account values as of December 31st of the year prior to the year the RMD is taken. This means that as you get older and if your account grows throughout retirement, your RMD amounts will generally be bigger too!
One situation this strategy helps with is one where your pre-tax account(s) increases one year, and then declines the next year. You will then have to take an RMD based on the larger account balance from the previous year when it grew, even though currently your account could be in the dumps! This can put pressure on your account over time because it causes you to take larger withdrawals when markets are down.
The second way we aim to mitigate RMDs is to manage how you invest each of your retirement portfolios (the barbell). In order decrease the probability of you outliving your retirement assets you will want to maintain a well-diversified portfolio throughout retirement. This means that you should have a healthy mix of growth assets and less-volatile income paying assets, or assets that are mainly used for capital preservation. So how can you achieve long-term growth in your portfolio while keeping RMDs to a minimum at the same time?
The key is to use the Roth IRA as your "growth bucket" as you slowly convert pieces of your larger pre-tax account into it. The overall percentage of growth assets in your "overall retirement portfolio" should be invested in the Roth IRA. This can give that account most of the long-term growth opportunity. If it ends up having significant upside, it won't increase your RMDs. You can then use the pre-tax account as the more "conservative" and less volatile slice of your asset allocation.
This does not necessarily mean eliminate all growth assets from your pre-tax account, but using it primarily as your "income/capital preservation bucket". This side of the barbell will still have the potential to increase in value, but the goal is to try and shift the majority of the long-term growth potential to the Roth IRA - the other side of the barbell. This can allow you to maintain an overall diversified retirement portfolio while mitigating RMDs throughout the remainder of your retirement years.
The Bottom Line
This strategy isn't for everyone but can work for many. From what we have seen in the real world, it makes sense for those who have a relatively large portion of their assets in pre-tax retirement accounts. The ultimate goal depending on your situation may be to eventually have a majority of your retirement assets in the more tax-efficient Roth IRA. We typically do not see (nor expect) that a retiree is able to shift all of their pre-tax money, but any amount can help make an improvement and offer flexibility in the long run. As time goes on and the Roth IRA becomes a significant portion of your retirement assets, the investment allocations will surely need re-balancing and other adjustments. Also note that there are other ways to mitigate the effects of RMDs that are beyond the scope of this article.
Cameron Valadez is a CFP® Practitioner.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
Waddell & Reed and its representatives do not offer tax advice. This is meant for educational and informational purposes only. It should not be considered advice, nor does it constitute a recommendation to take a particular course of action. Please consult with your financial, tax and/or legal professionals regarding your personal situation prior to making any financial related decisions.
Using diversification/asset allocation as part of your investment strategy does not guarantee a profit or protect against a loss.