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Rethink the Order of Your Retirement Account Drawdowns. It Can Save You on Taxes.

Common wisdom says that pension savings should be spent with an emphasis on withdrawing tax bills early in retirement. However, many seniors can reduce their tax bills by ignoring this advice and outlining a more thoughtful approach.

The standard advice for retirees has long been to first take advantage of savings in taxable brokerage accounts and bank accounts, until they touch tax-deferred accounts, such as 401 (k) or traditional individual retirement accounts, until minimum distributions start at age 72. .years of assets within traditional IRAs or 401 (k) with maximum deferred tax growth.

The problem is that this approach results in many retirees paying almost no tax early in retirement and then getting harsh tax bills in the 1970s after they start collecting Social Security and start the required distribution from deferred tax accounts.

“We had clients [in their 60s] come in and say, ‘We haven’t paid taxes in the last five years. Isn’t that great? ” Says Wealth Manager and Certified Public Accountant Theodore Sarenski of Syracuse, NY ‘And I say,’ No, it’s not. ‘ ”

Sarenski says clients should instead focus on reducing their life tax. And that often means paying more taxes in early retirement to reduce the tax later.

As an example, he notes that a couple over the age of 65 with no other taxable income can withdraw $ 47,700 from a deferred account and pay only $ 1,990 in taxes, a tax rate of only 4.2%. The same couple can take out $ 108,850 and pay $ 9,328 in taxes, a tax rate of 8.6%. Any rate is lower than they are likely to pay once they start charging Social Security.

Many seniors should therefore consider eavesdropping on deferred tax bills earlier in retirement and pay taxes while income is still relatively low, property advisers and accountants say.

Some early retirees in low tax brackets can save even more by converting deferred tax accounts into Roth accounts.

Greg Will, financial advisor and certified public accountant in Frederick, Md., Refers to retirees of the late ’60s as an“ empty year ”. The decisions they then make will affect their taxes for the rest of their lives. It would be optimal to enter the 70s with three buckets of money: a post-tax bucket, a tax-deferred bucket, and a tax-free bucket for the Roth IRA, Will said.

Retirees can often save money by exchanging different bins. For example, towards the end of the year, if Will sees his clients hitting a higher tax bracket, he will advise them to withdraw money from an after-tax account instead of from a tax-deferred account.

“If we have the flexibility to pull out of any of the three accounts, we have a lot more impact on their future taxes,” Will says.

For many retirees, especially those with higher incomes, Roth conversions Early retirement is the best way to reduce taxes later in retirement. In the simplest type of Roth conversion, investors transfer assets from a tax-deferred account to a Roth account. The value of the property is taxed at the time of transfer as ordinary income.

Consider an earlier example of a couple without other taxable income. Instead of spending $ 109,450 from a deferred tax account, they could convert $ 109,450 of assets from a deferred tax account to a Roth IRA account and pay the same $ 9,328 bill. All the money they draw from Roth for the rest of their lives will be tax-free. Or they could leave it to the heirs.

Roth conversions make sense for retirees who have enough money after tax to pay tax on the funds being converted. Otherwise, retirees must withdraw even more money from their tax-deferred account to cover the tax.

Marianela Collado, a wealth advisor and certified public accountant at Plantation in Fla, analyzes each client’s projected future taxes and determines when current Roth conversions make sense to avoid higher taxes in the future. A middle-income client may make Roth conversions in the 12% tax bracket, while a higher-income client can perform them up to a level of 24%, she says.

Roth’s conversions also make sense for wealthy retirees who have assets too large to be covered by lifetime benefits of $ 11.7 million per person, says Bruce Weininger, a financial advisor in Chicago and a chartered public accountant in Kovitz. Wealthy clients like this are likely to pay about 40% to make a Roth conversion, reducing property size and property taxes.

But it will be much more expensive if they do not perform the Roth conversion. The tax on their property will be higher, and their heirs will eventually still pay more tax when they withdraw money from an inherited tax-deferred account.

Conversely, with Roth’s conversion, “you get all the non-taxable growth from the day you do it to the day the kids pull out the money,” Weininger says.

Current low interest rates make tax deferral less valuable, says economist Laurence Kotlikoff of Boston University. Many early retirees have a lot of wealth in bonds they keep in tax-deferred accounts to avoid taxing interest.

But bonds yield less than inflation, which means there’s no growth in value if we let them sit in the tax-deferred account, Kotlikoff notes.

“If you’re in a period when you’re in the low tax bracket, then you want to remove that from your IRA,” he says. “The real gain from this game is the smoothing of tax brackets” later retired.

That’s not all. Retirees with large tax-deferred bills are often affected higher Medicare premiums when they start taking the required minimum distributions to 72. The best way to reduce RMD is to withdraw money from a deferred tax account before they start.

That has to be done carefully. If a retiree withdraws too much money from a tax-deferred account or makes an excessive Roth conversion in a particular year, it could also trigger higher Medicare premiums.

Kotlikoff sells software that shows safe ways in which individuals can increase their income. He made an analysis of an imaginary 62-year-old retiree with $ 1 million in tax-deferred assets, $ 250,000 in a savings account and $ 250,000 in a non-taxable Roth account. The retiree planned to live off the savings account until age 66, and then begin withdrawing the tax-deferred account.

If he did, the retiree would not pay taxes from 62 to 65, and then he would see his taxes rise later in retirement. The analysis found that a retiree could increase his or her lifelong pension income by $ 25,000 by tapping earlier on a deferred tax bill.

Part of the profit came from spending tax-deferred money at lower tax rates earlier in retirement. But the retiree also managed to avoid higher Medicare premiums by lowering his RMDs.

It’s math. The reality is that convincing clients to pay more taxes in the ’60s is often a difficult sale, financial advisers say.

David Frisch, a certified public accountant from Melville, NY, says most clients come after he shows them how it can reduce their lifetime taxes. He recently spoke with a client when he told her that extra money should be taken from her individual pension account, as she will still be taxed at a rate of 12%, but will be taxed at a much higher rate later in retirement. He told her she could cut her future taxes or her children’s taxes if the property passed on to them.

“She basically said,” Frisch recalls, “I paid for college for my kids. I even paid for dinner for Mother’s Day. Now I have to pay their taxes!”

Write to penzija@barrons.com