When it comes to spending from your portfolio, it's important to develop a dynamic withdrawal strategy that reduces the tax drag on your investments.
A common rule of thumb is to distribute from taxable accounts (i.e., after-tax dollars), then from tax-deferred accounts (e.g., Traditional 401(k)/IRA), and finally from tax-exempt accounts (Roth 401(k)/IRA, Health Savings Account, etc.).
Unfortunately, most retirement accounts won't allow you to defer your taxes forever. At the very minimum, you will eventually have to distribute the funds from your tax-deferred accounts to satisfy the government's required minimum distributions (RMDs), and these distributions will generally be subject to ordinary income taxes.
The applicable age for these distributions recently increased from age 72 to 73, thanks to the SECURE 2.0 Act of 2022.
As a result of this provision, you may be able to leave your retirement assets invested longer than you had anticipated. This brings us to the question: Should you wait to make IRA and 401(k) distributions until the IRS forces you to?
Strategies to discuss with your financial advisor
If you aren’t yet taking RMDs, the delayed RMD age means that you can delay taking assets from your retirement accounts, but that does not necessarily mean that you should.
After all, deferring your taxable retirement account withdrawals—and thus compressing your taxable income into fewer years—could push you into a higher tax bracket in later years, increasing the overall tax cost of funding your retirement.
Instead of sticking to the minimum distributions required by the government, we recommend working with your financial advisor and tax advisor on an IRA distribution strategy that maximizes your after-tax wealth potential.
With this in mind, here are some strategies that you should discuss with your financial advisor:
1. Accelerate IRA distributions to “fill up” your tax bracket in lower-than-normal tax years. This can help you to increase the after-tax distributions from your retirement assets versus an “RMD-only” approach.
2. Use Roth conversions and irrevocable life insurance trusts (ILITs) to boost the after-tax wealth you can leave to your heirs. Roth IRA assets can grow income tax-free and if a life insurance policy is purchased and owned by an ILIT, then the policy’s death benefit will not be included in the insured’s gross taxable estate at death.
3. Make qualified charitable distributions (QCDs) to meet your philanthropic objectives and maximize the value of your charitable contributions, while simultaneously satisfying all or a portion of your RMD.
When it comes to determining how these distributions will be taken and where the funds will be used, there are many factors you'll need to consider with your financial advisor. For instance, upcoming cash flow needs, current and future projected tax rates, and the beneficiaries who are currently designated for the account can all affect whether a particular strategy will lead to better outcomes for your particular situation.
Lastly, these are not the only strategies that you can use to improve after-tax wealth potential. It’s also important to understand the potential tax consequences of investment decisions in your portfolio. For insight and guidance regarding the asset allocation and asset location process when maximizing after-tax wealth potential, please see Constructing and managing taxable portfolios.
Main contributors: Ainsley Carbone, Justin Waring, and Daniel J. Scansaroli
Read the full report 3 strategies to improve your after-tax wealth potential 30 January 2023.
See also Constructing and managing taxable portfolios: Insights to help maximize after-tax wealth November 2022.
Review the 2023 Tax fact sheet as you aim to improve your after-tax wealth potential.
This content is a product of the UBS Chief Investment Office.