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Ensure Your Retirement Income Isn't Taxed to Death

Kelly Campbell

Management and growth of retirement accounts are usually our first priority, especially as we get closer to retirement. However, there is another concern that can have a significant impact on retirement.

People often wonder, "When I retire, what accounts should I access first?" This is one of the more common questions I'm asked when I meet with clients, and it can have an important impact on the longevity and quality of retirement savings. The answer is very much dependent on the retiree's specific goals and objectives, and should be part of a larger strategy of creating a retirement withdrawal plan.

Although you may have been a diligent contributor to your retirement savings accounts, knowing which accounts to access is equally important as funding your retirement, and is often overlooked in the retirement planning process. Creating a withdrawal strategy can have the dual benefit of increasing the longevity of your retirement savings accounts and decreasing your tax bill.

Think about tax considerations. Death and taxes: Though it's an old cliché, minimizing your tax bill and protecting your investments are two main goals of an effective withdrawal strategy. You can get on track to meet the first goal by following the "golden rule" of retirement, which is tapping into your least tax efficient vehicles first.

The logic is that you want to maximize tax-deferred growth. Most retirement accounts allow investment earnings to accumulate without tax within the account, provided certain requirements are met. This is appealing, because you can achieve compounded gains over a prolonged period of time and not pay tax on those gains. This portion of investment income can be deferred, until you begin taking withdrawals from the account, and depending on the type of account, the withdrawal is usually taxed as ordinary income. Some accounts (Roth IRA and Roth 401k) actually grow tax-free and will never be taxed.

Retirees should withdraw funds as follows:

-- From their taxable accounts (investment and others)

-- From tax-deferred accounts (401(k), 403(b), 457, SIMPLE IRA plans, etc.)

-- From tax-exempt retirement accounts (Roth IRA, or Roth-optioned accounts)

The goal is to effectively liquidate accounts which are subject to higher taxes, while preserving the tax advantaged accounts. By utilizing this strategy you can lower the amount of income taxes that you'll pay during your retirement and allow tax-advantaged accounts more time to grow and accumulate returns.

Figure out how to handle capital gains taxes. Non-retirement investment accounts in general are going to be your least tax efficient savings vehicles, because all of your investments are subject to the capital gains tax, unless you're in the lowest two tax brackets.

Capital gains are the profits that an investor realizes when he sells a capital asset (stocks, mutual funds or bonds) for a price that is higher than the initial purchase price. The resulting profit is called a "realized gain." An "unrealized gain" is an asset that has risen in value, but has not been sold. The Internal Revenue Service can only tax capital gains on assets that you've sold for a profit. It's important to think of these investment accounts as their own profit centers. Factor the capital gains tax into your returns, and allow these investments to pay their own tax.

Capital gains are assessed in two categories: short term, where an investment that has been held for less than a year before it was sold, and long term, an investment that has been held for a year or more before it's sold. The tax implications are different with the short term being higher, so be sure that you are up-to-date and understand the impact of both.

Know what a "step-up in" basis means. Remember when I said " Death and Taxes"? There is a way to avoid the capital gains tax completely. The only snag is that you have to die. If you hold a sizeable investment that has unrealized gains and you die, those unrealized gains are wiped out and the cost basis (original purchase price) is reset to the current value on the date of death. This price reset is called a "step-up in basis." If you have a large amount of stock that has significantly appreciated in value, you should consider leaving this asset to a beneficiary, and taking money out of designated retirement accounts. If you tap into this asset or give the asset to a beneficiary prior to death, the step-up potential is lost.

Investors are taxed on bond income. When a bond is purchased at its original offering price and then held until maturity, generally capital gains tax will not be assessed. An investor is taxed on income (yields and dividends) generated by that bond, and this income is then taxed at the same rate as ordinary income.

The tax issue becomes a bit more complex when a bond is purchased or sold on a secondary market. When a bond is purchased for any value other than the original offering price, then capital gains tax may be assessed on the transaction, regardless if the bond is held till maturity. Like other investments, taxes can be deferred by holding bonds in a tax-advantaged retirement account.

As you can see, taxable investment accounts offer little in the way of tax sheltering, and the capital gains tax can quickly eat into your earnings, especially if you're a particularly keen day trader. The lack of tax savings is the major reason why you should take retirement withdrawals from this type of account first, and save the tax-sheltered or exempt accounts for later. Remember, most retirees don't plan to fail, they simply fail to plan. Set up your retirement withdrawal plan now.

Kelly Campbell, certified financial planner and accredited investment fiduciary, is the founder of Campbell Wealth Management and a registered investment advisor in Alexandria, Va. Campbell is also the author of"Fire Your Broker," a controversial look at the broker industry written as an empathetic response to the trials and tribulations that many investors have faced as the stock market cratered and their advisors abandoned their responsibilities to help them weather the storm.

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