As people explore their options for retirement income, they don’t always take into consideration the tax implications. The percentage of your retirement income that gets redistributed to taxes could considerably impact your quality of life during retirement—if you don’t have a plan in place. Formulating a tax plan for retirement allows your funds to stretch much farther than they would have otherwise.
However, navigating the complicated world of tax law can take up more time and energy than the average person has to spare. This is especially true with the recent slew of changes to tax law, including those that directly impact retirement savings. For instance, the Inflation Reduction Act of 2022 introduced new retirement plan contribution limits and rules for required minimum distributions (RMDs). Taxpayers can benefit from working with a Certified Tax Planner to ensure they are factoring in the most recent legislative changes as they create their tax plan.
The first step in planning out how to be tax-efficient with your retirement income is to determine how you will generate cash. Your chosen approach will come with certain tax strings attached—the question is whether you are ready for them? For example, if your plan for generating retirement income involves ongoing sales and transactions, this can drive up your investment costs and increase the amount of work necessary to stay on top of your taxes.
The three basic cash-generating strategies that taxpayers can choose from are 1) investing for income, 2) capital gains top-up, or 3) a blended strategy.
Investing for Income. With this approach, taxpayers invest in anything that generates income—from traditional options like bonds and stocks to more recently popular options like real estate investment trusts (REITs) and master limited partnerships. As these investments earn income, the taxpayer receives the money directly and lives off of these earnings during retirement.
The key to this strategy is knowing what your target income is. How much money do you need to sustain yourself through a year of retirement? A potential downside to this approach is that since the cash is coming to you directly and you don’t have to liquidate any accounts, you may not be as aware of the attached tax consequences. If, for example, your money is coming from a REIT, you will have to project what the dividends will be in order to predict the tax implications.
Capital Gains Top-Up. This approach typically involves building a more balanced portfolio as you attempt to generate income through a combination of dividends, interest, and capital gains. Unlike investing for income, rather than spending your earnings on your living expenses, you immediately reinvest the money back into your brokerage accounts. The goal is to accumulate capital throughout the year and convert it to cash later.
With capital gains top-up, if you need cash at some point, you may have to sell off certain investments—which will result in a capital gain. The liability here is that because you are making a sale whenever the need for cash arises you will not likely know in advance how much that capital gain (or the attached taxes) will be. The amount you get will largely depend on market performance and how well your particular investments are doing, but the tax implications may not be clear until the end of the year.
Fully-Invested Total Return. Also known as a “blended strategy,” this last choice combines elements of the first two strategies. The taxpayer will likely have a combination of interest, dividends, and capital gains that are being reinvested into their accounts and producing growth over time. The goal is to maximize the investor’s overall return—both capital gains and income—rather than focusing only on one.
This option can take a lot of time to manage because in order to generate cash something has to be sold. If you need cash right away, you may not have a lot of flexibility in what you are selling, so you may simply have to accept the capital gains taxes attached to that sale. With this approach, the taxpayer often has an investment advisor who is reinvesting the interest, dividends, and capital gains distributions. Since you don’t actually see that money, you may not realize any tax is due on that income.
When choosing a strategy for generating retirement income, you will need to consider what your method will cost you in terms of risk and labor intensity—how reliable your investments are and how much work the strategy will take to implement. Investing for income will be the lowest cost, while a blended strategy will be the most expensive because you are continually selling things to generate the cash you need. If you use the blended strategy, you also need to make sure you are paying low transaction costs, since you will be making sales often.
For help navigating the tax implications of different approaches to generating retirement income, reach out to a Certified Tax Planner today.