Accounts can lessen your tax liability in retirement years

MONEY POWER: Kiplinger's Personal FinanceNovember 2, 2013 

Once you retire, certain expenses will diminish or disappear. But one expense that won’t go away is taxes. You may have $1 million in retirement savings, but the amount available for retirement income is much less because a portion will go to pay federal and state taxes. This is where different types of retirement accounts — taxable, tax-deferred and tax-free — come into play.

Retirees have long been encouraged to tap taxable accounts first to take advantage of low capital gains rates, which range from 0 percent for taxpayers in the 10 percent and 15 percent tax brackets to a maximum of 23.8 percent on assets you’ve owned more than a year. Investments that qualify for long-term capital gains rates or are tax-free typically include growth stocks, tax-efficient mutual funds and exchange-traded funds. If you own individual municipal bonds or muni funds, they also belong in your taxable accounts. In addition, many planners recommend keeping two years’ worth of living expenses in these accounts, typically in a money market or other low-risk account.

Next in line are your tax-deferred accounts, which include traditional IRAs, 401(k)s and other retirement-savings plans. Withdrawals from these accounts will be taxed at your ordinary income tax rate (except for any after-tax contributions you made, which will be tax-free). In most cases, you’ll also pay a 10-percent penalty if you take withdrawals before you’re 591/2. Use these accounts for the portion of your portfolio allocated to investments that are already taxed at your ordinary income tax rate, such as individual bonds and bond funds, real estate investment trusts, and preferred stocks. Many retirees should have stocks and stock funds in their IRA, too.

Last in the queue is your Roth IRA. You may withdraw Roth contributions at any time, tax- and penalty-free. As long as you’re 591/2 and have owned a Roth for at least five years, earnings are tax-free, too. Unlike traditional IRAs, you’re not required to take minimum withdrawals. If you don’t need the money, you can leave it to your heirs, who will be able to take distributions tax-free. Because withdrawals from a Roth aren’t taxed, Roths are suitable for a wide range of investments.

There are a few good reasons to depart from the conventional withdrawal hierarchy: Once you turn 701/2, you’ll need to take annual required minimum distributions from your traditional IRAs and other tax-deferred retirement accounts. If these accounts grow too large, the mandatory withdrawals could push you into a higher tax bracket. To avoid this problem, start taking withdrawals from your IRAs before you turn 701/2.

Sandra Block is a senior associate editor at Kiplinger’s Personal Finance magazine. Send your questions and comments to moneypower@ And for more on this and similar money topics, visit

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