Making the Most of Your Retirement Savings

Dan Hunt, Senior Investment Strategist

Markets don’t always cooperate with your best laid plans, including those you’ve made for retirement. But there are strategies you can use to help improve retirement readiness, even at times such as now, when our forecasts indicate it’s unlikely that markets will perform as well as they have been in recent years going forward.

One such strategy, known as income smoothing, seeks to minimize the impact of taxes once investors start tapping into their retirement savings.

Smoothing Out Your Income

Contributions to most retirement plans, such as 401(k) plans and traditional IRAs (excluding Roth IRAs), are generally made on a pretax basis, up to the applicable allowable contribution limit for that tax year, and remain tax-deferred until you retire and start to draw down the assets held in such accounts. When that happens, the IRS treats the withdrawn funds as ordinary income and taxes such distributions accordingly, for that tax year.

The idea behind employing an income smoothing strategy is that, when you are over age 59 ½, you can consider taking distributions from certain tax-advantaged accounts before distributions from such are required in an effort to lower account balances resulting in less money in those accounts when you reach the age at which you must start taking required minimum distributions(“RMDs”). Therefore, it is more tax efficient to smooth out the distributions you take from your retirement account prior to reaching the age at which you must start taking RMDs (“RMD Age”), which depends on an individual’s date of birth (e.g., if born after 1950, but before 1960, RMD Age is 73).¹ This can prevent higher income levels being realized in any given year as a result of RMDs for that tax year, which would push you into higher tax brackets.

Depending on the size of the retirement account, RMDs can sometimes be significantly larger than a retiree’s needs, after accounting for other income sources, such as Social Security. Given the progressive tax code, those withdrawals are often taxed at higher rates, which can substantially increase your tax bill.

Mind Your RMDs

Here’s an example of how income smoothing can reduce tax costs. Consider a retiring couple, both 65, who plan to spend around $17,000 a month. They have combined tax-deferred assets of $5 million and taxable assets of nearly $2 million. If they follow common practice and spend their taxable assets first, that could entail selling securities that would be subject to the lower capital-gains tax rate. As a result, their taxable income would be quite low during the first few years of retirement.

Once they attain RMD Age in their 70s, however, RMDs would force the couple to tap into their tax-deferred assets with respect to such distributions. These higher withdrawals would push their income into the highest tax brackets—and their effective tax rate would spike.

On the other hand, if this couple were to start taking distributions from their tax-deferred accounts at an earlier age (after attaining age 59 ½, but prior to reaching RMD Age),² effectively smoothing out their income, such distributions may result in lower estimated average tax costs during retirement. That means the couple may have more resources to support spending, gifting and other financial goals. One downside of this strategy is that tax rates can change, and if they were to go down in the future then that could adversely impact the tax efficiency of the income smoothing strategy (on the other hand, if tax rates were to increase, benefits would be magnified). 

Find Opportunities to Maximize Retirement Dollars

Income smoothing is just one of many techniques that investors can use to help maximize their retirement readiness, but it’s one of the few that doesn’t require taking on additional investment risk. This strategy can be even more effective when used in conjunction with other strategies that can reduce tax costs and increase flexibility to control the way income gets realized on a tax return, like investing in municipal bonds, or buying certain kinds of life insurance.

As the business cycle ages, opportunities for large market gains are more likely behind us. That makes strategies, like income smoothing, that can stretch the savings you do have, all the more important for achieving your retirement goals.

This article was derived from Wealth Management’s publication, On Retirement. You can ask your Financial Advisor for the full report.

Footnotes:

¹ RMD Age is (a) age 70 ½ for individuals born before July 1, 1949, (b) age 72 for individuals born after June 30, 1949, but before 1951, (c) age 73 for individuals born after 1950, but before 1960, or (d) age 75 for all others – note, apparent drafting error in the statutory language in the SECURE 2.0 Act of 2022, which was signed into law on December 29, 2022 makes it unclear when age 75 starts to apply in lieu of age 73, but it appears age 75 is intended to apply if born after 1959.

² Distributions taken by an individual from certain employer retirement plans and IRAs prior to attaining age 59 ½ are subject to a 10% early withdrawal penalty tax, unless such distribution satisfies an eligible exemption to the early withdrawal rules.