Navigating retirement distribution planning and understanding the tax consequences of your choices Featured

12:49pm EDT February 21, 2011
Bernard T. Garrah, Jr., Financial Planner and Special Care Planner, Skylight Financial Group Bernard T. Garrah, Jr., Financial Planner and Special Care Planner, Skylight Financial Group

Most people spend their working lives saving for retirement. But when you’re ready to retire, it’s a whole new ball game, and how you approach retirement distribution planning can have a huge impact on both your taxes and lifestyle.

“Most people focus on saving money for retirement their entire working lives, so they’ve been successful riding out volatility in the market because they didn’t have to rely on those dollars to live,” says Bernard T. Garrah, Jr., a financial planner and Special Care Planner at Skylight Financial Group.

“But as they get to retirement, the type of planning they have to do changes from wealth accumulation to wealth preservation. When you look at your distribution strategy, you need to consider the asset classes and tax consequences of the assets that you’re going to be spending.”

Smart Business spoke with Garrah about navigating retirement distribution planning and understanding the tax consequences of your choices.

How can people preserve their wealth so that it not only lasts for their lifetime but also transfers efficiently and effectively to the next generation?

With a retirement distribution strategy, you have to determine what fixed income sources you will be receiving, whether you have enough money saved, and in which decade you will be spending it. Then you earmark vehicles to fund those particular decades.

First, divide your retirement into a series of decades. If you’re retiring at age 62, determine the first 10 years of income needs, then the second 10 years, and, finally, the next 10 years. Then compare that to your fixed income sources to determine if you have a substantial reliance on investment income. If so, it’s not a good idea to keep 80 percent of your net worth in the stock market. Those dollars needed should be invested in a conservative manner because you don’t want to drastically change your lifestyle if the market doesn’t perform. Then, whatever dollars you are not going to spend, can be allocated into a growth position and used in later decades. By doing this exercise, you are identifying a bucket of assets for each decade. At that point, if there is money left, it can transfer to the next generation. By reviewing your estate plan and beneficiary elections, you can increase the efficiency at which your beneficiaries inherit those assets.

How can taxes affect retirement distributions?

Managing your taxes is a key component to retirement distribution planning. Retirement plans are good vehicles to reduce taxes today, but what happens once withdrawals start?

For example, take one fund that could be taxed three different ways. If you purchase that fund within your 401(k), you purchase it with pre-tax dollars today and the money grows tax deferred, but when you pull it out, it is 100 percent taxable as ordinary income. Second, you could buy that fund with after-tax money, and the interest will be taxed each year through ordinary income tax and when you sell it, you may have to pay capital gains tax on the interest. The third option is to buy that fund inside a Roth IRA with after-tax dollars. The fund grows tax deferred, and, upon withdrawal, if all IRS guidelines are met, it’s 100 percent tax-free. It’s the same mutual fund, but depending on ownership of the account, it could be taxed three different ways, not all of which are beneficial to you.

People assume their tax bill will be lower in retirement, but that’s not always the case. When you’re younger, you have many tax advantages. You’re not making as much money, you can write off property taxes and mortgage interest, and you can claim your children as deductions. In retirement, you may not have those things, so when you talk about retirement distribution strategy, you have to understand the tax bracket you’re in today and what it might be in retirement. Once this is understood, set up multiple buckets you can withdraw from that are all taxed differently.

Don’t wait until the day before you retire to create your distribution plan. Be savvy and proactive; start looking at this in your 30s, 40s, or even 50s so that you can possibly manipulate the tax system instead of being manipulated by it.

How can someone ensure they are making the right decisions for their situation?

Work with a team of advisers. Work with your CPA to determine where you are today from a tax perspective and what it could look like in the future. Work with a financial adviser to determine if you are saving in the right places and how much you should be deferring on a pre-tax basis and into after-tax accounts.

An estate planning attorney is also vital to make sure your estate transfers to the next generation correctly. Too often people have documents that were drafted when their children were born and have never been updated. This can be challenging because both people and their wishes may have changed in the last 10, 20 or 30 years.

Most people don’t plan to fail, they fail to plan. However, it is never too late to start planning.

The information provided herein is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any federal tax penalties. Entities or persons distributing this information are not authorized to give tax or legal advice. Individuals are encouraged to seek specific advice from their personal tax or legal counsel.

Bernard T. Garrah, Jr., ChFC, CLU, CFBS, is a financial planner and Special Care Planner at Skylight Financial Group. Reach him at (216) 592-7360 or bgarrah@finsvcs.com. Bernard T. Garrah, Jr. is a registered representative of and offers securities, investment advisory and financial planning services through MML Investors Services, LLC. Member SIPC. Supervisory Office: 1660 W. 2nd Street, Suite 850, Cleveland, OH 44113. (216) 621-5680 Skylight Financial Group is not a subsidiary or affiliate of MML Investors Services, LLC, or its affiliated companies. CRN201301-144191