Friday, March 7, 2025
One of my biggest jobs as a financial planner is tax planning. A lot of people ask me what that means and how it benefits them. There are two types of tax planning. Proactive tax planning, and reactive tax planning. Reactive tax planning is what a CPA would do for you. Do your taxes, maximize your deductions, and ensure that you aren’t over paying. Proactive tax planning is making sure that your taxable income, both now and in the future is as low as it can be. It’s also making sure that you’re taking advantage of new and existing tax law opportunities, as well as avoiding tax triggering events in the future.
Tax planning is important during the accumulation phase as well as the distribution phase of life. During the accumulation phase, it’s crucial to start building wealth in multiple types of tax advantaged accounts. For example, building up IRA’s, Roth IRAs, and non-retirement accounts. That way when you get to the distribution phase you have lots of options for how to approach it. The distribution phase is all about how to leverage those accounts to minimize your effective tax rate throughout retirement.
Today I’m going to be talking about how to lower your taxes specifically in the distribution phase. There are two tax rates. The income tax rate, and the capital gains tax rate. These are taxed at different rates and the limits are calculated slightly differently. I won’t go into detail on that for the sake of brevity, but it’s important to understand the difference between the two when trying to take advantage of lower tax rates. The goal for both of these tax brackets would obviously be to stay in the lowest tax rate possible. Easier said than done. Some people will ask me what order they should withdraw their retirement accounts in. The simple answer would be cash first, then taxable accounts, then tax-deferred accounts, then tax-free accounts. However, the most ideal answer isn’t always that simple. This article is meant to explain why withdrawing out of several different types of accounts each year in retirement could be beneficial. All of the examples in this article are purely hypotheticals and meant to be educational. Everyone’s tax picture is different and it’s important to use variables in your specific financial picture when making these calculations.
Tax planning is important during the accumulation phase as well as the distribution phase of life.
Say you use only cash for the first two years of retirement. Sure, you pay $0 in taxes on those cash distributions, but you also miss out on a lot of future tax savings, here’s why. If you use only cash for the first several years, then later in retirement you use only IRA dollars, now you might incur a 22-24% tax rate on those IRA distributions. Whereas, if you withdrew some IRA dollars and some cash for the first few years, the IRA dollars could be taxed at 12% while the cash is still taxed at 0%. Now with that one simple strategy you’ve saved 12% on each dollar you would’ve otherwise withdrawn under a 24% tax bracket.
Now, what’s the best way to maximize this strategy. In 2025, the maximum taxable income you can have to stay in the 12% tax bracket is $96,950. If your social security benefit is $60,000 a year (for example), you have a $36,950 gap before you push yourself into the next tax bracket. In that example, you would likely want to fill that $36,950 gap with IRA dollars and capital gains dollars. Since any IRA dollars you withdraw in that gap are taxed at 12% and any capital gains dollars are taxed at 0%. Of course, it’s important to also include your standard tax deduction in these calculations, so make sure to factor that in when deciding how much money you can withdraw and stay in your targeted tax bracket.
You would most likely want to withdraw capital gains first, since you are paying a 0% tax as compared to later in retirement when you might have to pay a 15% capital gains tax. Then once those are exhausted for the year, start withdrawing IRA dollars. Then once you hit the $96,950 for the year, switch to cash and Roth dollars for any extra income you need in retirement. Again, this example is assuming you have all of these account types and you don’t have any other unique factors that would impact this strategy.
This strategy could also potentially help with RMD issues down the line, as you’re withdrawing IRA dollars earlier as compared to waiting until your cash and taxable accounts are empty. There are many more factors that go into these decisions and the most ideal strategy might be different for each individual person. I wanted to write this article to highlight a strategy that works for a number of people and to invoke some new ideas that could be beneficial when building out your retirement plan. If you have questions on if a strategy like this would work for you, what other tax opportunities are available to you, or how to prepare for this strategy in the accumulation phase, make sure to consult your financial planner so that they can assess what the best plan for you would be. Thank you for reading!
Quinn Davis, Financial Advisor
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results
References to tax strategies should not be confused with tax advice. LPL Financial and Riverfront Capital Strategies do not provide tax advice. Clients should consult with their personal tax advisors regarding the tax consequences of investing.
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