Limiting Taxes through Distribution Planning

February 25, 2016

Many investors have multiple asset vehicles in which their retirement nest egg resides. Examples include their IRA, Roth IRA, and non-qualified (or Non-IRA) accounts. A main distinction between these three are how they are taxed. Questions often arise regarding from which account someone should take distributions. The answer to this question is very important.

Having to recognize increased income can have some unintended tax consequences. For example, it may affect how much medical expense one can deduct. Or, a greater portion of Social Security income may become taxable. You may even be pushed into a higher bracket.

Planning on which asset vehicle to take from may help you limit your tax liability and make your distributions more efficient!

Assets within IRAs likely have been deferring ordinary income since contributions were made to the account. When distributions are made, this is considered ordinary income to the recipient. The tax rate charged depends on the taxpayer’s income level. You have flexibility to decide when distributions come out (and become taxable). Of course, if you are older than 70 ½ you are required to take a distribution each year (click here for more information on RMDs).

Non-reoccurring living expenses are by definition much less frequent, but they are usually a bit bigger. Examples include medical expenses, or purchasing a new car. Large distributions from IRAs have the potential to move us up a tax bracket quickly and may fall into what we call the “IRA Tax Domino Effect”. This is where money is withdrawn from an IRA to pay for an expense, but then another withdraw from that same IRA is needed to pay the taxes, and then another to pay those taxes, and so on.

For these types of distributions, we suggest you consider using money from Roth or Non-Qualified (Non-IRA) accounts. For Non-IRA accounts, the only tax you owe at the time of sale is on the gain you received from the investment that is being sold. In addition to this, if you hold the investment for longer than 1 year, the tax rate applied is a preferential rate (this rate ranges from 0% - 23.8% depending on your income), no matter the rate, it will always be lower than your ordinary tax rate.

For Roth Accounts, there are zero taxes due provided certain requirements are met*. This could be the most tax-efficient place to take distributions from, but they should be used sparingly, because once they are gone, you lose the flexibility of using it as a great estate planning tool.

Having a strategy to know from which accounts to take distributions is essential to maximizing your returns. As we know, it’s not what you make, but it’s what you keep – that matters most!

* Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Otherwise, taxes and 10% penalty may apply to earnings withdrawn.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual, nor intended to be a substitute for specific individualized tax advice. SagePoint Financial nor its representatives offer tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.