Here’s how to use retirement account funds to meet financial goals in a tax-efficient way

Even though everyone has different financial needs and objectives – both current and future – most people’s life savings comprise funds that are in retirement plans like IRAs and employer-sponsored plans like 401(k)s or 403(b)s.

These savings often have two different goals, such as the following:

• Providing an adequate amount of retirement income
• Creating a legacy for your loved ones

If you aim for achieving both of these objectives, your financial plan can include a strategy for making each of these types of distributions more tax efficient – meaning that you can keep more money in your own pocket (or that of your beneficiaries) and give less to Uncle Sam in the form of taxes.

Even if you have access to a defined-benefit pension plan and/or Social Security retirement income benefits, if you need to generate additional cash flow in the future, you may opt to take it from a traditional IRA or an employer-sponsored savings plan such as a 401(k).

There are several ways that you could configure these savings into an income stream. Some of the most common methods can include taking interest from bonds or other fixed income investments, or alternatively, using a portfolio “draw down” strategy where you access a certain percentage of your total portfolio – such as 3% or 4% – and leave the remaining funds in the portfolio to (hopefully) continue growing.

If the accounts where you are accessing this income from are traditional in nature (versus being Roth accounts), then 100% of the cash flow that you generate will be taxable – and without knowing what future income tax rates will be – the ability to generate a certain type of retirement lifestyle could become uncertain for you.

Likewise, the issue with any type of income plan that relies on the unpredictable movements of the stock market can lead to a very worrisome retirement – especially if you feel that your money will be depleted while you still need it.

An alternate option that many retirees turn to for income is the annuity. These financial vehicles are designed for paying out a reliable and known amount of income either for a pre-set period of time, such as 10 or 20 years, or even for the remainder of your lifetime, regardless of how long that may be.

Because of these annuity guarantees, you won’t have to worry about running out of income – even if your retirement lasts for many years. This, in turn, can allow you to focus on other important aspects of your life, like traveling, relaxing and spending time with family and friends.

The fixed index annuity can be particularly beneficial for those who are retired, as well as individuals who are still in the planning stages. For example, in addition to the reliable income stream that fixed index annuities can provide for you, they also offer the opportunity to generate a higher return than a regular fixed annuity, while at the same time keeping your principal safe.

This is because the returns on fixed index annuities are determined, based on the performance of one or more underlying market indexes, such as the S&P 500 and the Dow Jones Industrial Average (DJIA). During specific time periods – such as an annuity contract year – when the indexes perform well, a positive return will be credited to the annuity, often up to a stated maximum or “cap.”

On the other hand, if the indexes perform poorly and attain a negative return during a given time frame, the annuity will not be docked with a loss. Rather, the principal – and your previous gains – are still protected.

In addition, unlike other types of “safe” money investments like CDs and bonds that don’t lose value when the stock market craters – and in turn trade off a low-interest rate for protection – fixed index annuities do not incur losses in any type of stock market environment.

Plus, because these annuities often have a minimum guaranteed “floor” rate (which is generally in the range of 0% to 2%), you could actually generate a positive return on the fixed index annuity, even if the underlying indexes being tracked sustain a loss within the given time period. The guaranteed floor also protects the annuity’s account value from the negative impact of declining interest rates in the economy.

Further, because the fixed index annuity’s account has no losses to make up for, the value can continue to build exponentially going forward when the tracked indexes perform in the positive again.

Plus, because the growth that takes place is tax-deferred, the value of the fixed index annuity’s account can grow and compound exponentially – especially over time. Given its tax-advantaged growth, a fixed index annuity could also provide you with a place to deposit more funds – even after you have made the maximum annual contribution into an IRA and employer-sponsored retirement plan – as there are no maximum annual contribution limits on these annuities.

In addition to generating a reliable and ongoing income stream in retirement, many retirees – and those who are approaching this time in their lives – may also wish to leave a legacy for their children, grandchildren or other loved ones. Money in IRAs or retirement plans may be considered as part of their future gift.

Unfortunately, though, when settling an estate, inherited IRAs and retirement funds could be a complex issue – and even just one wrong decision could lead to expensive consequences for the recipient of this type of inheritance.

Retirement savings have a unique tax status from other forms of inheritance. For instance, “qualified” funds are taxed to whoever receives the distribution – whether it is the person who initially saved the money or their beneficiaries who inherit the account.

Typically, a beneficiary will have to open their own IRA account when they inherit a tax-advantaged retirement plan like an IRA or 401(k) of the deceased.

That’s the easy part. But there are some specific rules that the recipient will have to follow when receiving a retirement account as an inheritance. Otherwise, they could end up being penalized by the IRS.

With that in mind, while leaving any form of inheritance could benefit those you love and care about, there could also be some potential drawbacks when an individual receives IRA or money from an employer-sponsored retirement account, such as a 401(k).

For instance, withdrawals from traditional retirement accounts – whether these are taken by the original account owner or their beneficiary – are usually 100% taxable. This is because none of the money in the account has yet been subject to income tax (as the contributions go into the account pre-tax, and the money in the account grows tax-deferred).

In addition, because traditional IRA and retirement plan funds are taxed by the IRS, this money – when it is accessed by the beneficiary – could raise their income tax bracket, resulting in a higher tax bill for them during that year.

Plus, IRA beneficiaries are also now required to have inherited IRA accounts fully liquidated within 10 years of the initial account owner’s death. By no longer being able to spread out such distributions over their own life expectancy, traditional IRA and retirement account beneficiaries can be hit extremely hard with taxes, in turn, reducing the net amount of money that is actually available to spend or invest.

But if you don’t need the income that a traditional IRA or retirement plan may produce – and your intent is to leave these funds to someone else as part of your legacy – there are strategies available that could allow your beneficiaries to receive the money free of income taxes. The most tax-efficient method is through implementing a Roth IRA conversion prior to your passing.

Although the funds moved over in a Roth IRA conversion would be taxable at the time the transaction occurs, investors who spread out a series of conversions over the next few years may benefit from the lower income tax rates that are set to expire in January 2026.

The idea here is to convert the maximum amount to a Roth IRA account each year without going into the next highest tax bracket – and then continue to do so each year going forward, until all of the funds that you intend to give away as part of your legacy are in the Roth IRA account.

Federal Income Tax Rates in 2023

Using this strategy can be particularly beneficial if your tax bracket is lower than the tax bracket of your loved one (the intended recipient) who may still be in the working world and generating a high annual income. Further, because distributions from a Roth IRA are income tax free to your beneficiaries, your legacy won’t come along with a tax bill!

A Roth IRA conversion involves the transfer of retirement assets from a traditional IRA or other type of retirement account like a 401(k) into a Roth IRA. While the account holder must pay income tax on the money that is converted out of traditional plans, they (or their beneficiaries) will be allowed to make tax-free withdrawals from the Roth account in the future.

Converting a traditional IRA or retirement account to a Roth can provide other incentives, too. For instance, in order to open and make contributions to a Roth IRA account, income must be below certain thresholds. However, even those whose income exceeds these limits may still be allowed to initiate a Roth IRA conversion.

Roth IRA Income Limits (in 2023)

In addition, the direct contributions into Roth IRA accounts are limited to an annual maximum dollar amount each year. But when making a conversion from a traditional account to a Roth, the account balance may be any amount.

IRA Annual Maximum Contribution Limits (in 2023)

Because the U.S. has been languishing in a relatively low tax-rate environment for many years, it is estimated that income tax rates will rise in the future – likely in 2026, when the estate and gift tax exemption figures will also revert back to their pre-Tax Cuts and Jobs Act levels.

With the 2023 top federal income tax rate being just 37%, many investors – and retirees – may wish to pay taxes now on Roth IRA conversions instead of paying potentially higher income tax rates on withdrawals in the future if money is left in a traditional IRA or retirement plan.

Although no one knows just how high tax rates may rise down the road, if the past is any indication of the future, they could be substantial. Over the years between 1913 and 2023, the top federal income tax rate in the United States has been as high as 94%, and it is has been at 70% or higher for 49 of the past 110 years. So, leaving taxable traditional IRA funds to your beneficiaries could require them to hand over a significant amount of your savings to Uncle Sam.

Top Federal Income Tax Rates 1913 – 2023

But, based on your particular situation, moving ALL of your traditional IRA and retirement funds may or may not necessarily make sense. Similarly, even if you opt to move your entire traditional IRA or plan to a Roth account, doing so all at one time (i.e., in one year) could be a costly mistake.

With that in mind, how much of your traditional funds to convert to a Roth account each year should ideally depend on several important factors, including:

• Your income tax bracket at the time of the conversion (compared to your anticipated income tax bracket in retirement). Often, retirees’ tax brackets will go down when they have left their job and they are solely receiving income from Social Security and investments. So, it could make sense to wait until you have retired and are in a lower tax bracket to move all of the funds to the Roth account.
• Where you will access the money for paying the tax on the Roth IRA conversion. Even though moving from a traditional to a Roth IRA can save you (and/or your beneficiaries) a substantial amount of taxes in the future, you will have to pay tax on the money that you convert – and if you end up with a high-income tax bill in the year that you’re moving the money over, you should have a plan in place for how you will pay it. Given that, it is important that you not use funds that have been earmarked for other needs, such as your emergency fund or a college savings fund that you have set up for a child or grandchild.
• Your age at the time of the conversion. If you are younger than age 59½ when you implement a Roth IRA conversion, you could face a 10% IRS early withdrawal penalty on the amount of traditional retirement funds that you move. This penalty would be in addition to any taxes that you owe.
• Whether or not you plan to make more contributions into the IRA account. In this case, while both traditional and Roth IRAs now allow investors to keep making contributions indefinitely, the funds that go into a Roth IRA will grow – and will also be accessed – tax-free. So, depending on your specific objectives, it could make sense to continue making contributions into a Roth IRA account.
• If you need some or all of the money yourself for income in retirement. If you don’t anticipate needing money from your IRA or retirement plan in the future, then moving it to a Roth account can make sense. Unlike traditional plans, which require you to take at least a minimum amount of withdrawal each year starting at age 73 (in 2023), there are no such required minimum distribution (RMD) rules with Roth IRAs – at least not for the original account owner. If, however, someone inherits a Roth IRA, they must still liquidate the account within 10 years after the original account owner’s death.
• When you anticipate your beneficiaries receiving their inheritance. Similar to traditional IRAs, those who inherit your Roth IRA will be required to deplete the entire account within 10 years of your passing – even though the money that they receive from the Roth account will be tax free provided that the Roth account has been open for at least five years. Given this, if you have a shorter anticipated life expectancy, it may or may not make sense for you to initiate a full Roth IRA conversion.

Converting traditional retirement savings to a Roth IRA can have many advantages – both for you and your loved ones. But in addition to the many benefits of going this route, there could also be some possible drawbacks, too. So, it is important that you know what these are so that you can navigate around them.

Some of the possible advantages of converting some or all of your traditional retirement funds to a Roth account include the following:

• Future tax-free withdrawals (regardless of what the then-current income tax rates are)
• Ability to have a tax-free Roth account, even if your income exceeds the IRS limits
• Diversification of your overall portfolio
• Tax-free earnings can grow and compound more than earnings that are taxed on the gains each year
• Ability to take advantage of low tax rates now on the conversion
• No need to take required minimum distributions (RMDs) at any age
• Ability to make future contributions to the Roth account that grow and can be accessed tax-free
• Contributions to a Roth IRA may be withdrawn any time, for any reason, tax-free
• Money can be withdrawn tax-free by beneficiaries

Even with these advantages, though, Roth IRA conversions are not right for everyone. So, it is important to understand the potential drawbacks to doing so, such as:

• You must wait for five years to withdraw earnings tax-free from the Roth account
• Taxable income in the year that you make the conversion may increase (and in turn, your taxes will also go up)
• You could face a 10% IRS early withdrawal penalty if you convert from a traditional to a Roth account prior to turning age 59½

Roth IRA Conversion Pros and Cons

Converting funds from a traditional IRA or retirement plan to a Roth can present you with many enticing benefits. But before you make a commitment and move forward with such a transaction, it is recommended that you first discuss your situation and objectives with a retirement expert. That way, you will be better able to determine whether or not the transaction is right for you.

At Alliance America, our financial professionals can help you to navigate through the windy roads of planning for the future. This includes ensuring that you can count on a retirement income stream that continues flowing in for the rest of your lifetime – regardless of how long that may be.