One of the questions I receive quite often is, “how do you determine where we should draw funds from when we need money from our Retirement Bucket™ of investments?”
It’s a very important question.
All other variables held constant for a moment, we’re always looking to “free up” funds in the most tax efficient manner, i.e. have you pay the least amount of taxes you’re legally obligated to pay in the process.
And, at the same time, we recommend maintaining the same prescribed Retirement Bucket™ target allocation post withdrawal. This is a very important point that you can’t afford to overlook.
You don’t want your withdrawal to leave large holes in your strategic Retirement Bucket™ mix.
Funds Held Inside Your IRAs
If you only have funds to draw from held inside of IRAs, the only variable you need to consider is “when” you’ll withdraw the money.
For example, when asked by one of our Relaxing Retirement members (who has all of their funds in IRAs) to free up $120,000 for them to loan to their son for the down payment on a new home, the big question is “when,” not where.
They hadn’t given it much thought, but I asked when the closing for his son’s home was to take place, i.e. did he need the entire $120,000 before the end of the year?
I asked because I know where all of their taxable income comes from each year and withdrawing $120,000 (“net” after taxes) from their IRA in one year would cause a large chunk of that withdrawal to be taxed at a much higher marginal tax bracket.
If they were able to withdraw part now in 2021 and the other part in January 2022 instead of all of it in 2021, that would save them a minimum of $11,500 in federal income taxes in the process. This doesn’t count state income taxes.
This strategy is called “Income Tax Straddling”.
As it turned out, the closing was to take place in January, so they were able to follow this lead and save that $11,500 which can now go toward something they really want to spend that money on!
Home Equity Line of Credit
Had they needed all of the money before the end of the year, we may have recommended that they withdraw half from their IRAs now (in tax year 2021) and the other half temporarily from a home equity line of credit.
Then, in January (2022), they could withdraw the second half from their IRAs to pay off the line of credit. This would have the same effect as my first recommendation, i.e. Income Tax Straddling. And, because borrowing rates are at historic lows right now, the cost to do this would be minimal.
Had the funds only been needed on a short–term basis, I may very well have recommended utilizing a home equity line of credit instead of an investment withdrawal, especially during times like these when interest rates are so low.
Saving $11,500 is something that is possible for you, but only if you ask the right questions and you have all the necessary information in front of you. Paying more taxes than you’re legally obligated to pay is not an act of patriotism. It’s laziness!
In the next edition, we’re going to outline how to free up the cash you need in a tax-efficient manner when withdrawing from Non-IRA accounts.