Morgan Stanley
  • Wealth Management
  • Jan 18, 2023

Making the Most of Your Retirement Savings

Carefully managing distributions from your portfolio during retirement can help you save on taxes, leaving you more money to spend and enjoy.

Markets don’t always cooperate with your best laid plans, including those you’ve made for retirement. But there are strategies you can use to help improve retirement readiness, even at times such as now, when our forecasts indicate it’s unlikely that markets will perform as well as they have been in recent years going forward.

One such strategy, known as income smoothing, seeks to minimize the impact of taxes once investors start tapping into their retirement savings.

Smoothing Out Your Income

Contributions to most retirement plans, such as traditional 401(k)s and IRAs, are generally made out of pretax earnings, up to allowable limits, and grow tax-deferred until you retire and start to draw them down. When that happens, the IRS treats the withdrawn funds as ordinary income and taxes them accordingly, every year.

The idea behind income smoothing is that, when reported income spikes during retirement, so does your average tax bracket, and therefore the taxes you will owe. Therefore, it is more tax efficient to smooth out the distributions you take from your retirement account. This can prevent higher income levels being realized in any given year, which would push you into higher tax brackets.

Why would anyone take a meaningfully larger withdrawal than they need to support their retirement spending? Sometimes it is out of their control. The most common reason is what’s known as required minimum distributions, or RMDs. Under the RMDs tax-code mandate, retirees must begin tapping their tax-deferred retirement accounts by age 73 (age 75 starting in 2033),1 using a formula calibrated to draw down the account over the course of an average retirement -- or face steep penalties.

Depending on the size of the retirement account, RMDs can sometimes be significantly larger than a retiree’s needs, after accounting for other income sources, such as Social Security. Given the progressive tax code, those withdrawals are often taxed at higher rates, which can substantially increase your tax bill.

Mind Your RMDs

Here’s an example of how income smoothing can reduce tax costs. Consider a retiring couple, both 65, who plan to spend around $17,000 a month. They have combined tax-deferred assets of $5 million and taxable assets of nearly $2 million. If they follow common practice and spend their taxable assets first, that could entail selling securities that would be subject to the lower capital-gains tax rate. As a result, their taxable income and tax bill would be quite low during the first few years of retirement.

In their 70s, however, RMDs would force the couple to tap their tax-deferred assets. These higher withdrawals would push their income into the highest tax brackets—and their effective tax rate would spike.

On the other hand, if this couple were to start taking distributions from their tax-deferred accounts at an earlier age, smoothing out their income, that may result in lower estimated average tax costs during retirement. That means more resources to support spending, gifting and other financial goals. One downside of this strategy is that tax rates can change, and if they were to go down in the future, that could adversely impact the tax efficiency of the strategy (on the other hand, if tax rates were to increase, benefits would be magnified). 

Find Opportunities to Maximize Retirement Dollars

Income smoothing is just one of many techniques that investors can use to help maximize their retirement readiness, but it’s one of the few that doesn’t require taking on additional investment risk. This strategy can be even more effective when used in conjunction with other strategies that can reduce tax costs and increase flexibility to control the way income gets realized on a tax return, like investing in municipal bonds, or buying certain kinds of life insurance.

As the business cycle ages, opportunities for large market gains are more likely behind us. That makes strategies, like income smoothing, that can stretch the savings you do have, all the more important for achieving your retirement goals.

This article was derived from Wealth Management’s publication, On Retirement. You can ask your Financial Advisor for the full report.

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