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Drawing from the wrong retirement accounts first can spike your tax bill, wreck your legacy assets, and make your retirement less fulfilling.

And the opposite is true:

Drawing from the right accounts first lowers your tax bills, builds your legacy, and pays for exotic vacations with your family.

So how do you know which accounts you should draw from first?

In this episode, I’m revealing which accounts are the best to draw from first and ways to protect your retirement from Uncle Sam’s greedy fingers.

Show Highlights Include:

  • How pulling money from the wrong retirement accounts skyrockets your tax bill (3:15)
  • Why following conventional retirement wisdom can sabotage your retirement plans (6:21)
  • How to maximize your earnings in the 12% tax bracket before it shoots up to 22% (11:45)
  • The counterintuitive way making less in your retirement accounts makes your children rich (15:35)

To schedule your free retirement tracking meeting, specifically for first responders, head to http://pensionattention.com/ or call us at 805-409-8150.

Read Full Transcript

Welcome to Pension Attention, the best show for first responders who want to take control of their finances.

After advising Los Angeles city firefighters for over 12 years, financial advisor, Brad Barrett now shares how you can grow your wealth, build your legacy and enjoy a life of freedom. And now here's your host, Brad Barrett. [00:19.9]

Brad: Welcome to Pension Attention, the show for you, first responders who want more out of their deferred compensation and pension plan. My goal with this podcast is to reach you where you are at whatever stage in your career you are in, in order to provide my nearly 15 years of experience working with both active and retired service members on their investment and retirement planning. My team of fiduciary advisors here at ONE Fire and Police are dedicated to ensuring you take control of your finances and build the life you deserve.

To find out more about me or my team here at One Fire and Police, you can go to our website PensionAttention.com or you can give us a call at (805) 409-8150 and a quick shout out to everyone who listens here each week. Thank you. And if you haven't already done so you can go to our website and there on the media tab at PensionAttention.com, you can click and download and subscribe the Pension Attention podcast. (01:22)

You can also download the podcast on any platform where you would otherwise normally download a podcast, whether that's Spotify, SoundCloud, Google podcasts, or the Apple app on your phone and leave us a review, let us know what you think. It's always good to get feedback. And as I’ve said before, if you like the show share with somebody you like, I guess if you don't like the show, share it with someone you don't like, but share it. Because today I actually want to tackle a subject that I think is something we answer a lot for clients, and for those listening right now, who aren't retired yet, this is still a good precursor to some questions we're going to have when you get to retirement. And that is once retired, which accounts do we draw from first? And what I mean by that is now you have your pension, you are retired, you may have a deferred comp plan, a drop, which has all deferred assets. (02:13)

You might also have Roth assets. You may also have taxable accounts, meaning a cash account or a brokerage account, or what we call after tax accounts. So when we need distribution, when we build a plan for a client and we have an $8,000 or $9,000 a month pension coming in, but our lifestyle requires us to have maybe 10 or $11,000 to live. Where are we getting an extra thousand or $2,000 from? We've talked about this before on this program, as it being part of what we call a sustainable distribution. But now I want to go a little bit further and say, okay, how would you look at which accounts you would take from first? Now it's important to probably say this right out of the gate is that when we talk about which accounts, we want to take from first, we're really talking about how we limit our tax exposure, right? [03:05.8]

Because ultimately when we're bringing money into our cashflow, while we already have a pension, you've heard me say this before. It's kind of a dumb statement, but I like saying it. The good thing is you have a pension. The bad thing is you have a pension. And what I mean by that is you're always in a high tax bracket, right? You're always going to have really good income coming in, which is a blessed thing. Something earned something you've paid into for many, many years while on the job. So we need to be mindful of how much money we then are going to be bringing into your cashflow on top of that. So when we're talking about which accounts we want to draw from first, what we're really saying is how do we, again, limit our tax exposure, which accounts should be drawn down sooner rather than later in retirement. (03:54)

The withdrawal strategy we ultimately decide on could make a big difference for you and ultimately for your heirs. One of the many reasons why having an advisor with you to help you through some of those decisions is a really important aspect. Okay? So let's dig in here, which assets should you draw down first? The now the answer will depend a great deal on each of your particular goals. Again, something we'll go through when we help you walk you through the retirement goals here. But if your main focus is on tax efficient income, we want to consider starting with distributions from taxable accounts, then maybe moving on to your tax deferred accounts. This would be your deferred comp plan, your drop accounts, and then finally taking withdrawals from tax free accounts. So the rational is that by delaying distributions from your tax favored accounts, as long as possible, those retirement dollars will have more time to continue growing. (04:51)

Now, if on the other hand, you're hoping to maybe leave a significant legacy to the next generation. I have a lot of clients saying, you know what? We're really good on our pension income. We have some rental income coming in. My wife or my spouse will ultimately have some social security. We're pretty good there. So we want some of these assets to more so grow for our next generation or ultimately legacy assets. So if that were the case, maybe your income generating strategy may require a bit more planning. So since tax deferred accounts such as IRAs or 457 accounts, which are your deferred comp plans, they don't receive a step up in basis. When you pass on. If we, if you hold highly appreciated assets like real estate or maybe individual stocks, you might own in after-tax accounts. So in those accounts, you may want to deplete them first to help reduce the tax burden on your beneficiaries. (05:45)

That's where it gets a little bit more in depth than that we'll talk about. But again, a lot of this will depend a great deal on your particular goals. So what I want to talk about first and foremost are some of the conventional wisdoms, let's call it, when it comes to which accounts to spend first. So most people think, again, first take from the after-tax money in the bank, then take from the tax deferred money, money like deferred comp plan, IRA money for drop, things like that. Remember a couple of minutes ago, I mentioned that that's typically how one would start now. This is what I would consider conventional wisdom. It's been promoted by, you know, many big investment firms from time to time. It's not a bad plan, but we know that conventional wisdom may not always be the best approach and something I talk heavily about each week here on Pension Attention, as well as when I'm meeting with a client, we talk about making sure that we take what we know to be out there in the world. (06:43)

As information may be construed as advice and bring it into your world, your reality. That's where you go from taking what you understand is just information that you've read and saying, okay, is that really right for me? So we'll call it conventional wisdom. So when we talk about that again, the conventional wisdom being, spending taxable money, first, the money that we have in our bank or your checking account, then spend tax deferred monies, things like deferred comp plan, IRAs items like that, and then spend tax exempt money. So not surprisingly this topic that I'm bringing up of which assets you should draw down first, it's drawn a lot of attention from academic researchers that actually specialize in financial planning. They've conducted multiple studies on how to prepare for retirement, using a combination of pension assets or social security to taxable bank accounts, to tax deferred accounts like IRAs and 457 plans like deferred comp plans, all the way up to tax exempt accounts, which are like Roth accounts. (07:48)

Now some of these studies they're titled one of them was titled “Converting to Roth IRA under new tax law: A Decision framework”. This is good by a guy named Kenneth Anderson and David holes. There's another one called “Tax efficient withdrawal strategies” by a lady named Kirsten Cook, also done by William Meyer. So you can look these studies up and I'm just reading the titles here. I've actually gone into these studies, looked at them. I nerded out, obviously those who know me know, I kind of like to know what I'm talking about, but I also like to know a little bit more than what's just being told to us, looking at it more dynamically. So I'm gonna talk about some of these studies today, and I'm going to bring a little bit into the real world for each of you and coming from my experience of working with first responders for over 15 years now and taking some hypothetical and examples of how we would look at this when it comes to again, the efficient ways to draw from the assets you've saved. (08:43)

So let's start for a second. I want to offer an alternative approach maybe to the conventional wisdom. So an alternative approach, there are two key elements in the early years first. And the early years being the years, right, when you retire. And for many of you listening right now, that's going to be probably in your mid-fifties, give or take. So there's some rules that we need to go through. We've talked about it on some of the episodes here and for those as clients listening in, you've definitely heard it from myself or from Toby or Nick in our firm, our advisors here that work with our LAFD and LAPD clients. So we've heard, you know, in the early years when we retire, again, that's usually in their mid-fifties. So I want to say something right out of the gate. And I want to take some of this conventional wisdom, this alternative approach, and bring it from the information you might read. (09:28)

If you were to just Google this topic or research it on your own and bring it into the first responders world. So number one, what's important. And you can look this up if you retire post meaning after the age of 50 years old, and you have your money still in the deferred comp plan, meaning the 457 Subcode B plan, your deferred comp plan. You can withdrawal from that without penalty. And the penalty usually is around 10% federal, maybe two to two and a half percent state here in California. So it's really important that we don't have that penalty attached onto your taxes because taxes are going to be owed regardless when you distribute from that, if you were, so those of you who are retiring 55, 56, 57, and you're being told to, Hey, let's roll over your drop or those kinda things to IRA. Be very mindful of what you have in deferred comp. And because that's going to be your saving grace for any distributions, from a tax deferred account between the ages or before I should say the age of 59 and a half that's number one. (10:26)

Do you know how much you should be contributing to your deferred compensation plan? Are you getting the most out of your current investment options? Looking at entering or about to exit the DROP program? Go to www.pensionattention.com to find out how we can help. [10:42.8]

Number two, I think would be then understanding your tax bracket. Now, you've heard me say this before, but a lot of taxes or tax planning comes into investment planning and ultimately into your entire retirement planning. Knowing what tax bracket you're in, working with your tax advisor or your CPA is really important as you go from, I call it the hybrid year, that year in which you retire, where you got some active duty pay some overtime, then you head into retirement. So you're starting to collect your once a month, end of the month pension. You also might have items like vacation or VC or SK time or bank hours coming off. So understanding how we want to utilize that to again, maximize the most efficient tax bracket for you. The best part about our tax bracket or our tax code, I should say is it's marginal. And it's hopefully going to stay that way. Now having said that it's important to make sure that we know that some of the bigger gaps in jump between the brackets is that 12% to 22% jump, it’s a 10% gap. (11:44)

Now I'm speaking of federal taxes here for a second. And specifically, those dollar amounts that those range from our, for married filing jointly up to, or between $19,900 and $81,050. Now that's a big, interesting gap for those listening right now, because that's right around where pension starts kicking in. So anything above that $81,000 for those married filing jointly heads into the 22%. The 22% federal tax bracket starts at $81,051. And it goes up to $172,000. That's a pretty wide gap. So most listening right now. And again, this is most, I'm not, I don't know your specific situation just yet. We fit into that camp. So we want to maximize as much as we can of that lower bracket of 12% before we get into that higher marginal balance of 22%, which again starts after 81,000. So those listening right now, when you're on active duty, you're in the 22%. Typically we try to get it lower with your CPA. I'm sure with your adjusted gross income and your write-offs, but when we get into pension, we're no longer contributing to deferred comp plan. So we lose some write-offs in house dues, some things like that. So we want to be very mindful of being efficient with our tax bracket, which leads to the biggest question I want to focus on for today. And one of the things we hear to bring it into very specific discussions around for first responders in particular is the competition. Brad, I have a Roth and I have a traditional deferred comp plan. Which one do I take from first? Great question. Now I'm going to shorthand this for a quick second. Then I'm going to give some detail to it, but this may be something you don't want to hear, but there is no wrong or right answer. (13:29)

I want to say that again, there is no wrong or right answer. It's important. Understand what your goals are at the top of the show. As I mentioned, there's different goals as to why you would distribute from your assets. So knowing your specific goals are important. The two, I mentioned were, you're trying to maximize your taxes most efficiently, which is usually the goal for many and for most, right? But there also are some goals for those that say, you know what, we're good on pension. I don't want to take anything from it. If I don't have to, until Uncle Sam tells us, we have to, which is another factor to consider here. Because once we raise the age of 72, which has recently changed with the secure act at age 72, Uncle Sam, our government's going to basically come into you and say, alright, we've let you to defer your income and have tax deferred growth during your career. (14:17)

Once you reach age 72, we're going to need you to take a required minimum distribution, otherwise known as an RMD from your tax deferred assets, again, tax deferred assets, being your deferred comp plan, your drop assets, anything that was deferred through your career. So for those in that second camp, I was mentioning where we want to just live on our pension and we're okay there, we want to defer defer defer. There may be some strategies to make sure that we potentially move from the traditional side into Roth or otherwise known as a Roth conversion. Yes, we can do that because want to do that because Roth isn't subject to RMDs. Something most people don't realize or totally know. So a Roth is essentially when you're working, you're putting into the Roth account within your 457 plan, your deferred comp plan. And you're not getting typically a tax deduction for it then, but when you retire after the age of 59 and a half, you're able to distribute from that Tax-free. (15:15)

Now ultimately the Roth portion isn't subject to RMDs. So it's a unique feature to think about if you're one of those listening right now saying, you know what? I think I'm good on my pensions. So I want to keep growing my accounts between the ages of, let's say 55 or 56, when you retire all the way up to until Uncle Sam eventually makes me take money. But remember the algorithm that RMD is based off of is the end of year balance prior to the year you are taking the RMD. So prior to the year in which you turn 72, whatever the balance was on December 31st, that's the starting base for the algorithm that kicks off the distribution numbers. So if we're growing that account, which we're doing for clients as the account gets bigger, your RMD gets bigger. Now that may not sound like a big deal to many, but there's two things that come up. (16:03)

One is taxes because we have to distribute from it and we don't want to pay taxes on income we don't need. And two, for those really trying to grow their legacy assets and give to either their church or their kids or their grandkids that becomes problematic, right? So we want to make sure you suss out whatever it is your goals are for each of your planning. Now, getting back to the original thesis for those that are having pension receiving pension dollars now in retirement, but also need distributions. The question is still there, which one do I distribute from first? And again on today's show, the shorthand is going to be there's no right or wrong answer, except for being efficient with your tax bracket. So let me give you an example. We have a client that we just did a discovery meeting for, built the plan for, he’s four years into drop just about almost a year away from drop exiting. Run through the pension numbers and going through, he has a Roth account as well as a traditional deferred comp plan. (16:59)

And in going through his analysis and understanding what he'll be needing in retirement to live his life for him and his family on top of his pension, we realized that we're gonna need to take some distributions. So we wanted to go through when we spoke with a CPA around what is his rough marginal tax bracket on the federal side. And I asked this question because his pension showed up for us around $85,000. So based on some deductions and adjusted gross income numbers, he was actually in the 12% tax bracket. And in talking with his CPA, there was around $7,000 to $10,000 that he could take still from his traditional deferred comp plan, where it would still keep him in the 12% tax bracket. So that answers the first question. If he needs and based on his analysis, he needed about a thousand dollars a month on top of his pension to sustain his life and to be able to live how he wants to live, do the traveling he wants to do see his grandkids now. (17:57)

That's what he needed on top of his pension. So when we did the math, we go through and say, okay, about $600 of that $600 to $700 of that will come from his traditional deferred comp plan because we can take it and still pay the lower of the highest tax bracket. Does that make sense? So we want to make sure that we got out while we still could, what we can in the lowest tax bracket. He's still in 12% and he has up to about $7,000 to $10,000 to take from it. So roughly equals like a monthly number of around $700-$800. So we're going to maximize that number. We're going to take seven, $800 of that number up to his federal tax bracket. And then the remainder of that's going to come from his Roth. That's how I suggest each of us looking at how we want to maximize the tax efficient way to distribute from your accounts. [18:46]

And for many listening right now, the majority of the accounts that we work with are traditional deferred comp plan and Roth deferred comp plan. Yes, we definitely have some that have trust accounts or brokerage accounts that are after tax vehicles. That adds another element to it because those are taxed and treated differently than tax deferred accounts. So if you have those that gets thrown into the mix and the same kind of analysis will still go through. We still want to maximize the highest amount we can get into with the lowest tax bracket. So for example, if we know we have $7,000 or $10,000 on this client example that is brought up, to get to before he goes above the 12% federal tax bracket, we want to utilize that. So we want to take that out because we're getting he's paying taxes on a lower rate. As soon as he goes above that 80 1050 on that married filing jointly, which he is, he's now into the 22% tax bracket. (19:39)

So it's really important to understand your tax brackets to help us answer the question that I started with today, right? Which is how and where, in which accounts do we distribute from first to create tax efficient retirement income. Remember because you're on a pension and because you have a pension, that's a great thing, but it's also a taxable event. Meaning you're always going to be at a pretty much 12% federal tax bracket the way it currently stands. So it's important to know how taxes play into how you would distribute your buckets, we call it. Whether it's tax deferred buckets, tax exempt, buckets like Roth. And then again, that third category you might have, which is taxable accounts, that's cash or brokerage accounts that are investments held, not in a tax deferred account, understanding how each of those three mixes in there is really important, but it all centers around maximizing the lowest tax bracket.You can to be able to get out the monies you need without paying too high of taxes. So if you have any questions on this, it's really important to number one, anything tax related, make sure to defer those questions to your CPA or tax advisor. That's very important, but also seek that advisor to help you understand these types of discussions. This question I pose today is actually a very advanced topic. And so I want to scratch the surface of it, but the reality is this is right where it takes that next level to make sure you sit with your advisor or really go through your number, say, okay, I have this coming on and pension, I know I need this or distribution. I have these accounts. How do I take from them? And what is the most efficient manner? [21:11.9]

Thank you for listening to Pension Attention, and before acting on anything discussed today, remember speak with a financial advisor near you about your specific situation. And again, if you'd like our help, you can visit us at PensionAttention.com or give us a call (805) 409-8150.

Next week on pension tension. What are we talking about? Biden's tax hikes. Why I think we don't need to sweat it as much as we're thinking we need to. Lots in the news right now on things like that. We have a new president it's important to go through. I'm looking forward to it until then stay safe. [21:43.5]

The information in this podcast is educational and general in nature and does not take into consideration the listeners personal circumstances. Therefore, it is not intended to be a substitute for specific individualized, financial, legal, or tax advice.

To determine which strategies or investments may be suitable for you consult the appropriate qualified professional prior to making a final decision. [22:06.3]

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