IRAs and 401Ks are not for tax avoidance. They are for tax timing.

The money in your IRA and 401K hasn’t been taxed yet.  (A few special IRAs contain already-taxed money, but those are not the subject of today’s post.)  SOMEONE IS GOING TO PAY TAXES ON THAT MONEY.  If you come to realize that retirement savings accounts (IRAs, 401Ks, 403Bs, etc.) help you time taxes but do not help avoid taxes, you and your family will lose less of that money to taxes.

(I’ll call them IRAs for the rest of the post so I can save my typing fingers and my sanity.  My comments still apply equally to 401Ks, 403Bs, etc.)

The power of an IRA lies in the ability it gives you to choose when you will take the money out and pay the income tax on the withdrawn money.  The ideal strategy is to start taking money out when your non-IRA income drops after you stop working.  For most people, that time is when they retire.  (For people with deferred compensation packages, the ideal time is after the deferred compensation ends.)  Except for IRA money that you need during the year to sustain your lifestyle, you should look at your income near the end of each year and then withdraw from your IRA the amount of money that will increase your income up close to the top of the tax bracket.  If your IRA has lots of money, you may want to withdraw enough to take you close to the top of the next tax bracket.

Your aim is to take withdrawals over a period of years (somewhere between 3 and 10 years, depending on how big your IRA is when you retire) so that the income is spread out over time, and your annual income in any one year doesn’t jump into a much higher tax bracket.  Better to be in a lower tax bracket for several years running than to be in a high tax bracket in even one year.

You don’t want to stretch the payments out over your life expectancy because, as you age, the risk of long term care goes up.  When you need long term care, you may be forced to withdraw from your IRA all at once, so you’ll want to have your IRA low or empty before your risk of long term care gets too high.  (Remember, I’m in Ohio.  If you’re in a state like Florida that doesn’t count IRAs as assets when applying for Medicaid, you may want to keep your IRA intact as long as possible.)

More on this topic in future posts.

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