Nuts & Bolts: Creating a Tax-Efficient Retirement Income Strategy

According to Statista, 88% of U.S. citizens over the age of 60 have some retirement savings in place. Aside from Social Security and a defined contribution retirement plan, everyday savers should be investing in health savings accounts, income replacement annuities, and many more potential tax-advantaged areas.

However, many people enter retirement income plans without the right guidance from retirement specialists or guidance from plan sponsors—potentially losing out on additional earnings or tax savings they would gain from a proper retirement income strategy.

Shawn Plummer

Retirement advisers and plan sponsors should also consider a tax-efficient retirement income strategy for their clients and employees to save them money from their negotiated salaries and a lot of trouble tax-wise. As someone who has trained financial advisers, particularly in the use of insurance and annuities, below are some of the key tips I believe financial coaches and advisers should be focused on with savers in 2024.

Take Advantage of Full 401(k) Offering

We can’t talk about retirement income strategies without talking about 401(k) plans. As the most basic retirement savings strategy for employees, continued expansion and growth of 401(k) offerings is crucial for a better retirement picture for all.

As readers of PLANADVISER know, a 401(k) is the most common retirement savings vehicle with the benefit of a plan sponsor matching an employee’s contribution to a 401(k) account. The catch with 401(k) is that the IRS limits how much plan sponsors and employees can contribute to this account yearly. For 2024, participants should be reminded that a general limit of $69,000 ($76,500 with catch-up) is imposed by the IRS for a plan sponsor (employer) and employee contribution.

The 401(k) is one of the most tax-advantaged retirement accounts out there, but what makes this a bit tricky to navigate is that it depends when plan sponsors would like to take advantage of the tax benefits of a 401(k) plan.

Let’s first discuss the traditional 401(k) and then the Roth 401(k).

Traditional 401(k)

In a traditional 401(k), the desired monthly contribution by a plan sponsor and an employee goes entirely into the retirement account with no tax deductions because, in this case, taxes are paid during retirement income withdrawals. This also means a tax break for the year’s contributions to the 401(k).

Simply put, taxes aren’t paid now, but retirement income in the future is considered ordinary income subject to applicable taxes.

Roth 401(k)

A retirement contribution to a Roth 401(k), on the other hand, is deducted with applicable income taxes. A Roth 401(k) will not reduce current taxable income because contributions are taxed as ordinary income today unlike traditional 401(k) which is taxed upon retirement income withdrawal.

Plan sponsors and retirement advisers should recommend this option for people who want to fully receive their and eliminate taxes as early as possible.

Willi Olsen, CEO and founder of LifeCovered, says, “In summary, there’s no one-size-fits-all answer for what type of 401(k) to get, as it depends on when and how one wants to be taxed, considering future earnings and the effects of tax bracket increases.”

Consider Tax-Friendly States

Retirement advisers should also offer their clients the option of relocation to take advantage of tax-free benefits on retirement income as part of effective tax-efficient retirement planning.

As of 2023, there are eight states with no state income taxes or those that don’t impose a personal tax on retirement income including Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. By 2025, New Hampshire and Tennessee are set to follow suit.

This means that if your clients live in these states, Social Security income, pretax 401(k), and other retirement income are not subject to income tax.

Andrew Pierce, CEO at LLC Attorney, says, “It is important to consider that while these states are free from state or personal income taxes, other types of taxes still apply, including sales, property, and local taxes, which may offset the lack of income revenue collection in each state.”

For example, New Hampshire and Texas are among the top ten with the highest property tax rates, and Tennessee, Washington, and Texas are among the top ten highest combined sales taxes despite being free of income tax.

Don’t Fall for Lump-Sum Pension Withdrawals

As retirement advisers, it is your duty to make sure that your clients don’t fall for crazy retirement withdrawal money traps without a plan in place—particularly lump sum pension withdrawals.

“A person’s pension is meant to sustain the monthly cost of living even after retirement; however, the government won’t stop anyone from withdrawing pensions in a lump sum—not without consequences,” says Stephan Baldwin, founder of Assisted Living Center.

Remember to remind your clients and plan sponsors that lump-sum withdrawal will subject the entire withdrawal to a 20% withholding tax as it is treated as ordinary income in the year it is withdrawn. In addition, it will also be subject to a 10% penalty tax if it is withdrawn before the age of 59 ½.

One leeway is to roll over or transfer lump sum withdrawals to your client’s individual retirement arrangement or a separate retirement plan to defer taxes within 60 days after the date of distribution—in which special lump sum tax treatment rules will no longer apply.

Annuity Consideration

With an annuities, an employee gets fixed income stream payments after retirement, either through a lump-sum payment before retirement (immediate annuities) or making a lump sum or multiple payments first and receiving benefits on a fixed timeline in the future (deferred annuities) from workplace plan sponsors or individually through insurance companies.

It is very crucial for plan sponsors and retirement advisors to thoroughly examine if annuities are the best kind of retirement plans for their teams or clients, as some annuity contracts may be difficult and costly to deal with, especially considering the risk of business continuity of your chosen annuity providers to provide income streams to your clients for a long period in the future.

Recent government legislation and a robust retirement industry are making tax-advantaged savings plans more prevalent. But it’s up to the plan adviser and sponsor community to ensure savers are getting the right guidance to take maximum advantage of the offerings.