Maximize your retirement savings by minimizing your taxes

To maximize retirement income, it's important to leverage current tax law to your advantage. The coordinated use of taxable, tax-deferred and tax-free retirement accounts — including Health Savings Accounts (HSA) — is critical to your success and requires intentional planning. Big picture, the less you pay Uncle Sam, the more you keep for yourself.

Strategy One

Everyone should keep some savings in a taxable checking, saving or investment account for everyday spending. Keeping at least three months of regular expenses is a good start. The income that assets held in such accounts generates is subject to ordinary income tax, but gains on investments in a taxable investment account held more than one year are subject to a favorable long-term capital gains rate, currently 15% for most people.

The greater your income, the more you should consider municipal bond funds, which are not subject to federal income tax on the interest received. Additionally, you're allowed to bequeath any highly appreciated assets held in a taxable account to an heir who will receive the asset with a "step-up" in cost basis — i.e., the value at your death — for purposes of calculating his/her/their long-term capital gains.

Strategy Two

Saving for retirement in an employer-sponsored retirement plan, like a 401(k), is the next priority especially if your employer offers to match your contribution. If your employer does not sponsor a retirement savings program, then an Individual Retirement Account (IRA) offers essentially the same tax benefits and nearly as much legal protection against creditors while the maximum allowable annual contribution is lower.

The key is determining the type of retirement plan or IRA account to fund. A traditional tax-deferred account allows you to deduct your contribution from your taxable income, which makes the most sense if you're in a higher tax bracket when you contribute. However, the distributions in retirement are taxed as ordinary income. On the other hand, a Roth account provides no deduction for contributing, but everything you accumulate in the account is withdrawn tax-free in retirement.

You can answer the question of which type of retirement account is best by comparing your pre-retirement and post-retirement tax brackets. Theoretically, if you invest the tax savings received from contributing to a traditional account, then the issue is moot. However, most are not disciplined enough to invest their tax savings. Therefore, the Roth account, in which you invest after-tax money and withdraw principal and earnings tax-free, ends up netting the typical saver the most spendable income in retirement.

Other benefits of a Roth account include the avoidance of required minimum distributions (RMDs) in your 70s, tax-free inheritance for your heirs and the emotional benefit of knowing you aren't compounding your future tax bill to the government.

Strategy Three

After contributing to your retirement, the next consideration should be a Health Savings Account. These accounts allow you to save for current or future medical expenses with the most robust tax advantages of any account available. Not everyone can open an HSA, but if you participate in a high-deductible (at least $1,600 for individuals) health insurance plan, there's a good chance you qualify.

HSAs allow you to deduct the amount contributed, up to $4,150 for individuals and $8,300 for families this year, from your taxable income. Your contributions grow tax-free and, if used to cover any related medical expense, and withdrawals are tax-free as well. It's the trifecta of tax savings and a great way to save for future needs while minimizing your taxes.

Strategy Four

When planning your retirement income, carefully consider the order in which you liquidate and spend your retirement savings between assets held in taxable, traditional tax-deferred and Roth accounts.

Generally, you should spend any excess of your three months in expenses in your taxable investment accounts first, spend tax-deferred assets second and save your Roth assets for last. The longer that assets stay in a Roth account, the more you benefit from their tax-free compounding. For some, Roth assets can also come in handy for keeping taxable income in retirement under the necessary level to protect Social Security benefits from taxation.

Once you reach RMD age, the IRS requires distributions from your traditional IRA and 401(k) accounts. The required withdrawal amount is approximately 4% of the account balance and gradually increases annually to around 8% by age 90. The IRS levies a substantial penalty for failure to comply. If you donate to charity, another distribution strategy is to utilize a Qualified Charitable Distribution from a traditional IRA. The IRS allows you to donate directly from an IRA to satisfy your RMD and not pay income tax on the distribution.

In the final analysis, your tax-planning strategy might be more complex than your contribution strategy, but both require careful planning and execution to maximize your retirement income.

Michael J. Francis, is president of Francis LLC, a registered investment adviser with offices in Minneapolis and Brookfield, Wis. Francis can be reached at michael.francis@francisway.com. The information contained herein is provided for informational purposes only.