The Tax-Efficient Way to Consolidate Accounts

As pre-retirees prepare for retirement and the eventual withdrawal from retirement accounts, there may be some confusion about how to optimize their withdrawal strategy. Two of the most common questions I hear are “Which account should I take from?” and “What investment should I sell first?” One of the likely reasons for this confusion is that they have accounts in various places, making it difficult to organize. In addition, different custodians have different formats and names for accounts - a Rollover IRA at Schwab might be called a Traditional IRA at Vanguard.

One of the first steps in getting organized is to take inventory of all your accounts and then choose a primary custodian to consolidate accounts to. However, there can be significant challenges to doing so as none of the custodians want you to move money away from them. For example, it’s not uncommon when transferring an IRA or 401(k) for the representative to tell you that there could be significant taxes involved in the transfer. While there is some truth in that statement, these taxes can be easily avoided.

There are several forms of taxes to be aware of -

(1)   Ordinary income taxes

(2)   Tax penalties

Typically, ordinary income taxes and the 10% tax penalty are imposed on tax-deferred retirement accounts such as IRAs, 401ks, 403(b), TSP, and more that are not transferred properly. If you roll over a 401(k) to an IRA for example and elect for a check to be made out directly to you, there can be taxes (and a penalty typically if you are under age 59 ½).

To avoid this, I typically recommend direct transfers where funds are either transferred directly into the account at the other financial institution or a check is made payable to that account registration (for example Charles Schwab FBO John Doe’s IRA). If done properly, there are no taxes associated with a direct transfer and your 1099-R tax document that you receive next tax season will read “$0” for taxable amount.

(3)   Capital Gain taxes

Capital gains taxes are typically reserved for taxable investment accounts, which are often called investment accounts, brokerage accounts, mutual funds, stock accounts, and more. Most investment accounts that you have outside a “retirement account” fall into this category. You pay taxes on these accounts as you realize income, which is often when you sell an investment at a gain. This is different from a retirement account, where taxes are paid when they are withdrawn.

To avoid this, you want to request an “in-kind” transfer which means the investments are not sold before transferring to the new institution. For example, if you own a Vanguard XYZ fund at Vanguard and transfer that fund to Schwab, your Schwab account will continue to hold the Vanguard XYZ fund in it once the transfer is complete. Because nothing was sold, no taxes are owed.

After completing all your transfers, document everything and keep it for the next tax season. Occasionally, companies incorrectly report a distribution as taxable and you need to have it corrected. If you do your taxes on auto-pilot, this can be a problem so look extra closely during these years.

Consolidating your financial accounts can simplify your financial life and make it easier to optimize your retirement withdrawal plan. However, it's crucial to approach consolidation with an eye on the potential tax consequences. By carefully planning your consolidation, considering tax implications, and seeking professional guidance when needed, you can streamline your accounts while minimizing any adverse tax effects.

Happy Planning,

Alex

This blog post is not advice. Please read disclaimers.