If you have multiple retirement accounts, you’ll need a smart withdrawal strategy.
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Some people have been saving and investing for retirement for decades, only to realize they missed a step along the way. What are the commonly “missed” steps? Devising a decumulation plan, or retirement withdrawal strategy. Because just as you need a plan to build your nest egg, you also need a plan to plan it wisely.
A retirement withdrawal strategy is simply a plan for leveraging your assets to cover expenses during your golden years. Let’s say you have a single retirement account, like a self-directed Roth IRA. Having a withdrawal strategy is essential no matter how many accounts you have, but planning is easier if you only have one account. That’s because the order in which you withdraw money from your retirement accounts and the percentages you use when tapping them will affect the taxes you pay. That means it can play a key role in determining how long your money will last.
Minimum distribution required
One decision is whether to start withdrawing money from your retirement accounts in your first year of retirement or wait until required minimum distributions (RMDs) require you to start making withdrawals. RMDs must begin being withdrawn from defined contribution plans, such as IRAs and 401(k)s, once you reach age 73 (until age 75 for those born after 1960). These forced withdrawal amounts are calculated as a percentage of the assets in your account, and that percentage increases as you age.
Failure to take RMDs can result in hefty penalties from the IRS.
Brokerage accounts, 401(k)s, IRAs, etc.
There is no single rule that dictates the order in which withdrawals should be made, as everyone deals with different situations. However, as the following scenario illustrates, a good starting point is to consider brokerage accounts first, then tax-deferred accounts, and finally tax-free accounts.
don and nancy
Imagine a couple named Don and Nancy. They are both 67 years old and collect $1,500 a month in Social Security. So Don and Nancy start with a guaranteed income of $36,000 per year. In addition, Don and Nancy have $1 million invested in various retirement accounts.
- Securities account: $300,000 (gains taxed as long-term capital gains)
- Traditional 401(k): $400,000 (taxed at regular tax rates)
- Roth IRA: $300,000 (tax not included)
Don and Nancy want to withdraw a total of 4% each year from their retirement account to cover their expenses. This will increase your income by an additional $40,000 this year.
focus on taxes
The couple recognizes they may need to tweak their strategy as their circumstances change over the years, but for now, it’s all about saving money on taxes this year.
Between Social Security payments and retirement account withdrawals, the couple has an income of $76,000. Their ultimate goal is to stay in the 12% tax bracket ($23,850 to $96,950).
deduction
Don and Nancy aren’t worried because they know they only have to pay taxes on their adjusted gross income (AGI), or their final income after deductions. The deduction amount for that year is as follows:
Couples take a close look at their retirement accounts and carefully consider how each will affect their tax burden.
- Securities account: Don and Nancy have had a brokerage account for years, and any gains they record on the stocks they sell at this point will be taxed at the lower long-term capital gains tax rate. And in fact, their income is low enough that they don’t owe capital gains taxes at all.
- Tax-deferred account: Because the 401(k) is a tax-deferred account, Don and Nancy paid no taxes on their contributions in the year they earned these funds. But from now on, withdrawals from a married couple’s 401(k) will be taxed at their regular marginal tax rate.
- Tax-free account: With Roth IRAs and similar types of tax-advantaged accounts, you pay taxes on the funds you contribute in the year they are earned. But later in life, all withdrawals are tax-free.
A few years ago, the couple agreed to use the funds in their Roth IRA to fund later retirement, when medical and living expenses would be higher. In the meantime, they are determined to give their tax-free accounts time to grow by not making withdrawals from them until absolutely necessary.
distribute $40,000
Withdrawals from Roth IRAs are off the table for now, so couples will have to choose how much to withdraw from their remaining accounts. They decide to withdraw 60% ($24,000) from their 401(k) and 40% ($16,000) from their brokerage account.
Developing an exit strategy isn’t an exact science, and this couple’s priorities may change from year to year, but for now, their total taxable income is well within the 12% marginal tax bracket. And since their joint income is less than $96,700, they don’t owe federal taxes on the money they withdraw from their brokerage accounts.
One size does not fit all
While it may be popular to withdraw money first from a brokerage account, then from a tax-deferred account, and finally from a tax-free account, it may not be suitable for everyone.
In retirement, you’ll undoubtedly spend some time determining the best withdrawal strategy for you, but the right answer may change over time as you go through different stages of retirement. You may have just one retirement account to withdraw funds from, or you may have multiple accounts. Your situation will be unique to you. This is where a good financial or retirement advisor can help you determine the best strategy to make your nest egg last.
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