Taxes rank with healthcare as one of your biggest potential retirement expenses. As such, it pays to have a comprehensive strategy on how and when to withdraw funds in order to minimize your annual tax bill.
The good news: Retirees have more control over their taxes than any other age group, with more options for after-tax income and diversification. The bad news: The “what,” “when,” and “why” of retirement withdrawals can appear to be a complex and overwhelming challenge.
Below, we break down the details and attempt to provide useful guidelines for getting the most out of every retirement dollar.
Diversify your taxes.
Inevitably, most of these financial concerns come down to a simple question—will I have enough money to last the length of my retirement? Without a crystal ball, we can’t be certain, so a smart way to start is to limit the amount you withdraw from savings in the first year to 4 or 5 percent, then increase that amount every year based on inflation.
But from what accounts should you withdraw? Conventional wisdom suggests that you want your financial resources stored in three distinct buckets:
Taxable accounts, which include individual, joint, and revocable trusts. Income from investments is taxed the year you earn it. Any dividends you get go on that year’s tax bill. In addition, you pay capital gains tax on withdrawals based on how much the investment has grown, not on the income.
Tax-deferred accounts, such as 401(k) plans, 403(b) plans, individual retirement accounts (IRAs), and Thrift Savings Plans (TSPs). You owe nothing until the day you withdraw funds, at which time you would pay the full income tax.
Tax-free accounts, which include Roth IRAs or Roth 401(k) plans. No taxes, period.
Unfortunately, many retirees find themselves with their savings primarily in traditional IRAs and 401(k) plans, with not much left over for tax-free options such as Roth accounts. Fewer buckets mean fewer tax choices when it comes time to use these funds for retirement.
Draw on taxable accounts first.
The most commonly recommended method to minimize your retirement tax bill is to draw from your taxable accounts first, then your tax-deferred accounts, and finally the tax-free pool. The wisdom behind this is that the longer you can leave your tax-deferred and tax-free accounts alone, the more tax is deferred and the more compound growth your money can experience. Tax-free accounts such as Roth IRAs allow you to keep every last penny of income and growth.
Take note of the role that required minimum distributions (RMDs) play in this strategy. At age 70½, you are obligated to begin taking withdrawals from tax-deferred accounts. Miss this milestone, and you will incur a 50 percent penalty on the withdrawal amount. Make sure to take your RMDs first, then proceed with your accounts in order as previously outlined.
An alternative strategy is to draw from all three buckets every year based on each account’s percentage of your overall savings. This is ideal for anyone with generally uniform yearly retirement income and for those who have worked for multiple employers and may have many retirement accounts as a result.
This approach spreads out your potential tax bill across accounts, reduces its effect, and allows you to keep money in these accounts longer. The impact can be substantial, with potential for higher after-tax income and lower long-term taxes. You may also be able to lower taxes on Social Security benefits and Medicare premiums.
Learn to ride the waves.
No matter which approach you take, your income and assets after retirement can ebb and flow over time, and so can your tax bill. Just as a surfer becomes accustomed to the unpredictable rise and fall of the waves, a savvy retiree learns to weather the peaks and valleys of the market.
Some years may bring you into a lower income bracket, and you may need to pull from your tax-deferred accounts rather than taxable accounts. Roth conversions can also be a useful tool, allowing more funds to be moved to a tax-free account.
In more flush years, you may find yourself in a much higher income bracket. Consider withdrawals from tax-free accounts during this time period to reduce your overall tax burden.
The simple fact that you may have ample retirement resources isn’t enough to guarantee prosperity. How and when you withdraw these precious funds may make the difference between just squeaking by and living the retirement of your dreams. Get started on your ideal retirement tax strategy with our Popular Retirement Plans e-book.