With good retirement planning, you probably have accumulated several different kinds of savings accounts to support you when you retire. You may have a few 401(k) accounts from different employers, a tax-advantaged IRA account, and maybe, a plain old investment account.
At some point, you’ll need to start making withdraws from these accounts. Having a plan and knowing the right order to structure your withdrawals will make your retirement savings last longer.
The 3 types of retirement savings vehicles
- Traditional IRAs and 401(k)s are tax-deferred. This means your contributions reduce your taxable income in the year you earn the money. In the meantime, the money you invest is allowed to grow tax-free. However, you will pay your ordinary income tax rate on your withdrawals, or distributions, when you take them.
- Contributions to a Roth IRA or a Roth 401(k) are made with after-tax dollars. This means they don’t reduce your income in the year you make the contribution. However, the money invested is allowed to grow tax-free. You don’t have to pay any tax when you take the money out, with a few exceptions. For example, you will pay a 10% early withdrawal penalty if you take any money out before 59 1/2, unless it’s for a qualifying reason like a permanent disability. The money must also remain in your Roth account for at least five years before you withdraw it. Otherwise, you may owe taxes on any earned interest.
- Investment accounts offered by a brokerage are taxable accounts, rather than the aforementioned tax-advantaged retirement accounts. You’ll pay taxes on any contributions to these accounts in the year that you earn the money, and you’ll pay taxes on capital gains as well. The tax on the capital gains will depend on how long you’ve held the asset that you are selling. Investment accounts not a retirement account per se; however, they are still a great place to sock away money especially if you’ve maxed out your tax-advantaged retirement accounts. Investment accounts are also useful if you need access to your retirement funds before you are 59 1/2 without paying a 10% early withdrawal penalty.
You should know the difference between a Traditional IRA and a Roth IRA.
Later, I will explain a simple strategy to help you determine the best order to tap your retirement savings vehicles and pay as little taxes as possible. You’ve already paid a lifetime of taxes. Why should you pay even more now that you are retired?
But before I begin, there is something else you need to be aware of.
Retirement accounts Required Minimum Distributions
Except for Roth IRAs, all retirement accounts have required minimum distributions (RMDs).
Once you reach 70 1/2, you must begin withdrawing money from your retirement accounts in order to ensure that the government gets its tax cut. The amount you must withdraw depends on your age and the value of the account at the time.
This worksheet can help you figure out your RMD.
This is how you calculate your RMD.
Divide the total value of each retirement account by the distribution period listed next to your age to figure out how much you need to withdraw from each account this year. Failure to take out at least this much will result in a 50% penalty on the amount that should’ve been withdrawn.
Be mindful of these RMDs. Otherwise, they could force you to withdraw more money than you were anticipating. Withdrawing too much might push you into a higher income tax bracket in your later years.
Drawing more heavily upon accounts subject to RMDs during the early years of your retirement helps reduce the amount of your RMDs when you reach 70 ½.
But, it could also raise the amount of taxes you’ll pay early in retirement. The key is to understand the rules and plan accordingly, to minimize your taxes and maximize your savings.
The best strategy for tapping your retirement accounts
Sound retirement planning means keeping your taxable income as low as possible. This means withdrawing enough money from your retirement accounts to live comfortably while allowing your tax-advantaged accounts to continue growing.
You can accomplish this by using the proportional withdrawal strategy: Withdraw a proportional amount from each of your accounts based on the proportion of your retirement savings in each account type.
Here’s an example to show you how this works: You’re a 60-year-old single adult and you’re relying on your retirement accounts for all of your income for the year. You need $30,000 to cover your living expenses, and you have $200,000 in a taxable investment account, $400,000 in a 401(k) and another $150,000 in a Roth IRA for a grand total of $750,000 in retirement savings.
Let’s examine the proportions: About 27% of your savings is in a taxable investment account, 53% in a tax-deferred, 401(k) retirement account, and 20% in a Roth IRA account.
If you only need $30,000 for living expenses, using the proportional withdrawal strategy, you’d withdraw $8,100 (27% of $30,000) from your taxable investment account, $15,900 (53% of $30,000) from your 401(k) account, and $6,000 (20% of $30,000) from your Roth IRA account. You wouldn’t pay taxes on the Roth distributions and the remaining $24,000 of taxable income is low enough to fall into the 0% capital gains tax bracket, so you would only end up paying taxes on the $15,900 you withdrew from your 401(k).
Don’t pay more in taxes
This proportional withdrawal strategy helps stretch your savings by spreading out the tax advantages that your retirement accounts offer so you don’t have some years where you owe little or nothing and others where you owe a lot.
Using this simple tax savings approach, you should end up paying a similar amount in taxes every year, which makes taxes easier to budget for. Plus, this strategy could save you as much as 38% in taxes over the course of your retirement, according to research by Fidelity.
Create a retirement budget
At the beginning of each year, create your budget and decide where you’re going to get that money from. First, total up how much money you think you’ll need to cover your living expenses for the year. Then, subtract any money that you anticipate getting from sources other than your retirement accounts, like a part-time job, Social Security, or a pension (if you are lucky enough to have one).
The difference between your total living expenses and the income you expect to receive from other sources is the amount that you need to withdraw from your retirement accounts during the year.
Figure out how much money you have in each type of retirement account and what proportion of your total retirement savings each account makes up.
Then, multiply these percentages by the total amount you need to withdraw from your retirement savings to determine how much you should take from each account.
Always be mindful of the tax brackets. Also, don’t be afraid to make adjustments as needed.
Careful planning means you can still get the money you need without paying Uncle Sam too much in taxes.