How Retirement is Like a Fine Pair of Shoes
Many people focus on creating a combination of investments to generate income during retirement. Although this is an essential piece of the puzzle, many near-retirees often overlook another central pillar of retirement: the order of withdrawals.
One school of thought recommends that you tap your taxable accounts first so that your tax-deferred savings can have more time for potential growth. Another school of thought suggests taking distributions first from your poorer performing retirement accounts, since this money is not working as hard for you.
However, much like a fine pair of shoes, one size retirement does not fit all. There are many unique factors to consider when formulating a withdrawal strategy:
Required Minimum Distributions: Upon reaching age 70½, you are required to take minimum distributions from some tax-deferred retirement accounts such as traditional IRAs or 401(k)s.1
Tax Management Depending on your income level, whether you itemized deductions, and your anticipated future tax rates, you may want to consider distributions from tax-deferred accounts even while taxable assets remain. For example, withdrawals from a Roth IRA may help manage the taxation of Social Security.2,3
Estate Management: Taxable assets may have the benefit of a “step-up” when transferred to your heirs, an advantage that may not be shared by retirement accounts. For some retirees, this may be a one reason to preserve taxable assets before exhausting taxable savings.4
As you can see, there are many factors that need to be considered when formulating a withdrawal strategy. Any retirement withdrawal strategy may involve tax and legal professionals, as well as your financial advisor.
1. Distributions from 401(k) plans and traditional IRAs are taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty. Generally, once you reach age 70½, you must begin taking required minimum distributions. 401(k) plans and IRAs have exceptions to avoid the 10% withdrawal penalty, including death and disability. Contributions to a traditional IRA may be fully or partially deductible, depending on your individual circumstances.
2. The types of securities and strategies illustrated may not be suitable for everyone. Some investments that are free of federal income taxes may be subject to state and local taxes. Also, the alternative minimum tax may apply. Withdrawals from a tax-deferred program are subject to ordinary income taxes. If a withdrawal is taken before age 59½, a 10% federal tax penalty may apply. Individuals should consider their time frame and income tax brackets when evaluating a financial instrument.
3. Roth IRA contributions cannot be made by taxpayers with high incomes. To qualify for the tax-free and penalty-free withdrawal of earnings, Roth IRA distributions must meet a five-year holding requirement and occur after age 59½. Tax-free and penalty-free withdrawal can also be taken under certain other circumstances, such as a result of the owner's death. The original Roth IRA owner is not required to take minimum annual withdrawals.
4. The tax strategies mentioned here are for information purposes only and are not a replacement for real-life advice. Make sure to consult your tax, legal, and accounting professionals before modifying your tax strategy. The 2017 Tax Cuts and Jobs Act is scheduled to expire on December 31, 2025.