Before we get into the specifics, it’s important to first categorize our retirement savings by how they are taxed.
1. Taxable savings – regular savings accounts or investments where income and capital gains are fully taxable.
2. Tax-deferred savings – a Traditional IRA or employee-sponsored 401(k), for example, where taxes are not paid until funds are distributed.
3. Tax-exempt savings – a Roth IRA or Roth 401(k), which, because they are funded with after-tax dollars, are not subject to any additional taxes.
Conventional wisdom tells us there is one proper retirement withdrawal strategy – minimize your tax burden by taking first from taxable accounts. The reasoning behind this move is that you will be in a lower tax bracket later in retirement, and so income from taxable savings will not impact you as heavily.
Even though you’ll find this sort of strategy advocated all across the web, it doesn’t always work as advertised.
Here are some points to consider in developing your retirement withdrawal strategy your withdrawal strategy…
Many retirees will find themselves in higher tax brackets after the age of 70.5 than they were just a few years earlier. Why? At age 70 you must begin drawing your Social Security benefit, and at 70.5 you must begin taking Required Minimum Distributions (RMDs) from your 401(k) and IRA – all of which is taxable income.
Once you have your withdrawal strategy in place, don’t automatically assume this is your new retirement budget. In some cases, this might be how it will work. But oftentimes, for tax purposes, we may be simply withdrawing money from one type of an account with the intent of moving a portion of those funds to another type of account.
As I mentioned earlier, you must begin taking RMDs from most tax-deferred plans at the age of 70.5 years. If we aren’t prepared, these RMDs could severely impact your tax status. So, once you reach age 59.5 and are able to begin distributions without penalties, it is crucial that we begin making the strategic moves necessary for long-term management of tax liability before the RMDs begin.
Now, I couldn’t possibly list all the factors influencing tax and how our retirement withdrawal strategy should respond to them. But here are a few more variables to consider…
• Paying off your mortgage. More and more Baby Boomers are carrying their mortgages with them into retirement. That isn’t necessarily a bad thing, but millions could find themselves in higher tax brackets once the mortgage is paid off and is no longer itemized.
• Death of a spouse. Going from joint to single filing status might dramatically increase taxes – even if income is reduced. Revising retirement withdrawal strategies is a must to limiting tax liability.
• Medical expenses. It might make sense to take larger distributions in years when itemizing large deductions, such as medical expenses. The deduction offsets the liability and provides an opportunity to make lemonade of lemons.
• Roth IRAs. I previously pointed out that withdrawals from these accounts will not be counted as income.
As you’re probably noticing by now, developing a retirement withdrawal strategy tailored to your unique situation is a complicated process. There are dozens of variables to factor into the equation, and the simplest of mistakes can result in thousands of dollars in tax liability.
This is why I strongly encourage everyone to consult with a retirement income specialist before committing to a withdrawal strategy.