Beware of three major threats to your 401(k) plan or IRA if you are 60 or older

For Americans approaching retirement or already in their retirement-age years, their 401(k) or individual retirement account (IRA) often represents decades of saving and the primary source of income to support their post-work lives.

But preparing for retirement involves more than just saving; it requires strategic planning to navigate the various risks and threats to those savings. By being aware of market volatility, developing a sound withdrawal strategy and understanding the tax implications, those age 60 and over can better position themselves for a comfortable and financially secure retirement. As these individuals age 60 and over near the time to tap into these resources, understanding the risks associated with these investment vehicles becomes crucial.

What is market volatility?

Market volatility refers to the rate at which the prices of stocks or other investments move up and down in a market over a given period. It's essentially a statistical measure of the dispersion of returns for a particular market index or security. High volatility indicates a higher potential for prices to change dramatically in a short time span, while low volatility points to more stable prices. This volatility is often gauged by looking at historical returns or using indicators such as the Volatility Index (VIX).

While volatility can mean the potential for high returns, it also means there's a risk for significant losses. It's this two-sided nature of volatility – the potential for gain and the threat of loss – that can be particularly nerve-wracking for investors. As individuals approach retirement, they have a shorter time horizon to recover from potential market downturns. A significant loss due to a volatile market can severely impact one's retirement savings, potentially forcing them to delay retirement or adjust their post-retirement lifestyle expectations.

What is sequence of returns risk?

The sequence of returns risk pertains to the order in which investment returns occur, particularly when an individual starts withdrawing from their investments, such as during retirement. This risk emphasizes that the order or timing of your investment returns can significantly impact your portfolio's value, especially if you're making withdrawals.

While the average return on an investment portfolio over time is essential, the sequence in which those returns are realized becomes particularly crucial during the distribution or withdrawal phase.

For retirees, the order in which investment returns occur can be as important as the returns themselves. For example, when a retiree begins to withdraw funds during a down market, it can significantly reduce the portfolio's long-term staying power, even if the market later rebounds.

While stocks have historically provided higher returns than other assets, they also come with greater volatility. Those age 60 and over might have portfolios that are too heavily weighted in stocks, leaving them vulnerable to market downturns.

Some financial professionals suggest that diversifying investments can help mitigate the risk of market volatility. As retirement approaches, those at or near retirement age can consider adjusting the asset allocation to include a mix of stocks, bonds and other investments. Working with a financial professional can help individuals create a more conservative portfolio that can weather market fluctuations without compromising growth.

What are withdrawal strategy errors for my retirement accounts?

Retirement represents a significant shift from the accumulation phase of one’s financial life to the distribution phase. One of the most challenging aspects of this transition is determining how to withdraw from your nest egg in a way that ensures your funds last as long as you need them. For those age 60 or nearing retirement, mistakes in this process can have profound, lasting impacts. Indeed, how and when one taps into their 401(k) or IRA can significantly influence the longevity of their savings.

One major problem is not understanding the safe withdrawal rate, which is a guideline indicating how much one can withdraw annually from their portfolio to minimize the risk of outliving their savings. Historically, the 4% rule (withdrawing 4% of the initial portfolio value, adjusted for inflation each year) has been a popular benchmark, although recommendations on that figure vary.

Many retirees either aren’t aware of the concept or fail to adjust the rate based on personal circumstances, such as health, other income sources or market conditions. As a result, withdrawing too much too soon can lead to prematurely depleting retirement savings. Conversely, being overly conservative may result in unnecessary lifestyle constraints.

Another issue involves required minimum distributions (RMDs). For traditional IRAs and 401(k)s, the IRS mandates that account holders begin taking RMDs by age 73. The amount is based on life expectancy and account balance. Failing to withdraw the correct amount can result in a hefty tax penalty of 50% of the amount not taken.

Crafting an effective and sustainable withdrawal strategy for retirement accounts is crucial to ensuring that retirees can maintain their desired lifestyle without prematurely depleting their nest egg. A sound withdrawal strategy takes into account various factors like market conditions, personal needs, inflation, and tax implications.

What are the tax implications of retirement account withdrawals?

Understanding the tax implications of retirement account withdrawals is vital to ensure you're maximizing your retirement savings and avoiding unexpected tax liabilities. Different retirement accounts have unique tax rules, and navigating them requires careful consideration.

Contributions to traditional IRAs and 401(k)s are often made with pre-tax dollars, meaning you can deduct the amount of your contribution from your taxable income in the year you contribute. The investments grow tax-deferred until withdrawn. When you make withdrawals from these accounts, the distributions are taxed as ordinary income. This includes both the original contributions and the investment earnings.

As mentioned, starting at age 73, you must begin taking RMDs from traditional IRAs and 401(k)s. Failing to withdraw the minimum amount results in a 50% penalty on the difference between the required minimum and the actual amount withdrawn.

This situation is different for Roth IRA and Roth 401(k)s, however. Contributions to Roth accounts are made with after-tax dollars, meaning you don't get a tax deduction in the year you contribute, but the investments grow tax-free.

Are withdrawals from Roth accounts tax-free?

Qualified withdrawals from Roth accounts are tax-free. To be "qualified," the Roth account must be at least five years old, and the owner must be at least 59½, disabled or buying a first home (subject to a $10,000 lifetime maximum). Otherwise, non-qualified withdrawals may be subject to both taxes and penalties on earnings.

Unlike traditional IRAs, Roth IRAs don't require RMDs during the owner's lifetime. However, Roth 401(k)s as of 2023 have RMDs, but these can be bypassed by rolling the funds into a Roth IRA.

Meanwhile, non-qualified brokerage accounts are funded with after-tax dollars, and they don't offer a tax deduction for contributions. Investment earnings in these accounts, when sold, are subject to capital gains tax. The rate will depend on whether the gain is long-term (held for more than one year) or short-term (held for one year or less). Long-term capital gains are generally taxed at a more favorable rate than ordinary income.

How do retirement account withdrawals impact Social Security?

Social Security benefits are a cornerstone of retirement for many Americans. However, how and when you take withdrawals from your retirement accounts can influence the amount of your Social Security benefits that is taxable.

The taxation of your Social Security benefits depends on a concept called "provisional income." This includes your adjusted gross income (not counting Social Security benefits); non-taxable interest (e.g., from municipal bonds); and 50% of your Social Security benefits.

Depending on the amount of your provisional income, a portion of your Social Security benefits may be taxable. For single filers, with provisional income of $25,001 to $34,000, up to 50% of benefits may be taxable, and those with over $34,000, up to 85% of benefits may be taxable.

Those married filing jointly with a provisional income of $32,001 to $44,000 have up to 50% of benefits taxed, and 85% is taxed if the amount is over $44,000.

Do retirement account withdrawals increase my taxable income?

Taking large withdrawals from retirement accounts, especially from tax-deferred accounts like traditional IRAs and 401(k)s, can increase your taxable income for the year. This may push your provisional income into a higher threshold, resulting in a larger portion of your Social Security benefits being taxable.

However, withdrawals from Roth IRAs do not count toward provisional income, as they are tax-free. Therefore, if you want to manage your provisional income levels, you might consider taking funds from a Roth IRA to limit the impact on the taxation of Social Security benefits.

To manage the impact on Social Security benefits, you might consider the timing of your withdrawals. For instance, if you anticipate a year where your income will be lower, it might make sense to make larger withdrawals during that time to balance out the income over multiple years.

Navigating the tax implications of Social Security and retirement account withdrawals requires a strategic approach. By understanding how different sources of income interact and affect your tax situation, you can make informed decisions to maximize your retirement savings and minimize tax liabilities. Working with a financial professional can provide personalized strategies tailored to your specific situation.

Conclusion

For Americans transitioning into retirement, strategically managing their 401(k) or IRA is paramount. While these accounts reflect years of diligent saving, it's crucial to be cognizant of the multifaceted risks that accompany them, particularly as retirees start to make withdrawals. Market volatility, inherent in the ebb and flow of investment values, poses potential challenges, especially since a market downturn can drastically affect those nearing retirement. Another significant concern is the sequence of returns risk, which underscores the importance of the timing of investment returns, especially during the distribution phase of one's retirement. Meanwhile, errors in withdrawal strategies, such as misunderstanding the safe withdrawal rate or not adhering to required minimum distributions, can jeopardize a retiree's financial stability.

Additionally, the tax landscape of retirement withdrawals is intricate. Traditional IRAs and 401(k)s, funded with pre-tax dollars, are tax-deferred until withdrawal, at which point they're taxed as ordinary income. On the other hand, Roth accounts offer tax-free qualified withdrawals, provided specific criteria are met. Importantly, the interplay between retirement account withdrawals and Social Security benefits is a nuanced dance, where withdrawals can influence the taxability of Social Security benefits.

In essence, transitioning into retirement isn't just about having saved; it's about smartly navigating the maze of risks, potential pitfalls and tax implications that come with retirement accounts. Collaboration with financial professionals can be invaluable in this journey, offering personalized advice tailored to an individual's unique retirement landscape.