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Use your nest egg wisely with the right withdrawal strategy during retirement

by John Levan | Contributor
April 8, 2020


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You’ve probably made a few transitions in your life, but going from full-time employment into part-time employment or retirement is one of the biggest. In addition to deciding what you will do with all those hours that you won’t be devoting to your full-time career, you’ll need to figure out how to use your financial resources to supplement your income.

If you’re like most retirement savers, you have your money in several different types of accounts such as:

  • Your company’s 401(k)
  • Traditional IRA
  • Roth IRA
  • Non-qualified brokerage accounts
  • CDs at your bank
  • Money market savings accounts
  • Savings bonds
  • Health savings accounts (HSA)

You’re likely concerned about using the best strategy for withdrawing these funds: Which of them should you tap first? What’s the most tax-efficient approach for liquidating your nest egg? Should you first take money from your traditional IRA or your Roth IRA?

Like most things in your financial life, there is no one-size-fits-all tactic to answer all of your questions. But there are some very important things to consider as you make these decisions.

Which order of withdrawals makes the most sense?

There are general guidelines that most financial professionals believe will work for the majority of new retirees. Keep in mind that there might be exceptions to this order of withdrawal in your specific situation. The rationale for this order is to minimize and defer taxes, but it could also have an impact on the growth and sustainability of your retirement portfolio:

  1. Income streams from pensions, Social Security and other passive income from investments like rental properties
  2. Taxable accounts such as non-qualified brokerage accounts, CDs at your bank or money market savings accounts
  3. Traditional IRA and 401(k)s
  4. Roth IRA

First, you should consider your streams of income to help you determine how much to take from your investments. Keep in mind that waiting until your full retirement age or longer to collect Social Security makes sense if you can afford to live without it since you’ll get a larger monthly check later. But if you choose to take it sooner, count it among your streams of income.

Make up any shortfall with your taxable accounts

If your income streams don’t meet your retirement needs, you should make up the deficit with withdrawals from your taxable investments. You might realize capital gains on these funds, but the tax rate on them is typically less than the income tax rate you would pay on traditional IRA withdrawals.

In most cases, you would not withdraw from tax-deferred accounts until you have depleted your taxable accounts so that you can delay paying taxes on them as long as possible and allow them to grow within the shelter of your qualified account.

But, as mentioned earlier, the order of withdrawals might not work out for you.

If you have a traditional IRA, you must make your required minimum distributions (RMD)

Let’s assume you retire at 62 years of age. Then, you would begin by liquidating your taxable accounts, moving on to your tax-deferred investments later. But keep in mind that starting in the year in which you turn 72 under the SECURE Act, you must withdraw a specific amount from your traditional IRA annually. The amount will be determined by the size of your account and your life expectancy.

If you retire at 72 or close to it, you’ll likely be taking money from your tax-deferred account before you deplete your taxable funds. In that case, take your required distribution and make up the difference from the taxable accounts.

Another consideration: If you retire in your early 60s with an IRA of high value, that account might grow to an amount that would cause you to take large RMDs, sending you into a higher tax bracket. If you have a sizable IRA balance at early retirement, it might make sense to withdraw a modest amount from your IRA account each year so that you won’t be hit with a big tax bill when you turn 72 and begin your RMDs.

Other circumstances to consider

While conventional wisdom indicates your order of withdrawals should end with Roth IRAs, other situations could change the standard order. RMDs and highly appreciated investments are the more common reasons, but there are other factors to think about:

  • You might have an annuity or the cash value from a life insurance policy that is no longer needed.
  • If you have a complex estate structure, it could impose a different method of generating your retirement income.
  • You might be anticipating an inheritance or some other source of income in the future.

If you have any of these atypical financial situations, it’s a good idea to talk to a financial advisor to help you come up with the best strategy.

Are there tactics designed to minimize taxes at retirement?

One of the basic tenants of investing is to stay away from strategies that are designed solely to avoid or minimize taxes. More often, you’ll come out ahead by focusing on the best investments for your situation without obsessing over the tax implications.

But that isn’t to say that you shouldn’t have a strategy for liquidating those investments without paying more taxes than you need to. Here is one example of how you can make withdrawals and keep taxes at bay. Notice that it diverges from the typical withdrawal order.

Here is a newly retired couple who have accumulated $750,000. Approximately 60% of their investments are in tax-deferred accounts, 30% in Roth IRAs and 10% in taxable accounts. The couple wants to spend $65,000 annually, of which $29,000 will come from Social Security benefits. They will be withdrawing a little less than 5% of their savings each year to make up the difference.

Instead of employing the conventional method of using taxable investments first, they might consider using their lower tax bracket in retirement strategically by filling that bracket with ordinary income from tax-deferred distributions. If they need additional income, they can tap their taxable accounts and then withdraw from their Roth accounts. Here’s how it would look:


  
  

  Conventional Wisdom
  

  Filling the tax bracket
  

  Account Withdrawals
  

  Taxable account: years 1-3
  Tax-deferred: years 4-18
  Roth IRA: years 19-30
  

  Tax-deferred distributions of $20,000-$23,000 each year; supplement
  with taxable accounts (years 1-5) and Roth (years 6-30)
  

  Federal taxes paid over 30 years
  

  $46,000
  

  $0 or
  minimal amount
  

  Longevity of portfolio
  

  29.2 years
  

  31.6 years
  

As you approach retirement, here are some points to remember:

  • Do some planning and spread your portfolio over several accounts. You can save on taxes and sustain your lifestyle over many years.
  • Diversifying your assets over multiple types of accounts will also give you more flexibility in retirement. In the previous example, the assets in the Roth IRA made the tax strategy possible.
  • Required minimum distributions will reduce your flexibility, so come up with a plan to manage taxes after you reach 72.
  • Converting your traditional IRA to a Roth is an option, but many financial advisors believe those Roth conversions are better suited for those looking to leave an estate.
  • Most importantly, taxes can be complex, so don’t hesitate to reach out to a tax professional or financial planner to assist you in carrying out these strategies.

Alliance America can help

An Alliance America financial advisor can assist you in maximizing your retirement resources and help achieve your retirement goals. Alliance America’s planning process is focused on personalized retirement income planning. As fiduciaries, our advisors are required to act in your best interest, and we are dedicated to helping you achieve the retirement lifestyle you seek. You can request a no-obligation consultation by calling 888-864-2542 today.

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