Do you like the idea of leaving money on the table? Do you desire to pay more in taxes than you need to? Of course not, but if you withdraw funds from the wrong accounts first in retirement, there’s a good chance you will. And if most of your investments are in your 401(k) or IRA, then we could be talking hundreds of thousands of dollars in extra taxes over your lifetime.
Let’s not do that.
One of the most crucial retirement decisions you’ll face is determining which accounts to withdraw funds from – and when. How you sequence your withdrawals can not only lower your taxes, but also impact the success of your retirement plan.
So, to help us see how this could actually affect a retirement plan, let’s walk through some of the details with our friend, Kimberly Chemist.
Start Your Other Income Sources
Before we even look at your accounts, take inventory of your other retirement income sources. Social Security is the first place to start since most of us will qualify. Pension income would be another potential source, although they’re becoming less common.
Don’t forget about other potential sources of retirement income, such as rental real estate, royalties, or part-time work.
Likely, there will be a gap between what you need every month and what’s coming in.
Let’s walk through this with our friend Kimberly Chemist. She and her husband, Chris, are both 65 years old and are about to retire. Kimberly has a small pension that will pay her $12,000 per year starting at age 65.
Both Kimberly and Chris expect to receive $2,700 per month in Social Security if they apply when they retire at age 65, as planned.
So, their retirement income will look something like this:
Kimberly’s Pension: $1,000
Kimberly’s Social Security: $2,700
Chris’ Social Security: $2,700
Total Non-Investment Income: $6,400
Kimberly and Chris have $6,400 per month coming in. Okay that’s great!
But they expect they’ll need $8,000 per month – after taxes.
How much of their pension and Social Security will be left after Uncle Sam takes his cut? For simplicity’s sake, we’ll assume Kimberly and Chris are projected to have a 20% effective tax rate in retirement. (In reality, – and not all of it income is taxable.)
Pre-Tax Income: $6,400
Less: Taxes at 20%: ( 1,280)
Net Income $5,120
If so, their $6,400 in income from pensions and Social Security will end up netting them a little over $5,100 per month.
When we compare their net income with what they expect to spend, we’ll know much their investments will need to cover. In this case, it looks like this:
Expected Monthly Expenses: $8,000
Less: Net Retirement Income: ( 5,120)
Income Needed from Investments: $2,880
Okay awesome. We now know that Kimberly and Chris will need their investments to give them a paycheck of $2,880 per month.
But which account do they withdraw this from?
Retirement Account Types
Retirement accounts come in various flavors, each with its own set of rules, tax treatments, and withdrawal requirements. The primary types of retirement accounts include:
Tax-Deferred Accounts such as 401(k)s and IRAs. Contributions to these accounts are typically tax-deductible and your investments grow tax-deferred. Any withdrawals you make in retirement are treated as taxable income.
Tax-Free Accounts such as Roth IRAs and Roth 401(k)s. Contributions to Roth accounts are made with after-tax dollars, and qualified withdrawals in retirement are tax-free, including both contributions and earnings.
Please note that, for simplicity, I’m going to refer to 401(k)s, 403(b)s, and other tax-deferred retirement accounts as “IRAs” going forward. Often, retirees will roll their retirement plans into one IRA to make managing their investments easier.
I’ll also refer to all tax-free accounts as Roth IRAs for simplicity as well.
Taxable Investment Accounts. While not retirement accounts, per se, they still play an important role in your retirement strategy. Any gains you realize from selling investments may be subject to capital gains taxes upon withdrawal.
Now, back to our friend Kimberly Chemist. Her situation is fairly straightforward:
Taxable Accounts: $ 150,000
IRA Accounts: $ 900,000
Roth IRA Accounts: $ 50,000
Total Investments: $1,100,000
A Baseline Strategy for Withdrawals
Getting the source and sequence of withdrawals right can help you:
- Optimize your lifetime tax bill,
- Increase your odds of retirement success, and
- Increase the amount of assets you leave to your heirs or charities of choice.
A general withdrawal strategy you would likely hear from a competent financial advisor would looks something like this:
- Use Taxable Accounts First. Any gains from selling investments in these accounts may be subject to capital gains taxes, but they’re preferable to earned income.
- Use IRAs Second. Withdrawals from these accounts are taxed as ordinary income. But by taking funds from taxable accounts first, IRAs can continue to grow tax-deferred.
- Use Roth IRAs Last. Not only are tax-free withdrawals a great hedge against future tax increases, tax-free assets are bonus for those looking to leave something extra for their heirs.
So, how does this withdrawal strategy play out for Kimberly Chemist? Does having a withdrawal strategy make a difference?
As it turns out, compared to taking their withdrawals from their accounts on a pro-rata basis, their new withdrawal strategy:
• Increases their odds of success from 88% to 91%, and
• Gives them an extra $587,000 more at the end of their plan to leave to the kids.
Fantastic! But what happens if we were to use other sequences?
If they were to sequence withdrawals like this:
- Taxable accounts,
- Roth IRAs, and then,
- IRAs.
Well, their odds of retirement success would remain at 91%, but they’d have a little over $31,000 less than our standard strategy.
So, what if they withdrew in this sequence?
- IRAs,
- Taxable accounts, and then,
- Roth IRAs.
Their odds of retirement success drop to 86% and they’d have $949,000 less than our basic strategy! Yikes.
Okay, we’ve landed on a great place to start for Kimberly Chemist. There’s a clear winner here: taxable accounts first, IRAs second, and Roth IRAs last.
She and her husband will keep over $500,000 and have better odds of retirement success.
But can we do better?
Taking It to the Next Level
While you should definitely pay your taxes (here’s an example of what happens if you don’t), our goal here is to keep you from paying $1 more in taxes over your retirement than you have to.
But if we don’t go through this process, you could end up paying a LOT more. In most cases, we’re talking a six-figure amount.
So let’s start playing a little chess instead of checkers.
To minimize your lifetime tax bill, what are the levers we can pull?
Traditional vs. Roth: The decision to withdraw from a traditional IRA or a Roth IRA depends on your tax bracket. If you’re in a lower tax bracket, withdrawing from the traditional account might make sense, while in higher tax brackets, a Roth withdrawal could be advantageous.
Required Minimum Distributions (RMDs): You’re required to take withdrawals from traditional IRAs and employer-sponsored retirement plans at either 73 or 75, depending on when you were born.
Timing of Social Security. By delaying our Social Security, we can create more “gap years” between your retirement age and the start of your RMDs for tax-savings strategies.
Timing of Pension Income. Similarly, by delaying pension income (if possible), can create more “gap years” for tax strategies.
Strategic Roth IRA Conversions. Speaking of tax strategies, our go-to will be strategic Roth IRA conversions during those gap years. This involves converting a portion of your IRA into a Roth IRA. It moves those funds directly from your IRA to your Roth IRA – but it also means that you’ll have to pay income taxes on that amount.
Retirement Capital Gains Harvesting. Like strategic Roth IRA conversions, as your marginal tax rate drops when you stop earning income, you may be able to sell low-basis investments and pay less in capital gains taxes. This would be common for someone who participated in their company’s stock purchase plan, received restricted stock, or exercised plenty of stock options.
Putting It All Together
Thinking back to our friend Kimberly Chemist, how could using some of these strategies improve their plan beyond our basic withdrawal strategy?
Without optimizing their plan further, their combined IRA RMD would be $87,000 the year they both turn 73. They’ll have to pay income taxes on that amount – which will continue growing every year.
But if Kimberly and Chris were to:
- Delay taking their Social Security until age 70, thus giving them 5 “gap years”,
- Make strategic Roth IRA conversions that fill up the 12% tax bracket during those years?
Well, we just found Kimberly and Chris an extra $200,000.
Now we’re talking! We’ve taken her original plan, improved her odds of retirement success to 99% and increased the amount that she and Chris can leave to the kids another $787,000 over taking their retirement withdrawals pro rata from their accounts.
Exceptions and Tax Considerations
Of course exceptions and specific circumstances can influence your withdrawal strategy:
Early Withdrawal Penalties. Withdrawing from traditional IRAs or 401(k)s before the age of 59½ may result in a 10% early withdrawal penalty, in addition to regular income taxes. Certain exceptions, such as disability or specific medical expenses, can waive this penalty.
IRMAA Penalties. Anytime you increase your taxable income, you run the risk of increasing your Medicare premium monthly adjustments, which increase depending on your Adjusted Gross Income.
Healthcare Expenses. Health-related expenses can be significant in retirement. Certain medical expenses may be deductible, subject to limitations, and could influence your withdrawal decisions.
Legacy and Estate Planning. Your withdrawal strategy may also be influenced by your goals for passing on wealth to heirs. Roth IRAs, for example, can offer tax-free inheritances, making them valuable for estate planning. Or you may just want to spend it all yourself.
Conclusion
So, do you want to keep more of your money in retirement? Getting your retirement withdrawal sequence right could save you hundreds of thousands.
And do you want to pay more in taxes than you need to? That’s where tax-planning to reduce your lifetime tax bill – not just your current year’s taxes – come into play. Watch this video to learn more about strategic Roth IRA conversions. I’ll see you there.
If you need help running these downsizing scenarios, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.
