You’ve made it to retirement! Time for a big sigh of relief, right? Maybe not just yet. Throughout your working years, you were reminded to save your money, invest in tax-advantaged plans to maximize your savings, and keep your eye on the prize. Yes, that prize is retirement – being able to stop working and just enjoy the good life. The key to enjoying the good life is two-fold. First, you have to be smart and consistent about saving, and grow your nest egg into something that will enable you to retire. The second part now is to make sure you manage withdrawals from your retirement accounts wisely, minimizing any sting of tax penalties so you’re not spending this precious time worrying if you will outlive your savings.
Now that the regular paycheck is gone, and you turn to your investments for income, it’s important to follow a common-sense sequence to withdraw funds from your retirement accounts, being mindful of the taxes that can be imposed on your savings. Fidelity.com suggests withdrawing money from retirement and investment accounts in this order:
The reason for the order sequence outlined above is that it’s best to start withdrawing from accounts you’re already paying taxes on. Keep in mind that RMDs only apply if you have reached age 70½. If you haven’t reached this age, you can skip this step. Once you turn 70½, you will be required to withdraw a certain amount (based on an IRS formula) from many types of tax-deferred accounts so you can begin paying back the taxes you’ve been deferring up until now. Taking the full RMD each year is essential, as the IRS can assess a penalty equal to 50% of the amount not withdrawn, if you overlook this requirement.
Once you’ve met the RMD requirement (if applicable), continue drawing down your savings according to steps 2, 3, and 4 above. According to Vanguard’s How to Set up Your Withdrawals, it makes the most sense to withdraw money from your savings in a way that allows you to pay the majority of your taxes while you’re in a lower tax bracket.
For example, if you find yourself at step 2 and you’re selling investments from a brokerage account, you’ll pay the capital gains tax on any appreciation. For most taxpayers, the long-term capital gains tax rate is 15% at the most, which is lower than the income tax rate for withdrawals from traditional retirement accounts, currently ranging between 10 and 37% for 2018.
Another benefit of using investments from your taxable accounts first is that you’re leaving the money in your tax-advantaged traditional and Roth accounts for a longer period of time, enabling them to continue growing tax-deferred or tax-free.
You’ll realize the greatest tax benefit when you reach step 4. Qualified withdrawals from a Roth account are not taxed because you funded that account with post-tax money, so your savings have been accumulating tax-free and the money will not be taxed when you need it.
Accessing your assets in the most tax-efficient manner can be a bit overwhelming. If you thought building up your retirement savings was complicated, knowing how to spend it down can be just as challenging. If you’d rather be spending your “new” free time on other things, consider enlisting the help of a financial advisor who can help you to maintain a steady and reliable income to last your lifetime.