You’ve made it! All your diligent financial planning, spending less than you earn, and investing has finally paid off. You’ve reached retirement with a nest egg spread out across several retirement accounts. It is time to kick back and enjoy your decades of hard work. As nice as it is to kick back, you must also be careful to not drop the ball at this important phase of retirement. There is money to be saved by withdrawing from your retirement accounts in the best order.
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What strategy to use to withdraw money from your retirement plans? The best strategy to tap your retirement accounts in your retired years is dependent on many factors including:
As a general rule, the longer you can wait to tap your tax-advantaged accounts like 401(k) plans and IRAs, the better. The longer you can give these accounts time to grow with that tax advantage, the larger your nest egg will be. However, when the right time is for your specific situations depends on multiple factors.
Additionally, if you want to avoid paying a 10% early withdrawal penalty, you must be at least age 59 and 1/2 to take withdrawals from your 401(k) and IRAs.
TIP: Wait until you can make penalty-free withdrawal before you start taking money out of your retirement plans.
A significant factor to consider is whether or not you have other sources of income.
The longer you can delay tapping your retirement funds, the better chance you have of successfully living your retirement the way you had planned.
TIP: Take advantage of all sources of income before tapping your retirement accounts.
If you have to take money out of your retirement accounts, you might be faced with a decision of withdrawing money from a Roth account versus a Traditional account. There is no right answer as far as which account you should tap first. The general guidelines come to this:
What is considered a high taxable income? There is no right answer either, because it really depends on your wealth and the lifestyle you are used to. In general, the answer is an income that will put you above the 15% tax bracket.
- If you don’t know how Roth and Traditional retirement accounts differ, be sure to read about the real difference between a Roth and a Traditional retirement accounts.
- Withdraw from Roth retirement accounts when you anticipate to be in a high tax bracket (e.g., above 15%); otherwise, take money out from your Traditional retirement accounts first.
When you pull money out of your retirement accounts, there are two important factors to consider: transaction fees and impact to your asset allocation. In general, you want to minimize transaction fees and sell toward your desired asset allocation.
Here are some specific techniques that you can use to reduce to transaction costs:
As you get older you will want to adjust your asset allocation away from volatile stock investments and more toward stable income assets, such as bonds. If your retirement accounts are made up primarily of stock mutual funds, you would want to pull from there first as you enter retirement to help balance out your asset allocation. Likewise if your portfolio consists of stable value or bond funds, you can wait until your required minimum distributions kick in to begin withdrawals.
- Plan your withdrawal so that you can minimize transaction costs
- Sell investments that no longer fits into your asset allocation plan, and thus automatically moving you toward the desired allocation.
For 401(k), 403(b), and Traditional IRA accounts you are required to take minimum distributions starting at age 70 and 1/2. Your Roth accounts can be held and passed on to your estate without ever taking a distribution (see below).
Your required minimum distribution is factored in on your age and a life expectancy calculation provided by the IRS. For example, an individual that turns 72 this year that is married with a spouse that is less than 10 years younger than them (who is also the sole beneficiary of the account), would divide their 401(k) balance from December 31st of the previous year by 25.6 to get their required minimum distribution for this year. If your 401(k) balance was $500,000 you divide by 25.6 and get $19,531.25 as your required minimum distribution.
Your RMD can change when you decide to start taking distributions based on what other accounts you have to pull retirement income from.
If you have a Roth IRA or Roth 401(k), you need to consider whether or not you plan to leave an inheritance to your heirs. If you do plan to leave an inheritance, it would be much better to withdraw funds from your Traditional accounts now so that your heirs inherit as much as possible in the Roth accounts. The money you pass to heirs in a Roth account will never have taxes charged to it because you have already paid tax on your contributions.
TIP: Do not plan to minimize inheritance tax unless you are 100% certain that you will have money to last you a life time; otherwise, it is better to minimize your own taxes and stretch your savings.
As you can see there are many factors that determine how best you should proceed in your specific scenario. Here are a few examples: