Retirement planning isn’t a cut and dry affair. It is complicated with many accounts to consider. Your decisions can greatly impact the quality of retirement you get to enjoy. What’s even better is that once you decide on a retirement strategy, it is likely to change at some point during your life. Life isn’t static. Your income, family situation, estate plans and even tax laws will change over many decades.
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When you are first starting out in your career and in a lower tax bracket it makes sense to save in a Roth IRA because you will be in a low tax bracket. (Plus, after your income rises to a certain point you won’t be able to contribute to a Roth IRA at all, so it makes sense to contribute while you can.)
As your income rises and you start to pay more in taxes you might decide to try to offset some of your tax costs by switching to a Traditional IRA where you get a tax break today but pay taxes on your withdrawals in retirement. As your income and thoughts on taxes change throughout life, you might even consider investing in both a Traditional IRA and a Roth IRA in the same year. (If you take this strategy just remember the IRA contribution limit is the total limit for all IRAs combined; you can’t contribute $5,000 to a Traditional IRA and then another $5,000 to a Roth IRA.)
All these changes mean you can end up at retirement age with many accounts to choose to pull your retirement income from. Which account do you tap first?
If you are entering retirement with your nest egg split between a Traditional IRA and a Roth IRA, how should you withdraw your retirement income? Is there a best strategy to use?
The answer to this question is dependent on a few key factors. Understanding these factors will guide you to your decision:
Once you understand how you feel about the above factors you can use a couple of strategies to withdraw from your IRAs in retirement.
Once you enter retirement your taxable income drops substantially. If you have no other form of income the only amount you will pay tax on is your Traditional IRA withdrawals. By tapping your Traditional IRA first you will pay taxes earlier in retirement while allowing your Roth portfolio to continue to grow. This leads to a larger Roth IRA balance and larger tax-free withdrawals in the future.
If you don’t live to use all of your Roth IRA you will be able to pass it onto your heirs and they will never pay tax on withdrawals. Additionally, the IRS requires Traditional IRA owners to begin taking required minimum distributions from the account beginning at age 70 and 1/2, so you will already be withdrawing when that happens.
If you decide to tap your Roth IRA first in retirement you could drop your taxable income completely to $0 if you have no other form of income. You paid income tax on the contributions into the account during your working career, and won’t pay tax again. If you take this route note you will still be required to begin withdrawing from your Traditional IRA at age 70 and 1/2 even if you don’t want to.
If you pass away with money still left in a Traditional IRA it can be passed onto your heirs. However, they will have to pay tax on any withdrawals made. Additionally, the IRS has special rules for inherited Traditional IRAs that require the whole account to be distributed either within 5 years of the original owner’s death or in payments over the life of the beneficiary using an IRS provided life expectancy table.
Perhaps the best strategy is to withdraw a little bit of money from both accounts. You will be forced to begin Traditional IRA withdrawals in a few years after you begin your retirement anyways, so that is part of the equation. You can carefully plan out your withdrawals to keep your taxable income below specific income brackets by only withdrawing a certain amount from your Traditional IRA and making up the rest of your income with your Roth IRA withdrawals.
If you pass away with money left in both accounts your heirs will still be required to do something relatively quickly with the Traditional IRA, but the Roth can be left alone until their own retirement.
Great article on a difficult subject. There are so many variables. I would like to take this opportunity to encourage people to own BOTH traditional and Roth IRAs. This is a form of diversification. It’s possible you will find yourself in situations where one or the other has a clear cut advantage for withdrawal at different periods in your life. Diversification has it’s advantages!
@Ken – It’s great if there’s an opportunity to invest in both. For me, most of the time it is more advantageous to contribute to traditional retirement accounts (401k and IRA), so I have a much smaller share of money in Roth.