Congratulations! For decades, you’ve been saving, saving, and saving some more for retirement. Maybe you even have money in a combination of retirement savings plans that may include a traditional tax-deferred IRA, a 401(k), Roth IRA, or taxable accounts.
Now that you’re ready to retire, the question is how to take the money out of these accounts in a way that maximizes income and minimizes taxes.
Yes, it’s a boring, complicated topic and you may have to read this article more than once to understand the options open to you. There’s also a good chance you’ll decide to consult a professional, like a tax attorney or accountant, before making any decisions. But in the end the tax savings of making the right choices are worth it.
Because the tax treatment of withdrawals among various savings arrangements differs substantially, a key issue is which ones to tap first. To make a decision, it helps to understand the rules governing distributions for each.
Tax-deferred retirement plans, including 401(k)s and traditional IRAs. All amounts attributable to tax-deductible contributions, as well as accumulated earnings, are subject to ordinary income tax at withdrawal. Amounts taken out prior to age 59 1/2 are also subject to a 10 percent penalty, unless special circumstances apply. Retirees must also begin taking required minimum distributions (RMDs) in the year they reach age 70 1/2, or face a stiff penalty if they don’t.
Roth IRAs. Distributions from a Roth held for at least five years are entirely tax-free if you’re at least age 59 1/2. There are also no required minimum distributions, so you can leave the money in the account as long as you want without tax or penalty. Regardless of your age or how long you’ve had the account you can always withdraw contributions from a Roth tax-free and penalty-free.
Taxable accounts. Ordinary income tax rates apply to interest and other types of investment income. Gains on stocks and other securities that are sold after a holding period of more than one year are subject to favorable long-term capital gains rates, while those sold before that period are considered short-term and will be taxed at ordinary income rates.
While those strategies often make sense you need to fine-tune them and perhaps make substantial adjustments based on estate planning considerations. For example,
Capital gains taxes. Taking money out of a traditional IRA or 401(k) increases taxable income, and possibly taxes on capital gains. A married couple filing jointly with income of up to $38, 600 in 2018 would pay no tax on qualified dividends and long-term capital gains. If income exceeds that amount, the tax from those sources increases to 15 percent or 20 percent, depending on total income. This suggests that in years when you expect to liquidate a substantial block of long-term holdings from a taxable account it may make sense keep taxable income in check by taking distributions from a Roth rather than a tax-deferred retirement plan.
Social Security. It often makes more sense to use retirement funds from any source first before tapping Social Security because each year you don’t claim translates into an annual bump-up in benefits of roughly 8 percent. While it can be emotionally difficult to start nibbling away at savings early on, the benefit boost from waiting to take Social Security is tough to pass up.
Taxation of benefits. Because distributions from tax-deferred retirement accounts are included in taxable income they count toward determining whether Social Security benefits are subject to tax. In 2018, a portion of benefits will be taxed if total income exceeds $25,000 for single filers and $32,000 for joint filers. Qualifying Roth distributions don’t count toward that income calculation.
As you can see there is no one-size fits all strategy for turning on the income spigot from different accounts, and it’s important to review and possibly adjust strategies from year to year as income or fluctuates financial circumstances change. With so many pieces to the puzzle what works well one year may backfire the next.
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