One of the biggest challenges for retirees is managing withdrawals from their various retirement accounts. These might include a 401(k), individual retirement account (IRA), annuities as well as taxable investment accounts. There are variety of factors to consider including tax implications. Many retirees don’t realize that the pre-tax money in tax-deferred accounts is subject to taxation as ordinary income when withdrawn. So that $1 million in your 401(k) might only provide an after-tax cash flow of $600,000 - $700,000 over time after taxes are paid. Here are some factors for retirees and their financial advisors to consider when planning for withdrawals from their retirement accounts.
As you approach retirement it is important to take stock of all financial assets available to fund your retirement. Here is a partial list. Depending on your situation there could be others. (For more, see: Closing in on Retirement? Read These Tips.)
Determine the value of these assets and the type of cash flow you can expect during retirement. As part of this you will need to assess the income tax issues associated with tapping some of these sources. (For more, see: Will You Pay Taxes During Retirement?)
Withdrawals from traditional IRA and 401(k) accounts are generally subject to income taxes on the full amount withdrawn. This also applies to other defined contribution retirement plans such as a 403(b), the federal government’s teacher retirement system (TRS) and 457 plans used by many state and municipal governmental units. This is certainly the case with any contributions made on a pre-tax basis and the associated earnings on those contributions.
Some defined contribution plans also allow for after-tax contributions. This is also true of traditional IRA accounts for the portion of one’s contributions that fall outside the income ranges allowed for deductible contributions. If you have made post-tax contributions you will need to keep track of these as withdrawals from accounts with both types of contributions are pro-rated between the two types. (For more, see: 5 Tax(ing) Retirement Mistakes.)
Contributions to Roth IRA accounts and to a Roth 401(k) are made with after-tax dollars. In the case of Roth IRAs the money can be withdrawn tax free as long as your initial Roth IRA contribution was at least five years ago and you are at least 59 ½. Additionally there no required minimum distributions as there are with traditional IRAs. A Roth 401(k) is similar but differs in that required minimum distributions must be taken. Rolling the account over to a Roth IRA is one solution to avoid this issue.
Taxable investment accounts are a valid way to save for retirement. The tax implications when using these investments could include capital gains taxes or the taxation of any interest or dividends received. Payments from a defined benefit pension are generally fully taxable as ordinary income. Social Security may be taxed based upon your age and income. (For more, see: Retirement Savings: Tax-Deferred or Tax-Exempt?)
Annuities can be funded with after-tax dollars (non-qualified) or they can be held within an IRA or certain tax-deferred workplace retirement plans (qualified). In the case of non-qualified annuities the portion that pertains to your contributions to the account are not taxed and the portion that represents gains in the underlying investments is. The actual taxation rules will differ based upon whether you annuitize the account or take piecemeal distributions at various times. Withdrawals from a qualified account are fully subject to taxation with the exception of any after-tax contributions that might have been made.
Cash value life insurance is often touted by insurance agents and commissioned financial advisors as a retirement savings vehicle. If structured correctly the policy holder can take what amounts to a tax-free loan from the policy to fund retirement. Care must be taken to ensure that the policy’s cash value does not fall below a certain level that would trigger a taxable event. (For more, see: How Cash Value Builds in a Life Insurance Policy.)
Given the information above and other factors the question remains which accounts should I tap for cash flow in retirement and in which order? There is no hard and fast answer but here are some factors to consider. Retirement today is a bit of a phased approach for many who may retire from their full-time job but might work at least part time during the early years of retirement. If this is your situation you might consider tapping tax-deferred retirement accounts later if you have the option to take money from taxable investment accounts first.
Once you reach age 70 ½ you don’t have a choice in terms of your required minimum distributions from any tax-deferred retirement accounts. This does not apply to non-qualified annuity accounts and may not apply to a 401(k) with your current employer if you are still working. (For more, see: How Much Should Retirees Withdraw from Accounts?)
Another factor to consider is that your Social Security can be adversely impacted by a higher income. In 2015 if your earnings exceed $15,720 and you are younger than your full retirement age your benefit will be reduced $1 for every $2 that your earnings exceed this limit.
Remember the top long-term capital gains rate for taxable investments held for at least one year is 20% for those in the highest income tax brackets. Even with the potential of the 3.8% Medicare surcharge this rate is cheaper than the ordinary income tax rates charges on withdrawals from tax-deferred retirement accounts if you are in one of the higher income tax brackets. (For more, see: Capital Gains Taxes in 2015.)
For many retirees the decision as to which accounts to tap will be a mix of several types. If you entirely deplete your taxable investments and savings you will be forced to tap tax-deferred accounts exclusively at some point and this can be an expensive source of money. For many retirees it can make sense to take full advantage of ordinary income up to the limits of the lowest tax bracket of 15%. For joint filers this ranges up to $74,900 and up to $37,450 for single filers in 2015. The strategy here is to keep your ordinary income within the 15% tax bracket and then tap sources such as a Roth IRA, a savings or money market account, cash value from a life insurance policy, the sale of taxable investments where the market value is lower than their cost basis or other non-taxable or low taxed sources of cash.
Moreover you will want to work with your financial advisor and tax professional to do some planning that includes the amount needed to fund your retirement and that takes into account your tax situation. (For more, see: Strategies for Withdrawing Retirement Income.)
Managing your withdrawals from various retirement accounts during retirement can be a complex task especially if you have accounts of various types. A skilled financial advisor can provide clients with invaluable advice in managing their retirement income.