Retirement distribution strategies: basic considerations

Q:

I’m planning on retiring at the end of 2025. My wife and I have calculated that after we have each received our monthly Social Security checks, we will need about $3,200 more monthly to maintain our current lifestyle, which is our desire. We each have money in 403(b) accounts, personal IRAs and other nonretirement connected funds. Which accounts should we withdraw from first? Second? Last?

A:

You and your wife seem to be on the right path. You’ve already made the major step of trying to figure out your monthly income needs in retirement and which accounts you should withdraw from first to get it.

A retirement distribution strategy is also a tax strategy

Getting the order right can be critical in helping you afford the retirement you and your wife desire because different accounts have different tax impacts.

You pay capital gains taxes on taxable account distributions while you pay ordinary income tax on distributions from deferred tax accounts like IRAs, 401(k)s and 403(b)s. You don’t pay any taxes on qualified distributions from Roth accounts, though you have to meet certain criteria, including the “five-year rule.”

What does this mean for you?

There is no one-size-fits-all

Based on expectations that taxes can rise in the future, there has been a general rule of thumb that you start with the taxable and deferred accounts and then end with nontaxable accounts. However, it’s not possible for there to be one effective strategy for everyone.

Because getting a retirement distribution strategy right is largely a tax question, the answer lies in your unique financial situation. In fact, an efficient tax strategy could involve taking varying percentages of two or more accounts at once over time rather than withdrawing from one at a time in a specific order.

All your finances need to be considered. That’s why you need to work with your financial advisor and a tax professional who have that 360-degree view.

Even though we can’t speak to your particular situation, we can provide you with the basic considerations that you can use as a foundation for the discussion all of you will have.

1. Your age

• Your age at retirement will impact your distribution strategy for a couple of reasons. First, your distribution strategy is not static because your overall spending and income needs will change, which will impact your taxes. The younger you retire, the more likely your distribution strategy will change over time.
• If you’re 65 or over, you’re eligible for Medicare. Your taxable income will help determine your premiums. Remember that all distributions from deferred accounts are considered ordinary income and are taxable accordingly. However, only the gains on taxable accounts are taxable income. Also, capital gains rates can be lower than ordinary income rates.

2. Spending needs

• If you know you will be spending more at a certain stage in retirement or a lot more in one year versus another, you will also require more income. You will want to consider a distribution strategy that minimizes taxes on this income. This could mean more distributions from taxable or Roth accounts that can have lower income taxes than deferred accounts.

3. Where you live

• State income taxes vary, and some states have no income tax, so where you live should be a consideration in your distribution strategy as well. If you live in California, for example, your distribution strategy will have to account for a higher income tax rate. If you move to Tennessee to be nearer to your grandkids, that state has no income tax, so your strategy may change.

4. Estate planning

• Do you want to make sure you have enough in your retirement accounts after you pass to leave to your loved ones? The less taxes levied on their inheritance, the more you will be able to leave them. Generally, taxes are not owed on inherited Roth accounts (provided the account was opened five years before you pass), so you could consider withdrawing from a Roth account last.

5. Account balances

• There are times when people have a lot more in one kind of retirement account versus another, and this could drive the order of distribution as well.
• Let’s say you have $600,000 in a 401(k), $40,000 in a taxable account and $70,000 in a Roth account. We know that the 401(k) will be subject to Required Minimum Distributions when you hit 73. To minimize those RMDs and their tax impacts, it may make sense to start withdrawing from the 401(k).

6. Other sources of income

• Beyond your investment portfolios, what other sources of income do you have and what are their tax impacts? If they increase your tax liability, a tax-efficient withdrawal strategy becomes even more important. For example, many Social Security recipients pay federal taxes on their benefits due to their income levels. You’re generally eligible to receive Social Security at 62, so when do you plan to start taking it? Do you have income from rental properties or a pension?

Next steps

Having a 360-degree view across your potential income sources will make it easier to create a tax-efficient distribution strategy when you meet with your financial advisor and tax professional. Consider consolidating all your investment accounts with your advisor to make this happen. Also, as you prepare for your conversation, consider dimensions to your retirement planning beyond your portfolio, like estate planning and future residence.

WE HOPE YOU’VE FOUND THIS INFORMATION HELPFUL

Remember that any financial guidance must be adapted to your unique circumstances, so consult your financial advisor. In the meantime, keep those questions coming!