You spent your lifetime working hard, diligently saving and investing money to secure your financial future. But what comes next? When it’s time for retirement, how do you take income from your savings in a way that preserves your wealth as long as you need? Whether you’re approaching retirement or already retired, the right withdrawal strategy can help you manage taxes and maintain the standard of living you’ve planned for.
What is the “right” retirement withdrawal strategy? It depends.
Every individual is unique, so the optimal answer depends on your circumstances, your goals and changes in the economic climate. At Edelman Financial Engines, our planners, along with your accountant, can help design a strategy for your unique situation, a plan that considers your changing needs, as well as the impact on your taxes, Social Security benefits, and even the amount you pay for Medicare.
Identify the challenges of retirement withdrawals
Planning for a steady stream of income in retirement can seem like an overwhelming task. First, you must consider your expenses and expected income from a number of sources: your investment accounts, pension, part-time work, rental income, Social Security, etc. In fact, many people are not certain how much they actually spend throughout the year, or even on a monthly basis. Since financial planning is about having financial security and an enjoyable lifestyle, a financial planner can help you determine how much that income stream should be and identify the income sources.
Here is another question: do you expect changes in your income or expenses in your retirement years? You might need to reassess how much income you need and how long your savings will last based on your desired retirement lifestyle.
Market considerations for your retirement withdrawal strategy
As anyone nearing or in retirement in the first half of 2022 knows all too well, market downturns, increased volatility and higher inflation can have a significant impact on your withdrawal strategy. That’s why building a year or two of cash reserves is a good plan – it can help offset some of the impact of drawing down your investments when market values are down.
Maintaining sufficient cash reserves can help provide the ability to cover unforeseen financial circumstances without needing to take withdrawals too early from your retirement accounts. This could also incur fees, interest or penalties.
Keep in mind that early on in your retirement, you most likely will be taking a small percentage of the total account value of your accounts. That means that the rest of your balance is still invested and positioned to benefit from any portfolio growth. It can be uncomfortable to see account values drop, but we have been through this before and our advisors will give you guidance on how to use those cash reserves to get you through. Remember, the markets go up and down, and we can construct a portfolio that is designed for these ups and downs.
IRA withdrawal rules
Let’s say you have an IRA and a 401k account from your prior employer. Many people think that when they reach the RMD age they can calculate the required minimum withdrawals from both and simply take the grand total out of one account – for example, the IRA.
But that’s incorrect. You cannot choose a retirement withdrawal strategy that only debits one account, even if it meets the Required Minimum Distribution amount. And an error like that could cause to you to incur a 50% penalty from the IRS.
That’s why it’s so important to have a retirement withdrawal strategy in place before you reach age 72 (or 70 ½ if you reach 70 ½ before January 1, 2020), the age at which you need to start taking RMDs.
Having money in both an IRA and a 401k is common. We typically find that people have five retirement accounts by the time they stop working. Those may be IRAs, 401ks from multiple prior employers, a 403(b) and others.
So, in this example, your retirement withdrawal strategy must include separate RMDs from each of the two accounts. Taking the RMD amount for the 401k portion from the IRA would trigger the penalty. Even though you took the proper total amount from all the accounts, the IRS will recognize you didn’t take it from the proper place.
If you eventually decided to roll your dormant 401k into an IRA – you would first need to take the current year’s minimum distribution from the 401k – then you could take the total withdrawal from just one of the IRAs in subsequent years. But be aware there are strict rules about rollovers, so to avoid facing any penalties, be sure to speak with the plan administrator or a financial advisor before choosing this option.
How much is the required minimum distribution?
IRS Publication 590b contains a table showing the amount that must be withdrawn each year, but there’s another trap you should avoid. The amount is based on the account value as of the prior Dec. 31, not on the value at the time the funds are withdrawn.
Although you can take out more than the required minimum distribution, if your calculations are off and you take out too little, that’s where the potential 50% penalty comes in.
The rules are different for IRAs and 401k plans. If you had five IRAs of different values, you could add up the total RMDs and withdraw the entire amount from just one of the IRAs. But with 401k plans, you must take your RMD separately for each 401k you have.
It is also important to note that the RMD rules apply to more than just IRAs and 401k. They also apply to a number of employer sponsored retirement plans such as profit-sharing and 403(b) plans, plus IRA-based plans such as SEPs.
Optimal withdrawal strategy for retirement income portfolios
There are many elements to consider when deciding which accounts to draw from. For example, should you be withdrawing from a single account or proportionally across all your accounts?
One approach is to withdraw from taxable accounts first, which allows your assets in tax-deferred accounts the ability to stay invested longer and potentially make more money. But this isn’t always the best approach because it could create a bigger federal tax bill down the line when RMDs kick in, possibly moving you into a higher tax bracket. In addition to federal taxation, depending on which state you live in, there can be potential state income taxation considerations.
When and from where you choose to make withdrawals can also impact if or how much of your Social Security benefit is taxable, or the amount you pay for Medicare. The difference can be significant. In 2022, the cost for Medicare Part B is between $170.10 and $578.30 per month depending on your income level two years prior. Your planner can join a call with your accountant to determine an option that can work for you.
Helping to explore tax-efficient retirement withdrawal strategies is just one of the ways we serve our clients. Talk with an Edelman Financial Engines advisor to see how we can help you.
Neither Edelman Financial Engines nor its affiliates offer tax or legal advice. Interested parties are strongly encouraged to seek advice from qualified tax and/or legal experts regarding the best options for your particular circumstances.