Making wise decisions about withdrawing funds from your retirement accounts is crucial as you navigate through your retirement years. It’s a significant financial aspect that requires careful consideration and planning.
After years of diligently saving and investing, you want to ensure that you optimize the use of your retirement savings while maintaining financial stability. The choices you make regarding when and how to withdraw money can impact your income, tax obligations, and the longevity of your funds. By understanding the various factors involved and following a strategic approach, you can make informed decisions that align with your financial goals and provide you with a comfortable retirement lifestyle.
Determining the Sequence for Withdrawing from Retirement Accounts
In order to withdraw funds from your retirement accounts during retirement years, it’s essential to follow a strategic order. Here’s a standard withdrawal sequence, taking into account various factors.
If you have an emergency fund equal to six months of expenses, cash should be your first source of income in retirement. Let’s say your monthly expenses amount to $10,000, and you have $100,000 in the bank. In this case, your initial $40,000 of income should come from cash or cash equivalents.
Drawing from cash initially can also help keep your taxes low during the early years of retirement. Transferring money from a traditional IRA or any pre-tax account to a Roth IRA at a potentially lower tax rate than you would otherwise pay.
#2 Taxable accounts
You can tap into your taxable investments once you’ve depleted your emergency fund. These may include individual, joint, and revocable trust accounts. Similar to the cash example above, this strategy considers tax implications. Withdrawals from taxable accounts held for more than a year are generally subject to more favorable long-term capital gains tax rates. Moreover, these accounts are not tax-deferred, meaning their growth potential is slower than retirement ones.
#3 Social Security
Here’s where things become more complex. While it’s not suggested that you immediately start claiming Social Security after depleting your taxable accounts, it’s important to consider breakeven points based on life expectancy and tax and legacy factors.
Benefits from Social Security can be claimed as early as age 62 and reach their maximum at age 70. The longer you delay claiming, the more you stand to receive from the Social Security Administration. Therefore, if maximizing income is your goal, waiting longer is generally beneficial.
#4 Pre-tax retirement accounts
This category includes traditional IRAs, 401(k)s, 403(b)s, 457s, SEP IRAs, and similar accounts that have not yet been taxed. Withdrawals from these accounts are taxable as income. In most cases, delaying withdrawals can be advantageous, allowing the accounts to grow further. However, the IRS will eventually require you to take the required minimum distributions (RMDs).
#5 Roth accounts
These accounts offer tax-free growth, and qualified withdrawals are also tax-free. Apart from health savings accounts, they are likely your most tax-efficient savings option. Continuing the previous theme, you should prioritize accounts with the highest growth potential for the longest period. Additionally, under the SECURE Act, Roth IRAs have become effective tools for transferring wealth to beneficiaries, as their distributions are tax-free, as well as the ability to defer withdrawals for ten years after your death.
It’s worth mentioning that the SECURE 2.0 Act eliminated the minimum distribution rules for all Roth accounts, allowing you to potentially never withdraw from these accounts and pass them on to your children. In the end, it’s up to you to decide how to balance tax planning and reap the rewards of your smart financial decisions.