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Everyone’s situation is unique and different. Here are issues and strategies to take into account when planning your retirement distribution strategy.

Tax treatment

  • Withdrawals from traditional IRA accounts are taxed as ordinary income. Any portion that was contributed on an after-tax basis is not subject to taxes. If you have made after-tax, nondeductible contributions it is critical that you keep good records.
  • Traditional 401(k) accounts work in much the same way.
  • Roth IRA account withdrawals are tax free as long as the account holder is older than 59½ and the first Roth contribution was made at least five years ago. Roth 401(k) accounts receive the same tax treatment.
  • The sale of taxable investments is subject to preferential capital gains tax treatment as long as they have been held for at least a year and a day.
  • Non-qualified annuities are taxed in proportion of the cost basis to the total account value at the time annuitization begins. In the event of partial withdrawals, the full amount is taxed until the “gain layer” is used up. Annuities are taxed at ordinary income tax rates.
  • Gains on the sale of your home will generally be tax free. If you have lived in your home for at least five years, the first $250,000 of gains are tax free; this increases to $500,000 if you are married and filing jointly. Gains in excess of this are reported as capital gains.

Do an inventory

An important aspect to developing a retirement withdrawal strategy is fully understanding all of the retirement resources you have available. These might include:

  • A defined contribution workplace retirement plan such as a 401(k) or a 403(b)
  • IRA accounts, traditional and/or Roth
  • A Health Savings Account (HSA)
  • A pension
  • Social Security
  • Taxable investments
  • An annuity
  • Ownership or interest in a business
  • Stock-based compensation such as options or restricted stock units
  • Real estate

There certainly could be other types of assets as well, but this list covers most of the common types of retirement assets that I’ve seen.

In addition, what does retirement really mean in terms of working? By this I mean that more and more people are working full or part-time during retirement. Part of this might be due to a need for the money and part can be due to a desire to stay mentally active and connected to others.

For items that have an income stream, such as a pension and Social Security, determine what that income stream is and when it will commence.

In the case of Social Security, you can take your benefit as early as age 62, but it makes sense to wait if you can. For example, the difference between claiming your benefit at age 62 and 66 (the full retirement age for those born before 1960) is about 25%. Waiting until age 70 adds another 8% annually from age 66 to 70.

With a pension there may be an option to take a benefit as early age 55, but the benefit will generally increase each year until it maxes out at, say, age 65. Each plan is different, so be sure to know the rules.

For your other retirement assets such as IRA accounts, run a retirement projection in combination with Social Security and a pension (if you have one) to see how much income your overall retirement resources can support over a reasonable life expectancy, which I would define to be at least out to age 95.

There are rules of thumb such as the 4% rule, which says you should be able to safely withdraw 4% of your nest egg annually during retirement and have your money last for at least 30 years. This is a useful “back of the napkin” estimating tool, but you should really sit down and either do the math yourself or engage the services of a fee-only financial planner to help.

Determine your income needs

The other side of the retirement withdrawal equation is to determine how much you will need each month to support your desired retirement lifestyle. It is important to create a retirement budget before you actually retire.

If the amount needed to support your desired retirement lifestyle exceeds what your assets can reasonably support, you have some choices to make. These include reducing your budget and working longer, among others.

Planning a withdrawal strategy

Once you have determined when you will retire, whether you will work and when to claim Social Security, you still have some decisions to make. Here are a few strategies to consider over the course of your retirement.

If you are working, especially in the early years of retirement, say, prior to age 70, you might tap taxable investments first. The reason is capital gains taxes will likely be lower than the ordinary income tax rate on tax-deferred accounts like a 401(k) or an IRA.

Some might suggest exhausting all of your taxable investment accounts and Roth accounts first. This does have merit in terms of deferring paying taxes on traditional IRA and 401(k) withdrawals until down the road, and based on the principles of the time value of money, it makes sense to push into the future the payment of these taxes.

The problem is by exhausting all of your taxable investments and Roth money first, you are leaving yourself at the mercy of future income tax hikes by Congress. If rates spike up and all of your money is in an account(s) that requires you to pay taxes at ordinary income tax rates, this can become a very expensive proposition.

Additionally, deferring all of your withdrawals from tax-deferred accounts until later will likely mean your required minimum distributions (RMDs) at age 70½ will grow to a larger amount than perhaps you need or want to withdraw and pay taxes on.

Relook at things each year

Perhaps the best approach is to look at your situation each year and decide which accounts to tap based upon your situation. Perhaps in some years this will be a combination of tapping taxable and tax-deferred accounts.

You might consider taking enough from your tax-deferred accounts to “fill up your tax bracket.” This entails taking full advantage of the lowest tax bracket of 15%. For 2016 this ranges up to $75,300 for those who are married and file jointly; for single filers it ranges up to $37,650.

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, 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 for the rest of your income needs.

The same strategy can also work if you are in a higher tax bracket.

Other strategies that can make sense are Roth IRA conversions in years prior to age 70½, when RMDs commence, in order to reduce the level of future RMDs. A Roth can also be a great way to pass money to heirs tax free. Whether or not this makes sense will depend upon your level of taxable income in a given year, among other factors.

The bottom line

Planning for a financially successful retirement is a complicated task. One of the most important aspects of this is to plan for your income needs and how these needs will be met. Determining which accounts to tap and in what order is critically important and takes planning, monitoring and periodic adjustments to be successful.

Roger Wohlner Freelance Contributor

Roger Wohlner is an experienced financial advisor, finance blogger and freelance writer based in Arlington Heights, Ill. His expertise includes providing financial planning and investment advice to individual clients, 401(k) plan sponsors, foundations and endowments.


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