RETIREMENT

Retirement: Order Of Withdrawals For Your Retirement Assets

YH.png

Upon reaching retirement, you will probably have accumulated funds in multiple different accounts:  from IRA's, both Roth and Traditional, to 401k's both Roth and Traditional, to regular brokerage accounts.... among a multitude of others.  So when it's time to start withdrawing (distribution mode) the question becomes:  Which account do I tap first? 

First, a quick rundown of the accounts we are discussing:

  • Traditional IRA's and 401k's - These are tax deferred, meaning you pay nothing over the years during the accumulation phase, but pay tax on the amount you withdraw.

  • Roth IRA's and Roth 401k's - These are tax free. They use after-tax dollars (income you already paid tax on in the year it was earned) and grow tax free. 

  • Taxable, Brokerage, Bank accounts - The funds here have no tax advantages. You'll pay taxes on any contributions to these accounts in the year the money is earned and you'll pay taxes on capital gains. Those capital gains would be subject to short term or long term rates, depending on how long the asset was held.

Withdrawal StrategyRemember, the goal here is to tap into the accounts for the funds you need during retirement while keeping your taxable income in any given year to a minimum.  

However, each individual is different so its hard to give a one size fits all answer.  There are multiple paths to consider. We will take a very general approach to the withdrawal strategy.  

First Withdrawal:  If you're under age 70 1/2 you would start with your taxable accounts.  Note however, that if you are over 70 1/2, you would always start with your required minimum distribution (NYSE:RMD) first, since that is required by law.

In your taxable you will have assets that have created some cash flows like dividends and interest.  Or perhaps you sold a mutual fund and created a capital gain.  These would be taxed anyway, so it's better to use these funds rather than reinvest them and have to sell a tax deferred asset to withdraw for your spending needs.

Also, generally speaking, a brokerage account has assets that are less tax efficient anyway, so burning through these first will reduce your overall tax burden in the future.  It will also allow the IRA portfolio years more of growth to increase its balance.  All things equal, the IRA will always grow faster than the taxable (assuming the same investments and dollar value) since the IRA doesn't have the tax drag associated with the taxable account (on interest, dividends, capital gains).

If you still need money in excess of the regular income that is created (interest, dividends, etc), we would then say start spending from your taxable portfolio in a way that minimizes taxes. So start with assets at a loss, and then assets at no gain or loss, and then sell assets at gains.

Remember, short term capital gains will be at ordinary income, so range from 10% to 37% under the current tax plan. However, if the asset was held longer than one year, long term capital gains rates apply.

3.png

(Source:  Investor's Business Daily)

Also another point to remember is that there is a 10% penalty to withdraw from an IRA or 401k before the age of 59 1/2.  So for those under 59, all withdrawals should be first from your taxable accounts. 

Second Withdrawal: The next place is with Traditional IRA's and 401k accounts. These have Required Minimum Distributions (RMDs) and are required by law. So again, if you are over age 70 1/2, you would have taken your RMD first, then moved to the taxable account as seen in point #1.  When you make your withdrawals from these accounts, you will be taxed at ordinary income rates.

If you have multiple Traditional IRAs, you can withdraw from each of them. But the more efficient move is to sum the assets from all your accounts and take one withdrawal from a single IRA. You can also consolidate them into one IRA to simplify things and make future RMD computations easier.

You can pool your distributions for 403b plans, too, but you can’t mix them up- say, by making withdrawals from an IRA to meet your RMD requirements for a 403b plan. Similar accounts have to be pooled together. Also, 401k plans can’t be pooled to compute a single RMD. To streamline those and roll them into an IRA.

Note on Withdrawals #1 and #2:  Another strategy is to blend #1 and #2;  take some from each.  As Michael Kitces suggests:

...By taking at least some withdrawals from the IRA every year, the brokerage account lasts longer before it is ever depleted (avoiding the point where the retiree must take all distributions from the IRA because there’s no other money left). 

By taking the blended-distribution approach, the portfolio lasts significantly longer..., driven by both the fact that “most” of the IRA still enjoys tax-deferred growth for an extended period of time, and more significantly because the annual distributions are modest enough to avoid ever hitting the 25% bracket!

3) Tax free accounts like Roth IRAs and Roth 401k's should come next.  These will have no tax owed and do not require RMDs.  

Like we said, everyone's situation is different, and the farther we get down the list the more personalization there is in the strategy. 

Remember, the goal here is to spend from your tax-deferred account when you think your tax rate will be the lowest. So if you think your tax rate is lowest when you retire, you would want to spend from your tax-deferred account then.

A lot of people may have part-time income when they retire or they may have rental income or things like that. So when they retire, they may actually be in a higher tax rate, in which case we would say spend from your tax-free assets—your Roth assets—upon retirement; and then spend from your tax-deferred assets later when your tax rate’s lower.

Here's a handy summary from Betterment on how accounts are taxed differently:

Lastly, remember just because the account is tax deferred, it doesn't mean it is generally better.  By using this strategy, sometimes the IRA can grow so large that when it is finally tapped at age 70 1/2, the RMDs can be so large that the retiree is pushed into a higher tax bracket than they are used to.  

So, revisiting Michael Kitces again, the fundamental goal to spend from the portfolio in a more tax-efficient manner and to find constructive ways to whittle down a pre-tax account and stop it from growing too large, either by taking distributions outright at an earlier phase, or by using another method such as partial Roth conversions.

Of course, if “too much” is withdrawn or converted in the early years, the retiree may drive up their tax rate now, which doesn’t help the situation either. In other words, the end goal is to find the balance point between the two. 

Also, by spending down taxable and tax-deferred accounts first, leaving just your Roth IRA, could put you in a situation of negative taxable income. Meaning deductions would exceed taxable income. If Social Security was your only income source, it wouldn't be taxed. The standard deduction would still apply and likely be wasted. Any strategy that doesn't take advantage of valuable deductions is inefficient.

Again, there is no one-size-fits-all approach to this.  However, I think we have hit on the issues that would affect a majority of retirees out there and at least give something to think about for everyone else...  

-------------------

RETIREMENT UPDATE: Possible Coming Changes To Your Retirement

Original article was from April 17, 2019.

The Senate held a hearing this week for the “Retirement Security and Savings Act,” which would allow people with little in savings to catch up and also help small businesses provide retirement plans to its workers.

The House of Representatives is expected to vote on the Retirement Enhancement and Savings Act (RESA) by the end of the month, a bill that would expand auto-enrollment features, link small businesses together to offer retirement accounts and describe a fiduciary responsibility. The SECURE Act (Setting Every Community Up for Retirement Enhancement Act) is also waiting for a vote in the House.

These bills, which we discussed more in depth last month, have been moving their way through committee in Congress. As usual, with each step revisions and modifications are made.

They look like the will go to conference for combination in June, where the Senate version and the House version are reconciled and 'combined'.

President Trump is expected to sign it.

Here are the four main provisions:

Small Business Access to 401k's

This is the main provision (there are over 50 between both bills)- to increase access to 401k's for small businesses. The Multiple Employer Plans (MEPs) would allow smaller businesses to group together and spread the costs of offering 401k plans to their employees, similar to what you see in HR services with the PEO (where small businesses group together to lower their medical rates on health and other insurance plans).

These bills allow small businesses in different industries to join together to “obtain more favorable pension investment results and more efficient and less expensive management services,” per the Senate Finance Committee summary.

In addition, lawmakers on both sides want provisions to provide tax credits to small businesses to make it more affordable for them to set up their own retirement plans.

Another group of workers who might see increased access to retirement savings plans: long-serving part-time employees. There are provisions in the House bill for part-time workers. On the other end of the Capitol, Senators Rob Portman and Ben Cardin are pushing similar provisions. Their plan would allow part-time workers access to their company’s retirement plans once they work over 500 hours for two consecutive years.

Save for Retirement While Paying Off Student Loans

This proposal was originally part of other retirement security bills, including the Retirement Security and Savings Act, but Sen. Wyden introduced the concept as a stand-alone proposal as well this week. The proposal, called Retirement Parity for Student Loans Act, would let employers make matching contributions to a 401k for employees who are paying off student loans, but not mandate it.

Basically this means if a 401k plan provides a 100% matching contribution on the first 5% of salary reduction contributions made by a worker, then a 100% matching contribution must be made for student loan repayments equal to 5% of the worker’s pay, according to Wyden. (It would be mandatory if an employer is offering a match, but they can offer whatever match they want.)

Contribute and Save for Longer

The plan would eliminate the maximum age to contribute to an IRA. Currently, you are only eligible to contribute to a traditional IRA if you are younger than 70 ½. There are no age limits on contributions to 401k plans or to Roth IRAs.

Lawmakers are also considering increasing the age when account holders must begin taking required minimum distributions (RMDs) from their accounts and pay taxes. Currently, RMDs begins at age 70 ½. The House bill would increase the limit to age 72. On the Senate side, the proposal from Senators Portman and Cardin would increase the age to 72 in 2023 and then up to age 75 by 2030.

Portman noted that as people are living longer, we must ensure that their savings last longer...

More Access to Retirement Plans

Experts are also pushing more forceful measures to encourage younger people to save. Tobias Read, Oregon’s State Treasurer, testified in Washington recently that the minimum age for investing in an IRA should be lowered. We should be “allowing minors as young as 16 to open their own accounts and hold the money in their own names,” he said to lawmakers. Many agreed, so we could see that added to either bill.

------------------