Retirement Account Withdrawal Strategies

The order in which you take distributions from your retirement accounts absolutely matters in retirement.  If you don’t have a formal withdraw strategy it could end up costing you more in taxes long-term, causing you to deplete your retirement assets faster, pay higher Medicare premiums, and reduce the amount of inheritance that your heirs would have received.  Retirees will frequently have some combination of the following income and assets in retirement:

·         Pretax 401(k) and IRA’s

·         Roth IRA IRA’s

·         After tax brokerage accounts

·         Social Security

·         Pensions

·         Annuities

As Certified Financial Planner’s®, we look at an individual’s income needs, long-term goals, and map out the optimal withdraw strategy. In this article, I will be sharing with you some of the considerations that we use with our clients when determining the optimal withdrawal strategy.

Layer One : Pension Income

When you develop a withdrawal strategy for your retirement assets it’s similar to building a house. You have to start with a foundation which is taxable income that you expect to receive before you begin taking withdrawals from your retirement accounts.  For retirees that have pensions, this is the first layer.  Income from pensions are typically taxable income at the federal level but may or may not be taxable at the state level depending on which state you live in and who the sponsor of the pension plan is.  While pensions are great, retirees that have pension income have to be very careful about how they make withdrawals from their retirement accounts because any withdraws from pre-tax accounts will stack up on top of their pension income making those withdrawal potentially subject to higher tax rates or cause you to lose tax deductions and credits that were previously received. 

Layer Two: Social Security

Social Security income is also something that has to be factored into the mix.  Most retirees will have to pay federal income tax on a large portion of their Social Security benefit.  When we are counseling clients on their Social Security filing strategy, one of the largest influencers in that decision is what type of retirement accounts that have and how much is in each account.  Delaying Social Security each year, increases the amount that an individual receives in the range of 6% to 8% per year forever.  As financial planners, we view this as a “guaranteed rate of return” which is tough to replicate in other asset classes.  Not turning your Social Security benefit prior to your normal retirement age can:  

·         Increase 50% spousal benefit

·         Increase the survivor benefit

·         Increase the value of SS cost of living adjustments

·         Reduce the amount required to be withdrawn for other sources  

For purposes of this article, we will just look at Social Security as another layer of income but know that depending on your financial situation your Social Security filing strategy does factor into your asset withdrawal strategy.

Roth Accounts: Last To Touch

In most situations, Roth assets are typically the last asset that you touch in retirement. Since Roth assets accumulate and are withdrawn tax free, they are by far the most valuable vehicle to accumulate wealth long-term. The longer they accumulate, the more valuable they are. 

The other wonderful feature about Roth IRAs is that there is no required minimum distributions (RMD’s) at age 72. Meaning the government does not force you to take distributions once you have reached a certain age so you can continue to accumulate wealth within that asset class. 

Roth’s are also one of the most valuable assets to pass onto beneficiaries because they can continue to accumulate tax free and are withdrawn tax free. For spousal beneficiaries, they can roll over the balance into their own Roth IRA and continue to accumulate wealth tax free. For non-spouse beneficiaries, under the new 10 year rule, they can continue to accumulate wealth for a period of up to 10 years after inheriting the Roth before they are required to distribute the full balance but they don’t pay tax on any of it.

Financial Nerd Note: While Roth are great accumulation vehicles, it’s impossible to protect them from a long term care event spend down situation. They cannot be transferred into a Medicaid trust and they are subject to full spend down for purposes of qualifying for Medicaid in New York since there is no RMD requirements.  It’s just a risk that I want you to be aware of.

Pre-tax Assets

Pre-taxed retirement assets often include:

·         Traditional & Rollover IRAs

·         401k / 403b / 457 plans

·         Deferred compensation plans

·         Qualified Annuities

When you withdraw money from these pre-tax sources you have to pay federal income tax on the amount withdrawn but you may also have to pay state income tax as well.  If you live in a state that has state income tax, it’s very important to understand the taxation rules for retirement accounts within your state.

For example, New York has a unique rule that each person over the age of 59½  is allowed to withdraw $20,000 from a pre-tax retirement account without having to pay state income tax. Any amounts withdrawn over that threshold in a given tax year are subject to state income tax. 

Pretax retirement accounts are usually subject to something called a required minimum distribution (RMD).  The IRS requires you to start taking small distributions out of your pre-tax retirement accounts at 72.   Without proper guidance, retirees often make the mistake of withdrawing from their after tax assets first, and then waiting until they are required to take the RMD’s from their pre-tax retirement accounts at age 72 and beyond. But this creates a problem for many retirees because it causes:

·         The distribution to be subject to higher tax rates

·         Loss of tax deductions and credits

·   Increase the tax ability of Social Security Increase Medicare premiums Loss of certain property tax credits for

seniors

·         Other adverse consequences……

Instead as planners, we proactively plan ahead and ask questions like:

“instead of waiting until age 72 and taking larger RMD’s from the pre-tax account, does it make sense to start making annual distribution from the pre-tax retirement accounts leading up to age 72, thus spreading those distribution in lower amounts, across more tax year resulting in:

·         Lower tax liability

·         Lower Medicare premiums

·         Maintaining tax deductions and credits

·         The assets last longer due to a lower aggregate tax liability

·         More inheritance for their family members

Since everyone’s tax situation and retirement income situation is different, we have to work closely with their tax professional to determine what the right amount is to withdraw out of the pre-tax retirement accounts each year to optimize their net worth long-term. 

After Tax Accounts

After tax assets can include:

·         Savings accounts

·         Brokerage accounts

·         Non-qualified annuities

·         Life Insurance with cash value

Just because I’m listing them as “after tax assets” does not mean the whole account value is free and clear of taxes. What I’m referring to is the accounts listed above typically have some “cost basis” meaning a portion of the account it what was originally contributed to the account and can be withdrawal tax fee. The appreciation within the account would be taxes at either ordinary income or capital gains rates depending on the type of the account and how long the assets have been held in the account.

Having after tax assets often provides retirees with a tax advantage because they may be able to “choose their tax rate” when they retire. Meaning they can choose to withdrawal “X” amount from an after tax source and pay little know taxes and show very little taxable income in any given year which opens the door for more long term advanced tax planning.

Withdrawal Strategies

Now that have covered all of the different types of retirement assets and how they are taxed, let move into some of the common withdrawal strategies that we use with our clients:

Retirees With All Three:  Pre-tax, Roth, and After-tax Assets

When retirees have all three types of retirement account sources, the strategy usually involves leaving the Roth assets for last, and then meeting with their accountant to determine the amount that should be withdrawn out of their pre-tax and after tax accounts year to minimize the amount of aggregate taxes that they pay long term.

Example: Jim and Carol are both age 67 and just retired and they financial picture consists of the following:

Joint brokerage account:              $200,000

401(k)’s:                                               $500,000

Roth IRA‘s:                                          $50,000

Combined Social Security:            $40,000

Annual Expenses                              $100,000

Residents of New York State

An optimal withdrawal strategy may include the following:

Assuming we recommend that they turn on Social Security at their normal retirement age, it will provide them with $40,000 pre-tax Income, 85% of their Social Security benefit will be taxed at the federal level but there will be no state tax deal, resulting in an estimated $35,000 after tax.

That means we need an additional $65,000 after-tax per year from another source to meet their $100,000 per year in expenses. Instead of taking all the money from their joint brokerage account, we could have them rollover their 401(k) balances into Traditional IRAs and then take $20,000 distributions each from their accounts which they not have to pay state income tax on because it’s below the $20K threshold.  That would result in another $40,000 in pre-tax income, translating to $35,000 after-tax.

The final $30,000 that is needed to meet their annual expenses would most likely come from their after tax brokerage account unless their accountant advises differently.  

This strategy accomplishes a number of goals:

1)      We are withdrawing pre-tax retirement assets in smaller increments and taking advantage of the New York

State tax free portion every year. This should result in lower total taxes paid over their lifetime as opposed to waiting until RMD’s start at age 72 and then being required to take larger distributions which could push them over the $20,000 annual limit making them subject in your state tax income tax and higher federal tax rates.

2)      We are preserving the after-tax brokerage account for a longer period of time as opposed to using it all to supplement their expenses which would only last for about two years and then they would be forced to take all of their distributions from their pre-tax retirement account making them subject to a higher tax liability

3)      For the Roth accounts, we are law allowing them to continue to accumulate as much as possible resulting in more tax free dollars to be withdrawn in the future, or if they pass onto their children, they are inheriting a larger assets that can be withdrawn tax free.

All Pre-Tax Retirement Savings

It’s not uncommon for retirees to have 100% of their retirement savings all within a pre-tax sources like 401(k)s, 403(b)s, traditional IRA‘s, and other types of pre-tax retirement account. This makes the withdrawal strategy slightly more tricky because if there are any big one-time expenses that are incurred during retirement, it forces the retiree to take a large withdrawal from a pre-tax source which also increases the tax liability associate the distribution.  

A common situation that we often have to maneuver around is retirees that have plans to purchase a second house in retirement but in order to do that they need to have the cash to come up with a down payment. If they don’t have any after-tax retirement savings, those amounts will most likely have to come from a pre-tax account. Withdrawing $60,000 or more for a down payment can lead to a higher tax liability, higher Medicare premiums the following year, and make a larger portion of your Social Security taxable.  For clients in the situation, we often have to plan a few year ahead, and will begin taking pre-text Distributions over multiple tax years leading up to the purchase of the retirement house in an effort to spread the tax liability over multiple years and avoiding the adverse tax and financial consequences of taking one large distribution. 

Since many retirees are afraid of taking on debt in retirement, we often get the question in these second house situations is “Should I just take a big distribution from my retirement, pay for the house in full, and not have a mortgage?” If all of the retirement assets are tied up in pre-tax sources, it typically makes the most sense to take a mortgage which allows you to then take smaller distributions from your IRA accounts over multiple tax years to make the mortgage payments compared to taking an enormous tax hit by withdrawing $200,000+ out of a pre-tax return account in a single year.

Pensions With No Need For Retirement Accounts

For retirees that have pensions, it’s not uncommon for their pension and Social Security to provide enough income to meet all of their expenses.  But these individual may also have pre-tax retirement accounts and the question becomes “what do we do with them if we don’t need them, and we expect the kids to inherit them?”

This situation often involves a Roth conversion strategy where each year we convert money from the pre-tax IRA’s over to Roth IRA’s. This allows those retirement accounts to accumulate tax free and ultimately withdrawn tax free by the beneficiaries. Versus if they continue to accumulate in pre-tax retirement accounts, the beneficiaries will have to distribute those accounts within 10 years and pay tax on the full balance.

Also when those retirees turn age 72 they have to start taking required minimum distributions which they don’t necessarily need. Since they are receiving pension and Social Security income, those distributions from the retirement accounts could be subject to higher tax rates. By proactively moving assets from a pre-tax source to a Roth source we are essentially reducing the amount of retirement assets that will be subject to RMD’s at age 72 because Roth assets are not subject to RMD‘s.

Using this Roth conversion strategy, it’s also not uncommon for us to have these retirees delay their Social Security. Since Social Security is taxable at the federal level, if we delay Social Security, it gives us more room to process larger Roth conversions because it free up those lower tax brackets. At the same time, it also allows Social Security to accumulate at a guaranteed rate of 6% - 8%. 

Nerd Note: When you process these Roth conversions, make sure you’re taking into account the tax liability that’s being generated. You have to have a way to pay the taxes on the amounts converted because the money goes directly from your traditional IRA to your Roth IRA.  Retirees that implement this strategy typically have large cash holdings, after tax retirement holdings, or we convert some of the money, and take pre-tax IRA distribution to cover the taxes.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.