Rosalind Evans
This article presents a typical sequence to determine which account to withdraw from during your golden years.
When was the last time you consulted a physician in a state of panic, only to be advised, “Hydrate, get plenty of rest and, above all, wash your hands!”? The analogies in personal finance often look like this: “Set aside 15% of your salary. Maintain an emergency fund. Steer clear of credit card debt.” However, none of this well-known wisdom pertains to extracting your hard-earned money from your retirement savings. This article aims to shed light on that subject.
In the following sections, I’ll propose a typical sequence to determine when to withdraw from your retirement accounts. It’s worth noting that there are significant exceptions to these general guidelines which should be addressed.
Cash
Assuming you have an emergency fund equivalent to six months of expenses, cash is your first go-to for income during retirement. For instance, if your monthly expenses amount to $10,000 and you have $100,000 saved in the bank, your first $40,000 should come from cash or cash equivalents.
There are two significant reasons for this: growth and taxation. Over an extended period, cash grows slower than most other assets. You’d want you faster, albeit riskier, investments to have the opportunity to succeed. Utilizing money first facilitates this.
Additionally, initially extracting from cash will lower your taxes during your early retirement years. This could enable you to transfer money from a traditional IRA or any pre-tax account into a Roth IRA at potentially lower rates than you might pay later.
Taxable accounts
Once you’ve depleted your cash to the level of your emergency fund, it’s time to draw from your taxable investments. These encompass individual, joint, and revocable trust accounts.
Similar to the previous cash example, this decision is mainly tax-driven. If held for over a year, withdrawals will likely be taxed at more favourable long-term capital gains rates. Also, since these accounts are not tax-deferred, all things being equal, they will grow slower than a retirement account.
Social Security
Here’s where it gets a bit complicated. I’m not suggesting that you immediately claim Social Security once you’ve exhausted your taxable accounts. There are breakeven points based on lifespan and tax and legacy considerations.
Social Security retirement benefits can be claimed as early as age 62 and are fully realized at 70. The Social Security Administration provides a significant increase for each month you postpone claiming. Thus, if your objective is to maximize income, the longer you delay, the better.
Pre-tax retirement accounts
This includes traditional IRAs, 401(k)s, 403(b)s, 457s, SEP IRAs, etc. All the accounts where you have not yet paid income tax. These accounts are tax-deferred and will be taxed as income upon withdrawal. As a result, deferring for as long as you can often works best. However, the IRS will inevitably come to collect. The chart below displays the latest age you can defer when taking required minimum distributions (RMDs).
Roth accounts. Roth accounts grow tax-free, and qualified withdrawals are tax-free. Aside from a health savings account, this is likely the most tax-efficient savings method. Consistent with the previous examples, you’d want the most efficiently growing vehicles to accumulate for the most extended period. Furthermore, Roth IRAs under the SECURE Act have emerged as incredibly effective tools for transferring wealth. Not only are distributions tax-free for beneficiaries but withdrawals can typically be deferred for a decade beyond your passing.
Make sure to distinguish the SECURE Act from the SECURE 2.0 Act, which abolished the cumbersome minimum distribution rules (referenced in the chart above) for all Roth accounts. Consequently, you can never withdraw from these accounts, allowing your children to benefit from your savvy tax planning. But then again, where’s the enjoyment in that?
To conclude, navigating your retirement savings and deciding the order of withdrawal doesn’t have to be intimidating. By understanding the nature and benefits of each account and the tax implications involved, you can maximize your retirement income and continue to enjoy the fruits of your years of hard work. However, remember that individual circumstances may vary, and it’s always a good idea to consult with a financial advisor to make the most informed decisions. Happy planning for a secure and enjoyable retirement!
