When people think about planning for retirement, they most often think about investing: how much they should put aside for retirement, and what type of account or accounts that money should be spread across. But when planning for your retirement, coming up with a savings strategy is only half of the equation — the other half is figuring out how to efficiently spend it.
Retirement income planning — identifying which accounts you’ll draw your income from, how much, and when — can help you minimize your tax liability, grow your investments, and ultimately make your savings last longer. So if you haven’t already thought about how you’ll be sourcing your retirement spending, it’s high time to start.
Below, we’ll share some different withdrawal strategies, who they’re right for, and what their pros and cons are.
Tips for Making the Most of Your Retirement Savings
What options do you have when it comes to retirement income planning, and what options might you want to consider? Read on for our top 6 tips:
1. Maximize Your Retirement Savings with the Right Account Choice: Taxable, Tax-Deferred, or Tax-Free?
A taxable brokerage account is set up for investing securities, including stocks, bonds, and mutual funds. The reason this brokerage account is referred to as taxable is you may have to pay taxes on realized investment capital gains and dividends or interest earned.
Tax-deferred accounts, such as an Individual Retirement Account (IRA) and Traditional 401(k) or 403(b), are utilized for retirement savings. Contributions are tax-deductible in the tax year you make them. Taxation is deferred until you withdraw the money, meaning you do not pay capital gains or income taxes on any of the earnings. You pay ordinary income taxes on distributions in retirement.
Tax-free accounts, such as a Roth IRA and Roth 401(k) or 403(b), have similar tax advantages as tax-deferred accounts. There are distinct differences with benefits. Since Roth account contributions are funded with after-tax money, you will not capture an up-front tax deduction in the tax year of contributions. Your investment earnings grow tax-free, and withdrawals of earnings may be made tax-free, provided you are age 59 ½ or older and have met the required 5-year holding period.
2. The Benefits of Withdrawing From Taxable Accounts
It is important to have a variety of account types (tax-deferred, taxable brokerage, tax-free) to fund withdrawals during your retirement years. Investing in a taxable brokerage account can provide tax diversification. By using multiple account types with varying taxation, investors can have more flexibility in the timing and taxation of withdrawals. Blending these withdrawals from different account types, while managing tax implications, can be an effective way to meet retirement spending needs.
Withdrawing income from taxable accounts, such as brokerage accounts, can be a particularly good retirement income planning strategy for early retirees who are not yet compelled to withdraw Required Minimum Distributions (RMDs)–typically, these kick in April 1st the year after you turn 73. The more you draw from a taxable account, the less you’ll need to draw from your tax-advantaged accounts, allowing the funds within them to continue growing.
Long-term gains on investments sold from taxable accounts are taxed at the 0%, 15%, or 20% capital gains rate. For many retirees, this rate is lower than their federal income tax rate. Accordingly, a taxable brokerage account may be a better choice for workers or retirees in higher tax brackets compared to traditional IRAs, where withdrawals are taxed as ordinary income.
3. Withdrawing Proportionate Amounts from Taxable, Tax-Deferred, & Tax-Free Accounts
If you don’t have enough funds in taxable accounts to draw an income from them alone, you might consider withdrawing proportionate amounts from taxable accounts, tax-deferred accounts such as traditional IRAs and 401(k)s, and tax-free accounts such as Roth IRAs and Roth 401(k)s.
Note that you will have to pay taxes on the withdrawals you make from the tax-deferred accounts. Withdrawals from retirement accounts are taxed as ordinary income, meaning they can be taxed at a rate of up to 37% at a Federal level and may be subject to state taxes as well. However, you can keep your tax bill to a minimum by balancing the withdrawals from your tax-deferred account with withdrawals from your taxable and tax-free accounts.
4. Aim for your RMD and no more!
If you have already hit the RMD age, you may want to consider withdrawing the lowest amount possible so that you can a) continue to allow the funds! in your retirement accounts to grow and b) keep your tax bill to a minimum. The IRS has some worksheets that can help you calculate what your minimum compulsory RMD will be.
If your expenses exceed what these minimum withdrawals can cover, you’ll likely want to turn to your after-tax assets that won’t incur taxation upon withdrawal, like a Roth IRA or a brokerage account.
5. How a Tax-Favorable Gifting Strategy Can Help Reduce Your Heirs’ Tax Burden
Another part of retirement income planning is not just figuring out how to withdraw your own income in retirement, but also how you will gift your wealth in the event of your passing. Chiefly, you’ll want to consider the tax situation of your heirs in order to determine which type of assets would be most beneficial to leave them. If your heirs pay a higher tax rate than you, it’s probably best to leave them taxable or tax-free assets such as Roth IRAs — in which case, you’d likely want to withdraw from tax-deferred assets for your own spending so your heirs can enjoy the appreciation from your taxable or tax-free assets.
6. How to Identify the Best Time to Start Collecting Social Security
You can start collecting Social Security as early as 62 years old, which can be helpful in reducing your reliance on your investment portfolio, enabling those funds to continue growing undisturbed. Every dollar that you get from Social Security is a dollar that you don’t have to withdraw from your private savings, after all.
This strategy, however, is not without its drawbacks. For one, you won’t be able to draw your full benefits until you reach your full retirement age. Receiving Social Security benefits below your Full Retirement Age may result in a permanently reduced monthly benefit for life. But what’s more, waiting to withdraw your benefits until 70 years of age actually increases your benefit amount, which can net you thousands of additional dollars in the long run.
The right age for you to begin collecting social security payments is a personal decision that is highly dependent on earnings history, family longevity, and health.
Find the Right Retirement Income Planning Strategy for You
While the tips above can work great for some individuals in some situations, they won’t necessarily be a fit for everybody. The optimal strategy for you as an individual depends on factors like your income, your expenses, your savings, and your estate plan, among others.
Your retirement income planning strategy certainly shouldn’t be based on anything less than a fully-informed decision — the wrong option can result in large tax bills, running through your funds more quickly than you’d like, or burdensome estate taxes for your heirs. So make sure to work with a qualified financial professional who understands your finances, goals, and the financial implications of all possible spending options.
If you’re looking for assistance with your retirement plan — or anything else related to personal finances, for that matter — the professionals at Team Hewins are here to help. Schedule a free consultation with one of our knowledgeable, CERTIFIED FINANCIAL PLANNERS™ professionals today!