During your working years, you've probably set aside funds in retirement accounts such as Individual Retirement Accounts (IRAs), 401(k)s or other workplace savings plans, as well as in taxable accounts. Your challenge during retirement is to convert those savings into an ongoing income stream that will provide adequate income throughout your retirement years.
Setting a withdrawal rate
The retirement lifestyle you can afford will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. The annual percentage that you take out of your portfolio, whether from income only or both income and principal, is known as your withdrawal rate.
Figuring out an appropriate initial withdrawal rate is a key issue in retirement planning and presents many challenges. Why? Do you know how long you will live? Do you know whether you will require assistance—medical or otherwise? How will your investments perform? Your withdrawal rate is especially important in the early years of your retirement, as it will have a lasting impact on how long your savings last.
One widely used guideline on withdrawal rates for tax-deferred retirement accounts (IRA, 401(k), 403(b)) states a withdrawal rate of 4% annually from a balanced portfolio of large-cap equities and bonds would provide inflation-adjusted income for at least 30 years. However, more recent studies have found that this guideline may be oversimplified. The general trend has been for longer, more active retirement years. Individuals may not be able to sustain a 4% withdrawal rate, or may even be able to support a higher rate, depending on their individual circumstances. The bottom line is that there is no standard guideline that works for everyone. Your withdrawal rate needs to take into account many factors, including, but not limited to, your current and future asset allocation and projected rate of return, annual income targets (accounting for inflation), investment horizon, legacy goals, tax bracket and life expectancy.1
Which assets should you draw from first?
You may have assets in accounts that are taxable (e.g., CDs, mutual funds), tax deferred (e.g., traditional IRAs), and tax free (e.g., Roth IRAs). Given a choice, which type of account should you withdraw from first? The answer is—it depends.
For retirees who don't care about leaving an estate to beneficiaries, the answer is simple in theory: withdraw money from taxable accounts first, then tax-deferred accounts, and lastly, tax-free accounts. By using your tax-favored accounts last, and avoiding income taxes as long as possible, you'll keep more of your retirement dollars working for you. But are you tempting fate—assuming your RMDs won’t push you into a higher tax bracket in the future?
For retirees who intend to leave assets to beneficiaries, the analysis is more complicated. You need to coordinate your retirement planning with your estate plan. For example, if you have appreciated or rapidly appreciating assets, it may be more advantageous for you to withdraw from tax-deferred and tax-free accounts first. This is because these accounts will not receive a step-up in basis at your death, as many of your other assets will. This strategy could impact not only your income taxes but your future Medicare premiums.
However, this may not always be the best strategy. For example, if you intend to leave your entire estate to your spouse, it may make sense to withdraw from taxable accounts first. This is because spouses may be given preferential tax treatment with regard to qualified retirement plans. A surviving spouse can roll over retirement plan funds to his or her own IRA or retirement plan, or, in some cases, may continue the deceased spouse's plan as his or her own. The funds in the plan continue to grow tax deferred, and distributions need not begin until the spouse's own required beginning date.
The bottom line is that this decision is also a complicated one. A financial professional can help you determine the best course based on your individual circumstances.
Certain distributions are required
In practice, your choice of which assets to draw first may, to some extent, be directed by tax rules. You can't keep your money in qualified tax-deferred retirement accounts forever. The law requires you to start taking distributions—called required minimum distributions or RMDs—from traditional IRAs by April 1 of the year following the year you turn age 72, whether you need the money or not. For employer plans, RMDs must begin by April 1 of the year following the year you turn 72 or, if later, the year you retire. Roth IRAs aren't subject to the lifetime RMD rules. (Beneficiaries of either type of IRA are subject to different distribution rules.)
If you have more than one IRA, a required distribution is calculated separately for each IRA. These amounts are then added together to determine your RMD for the year. You can withdraw your RMD from any one or more of your IRAs. (Your traditional IRA trustee or custodian must tell you how much you're required to take out each year, or offer to calculate it for you.) For employer retirement plans, your plan will calculate the RMD and distribute it to you. If you participate in more than one employer plan, your RMD will be determined separately for each plan.
It's important to take RMDs into account when contemplating how you'll withdraw money from your savings. Why? If you withdraw less than your RMD, you will pay a penalty tax equal to 50% of the amount you failed to withdraw, plus the income tax when you do withdraw it. The good news: You can always withdraw more than your RMD amount.
Through years of experience, extensive training and continuous study, the team at Busey Wealth Management uses its knowledge to maximize your greatest resource in retirement—time. To learn more about our retirement planning services, visit busey.com/wealth-management.
1 "The State of Retirement Income: Safe Withdrawal Rates," Morningstar, 2021
This is not intended to provide legal, tax or accounting advice. Any statement contained in this communication concerning U.S. tax matters is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties imposed on the relevant taxpayer. Clients should obtain their own independent tax advice based on their particular circumstances.
This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
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