By Christine Fahlund on May 8, 2012
For decades, the foundation of your financial life likely has been your income—and the amount you earned was at the center of most financial decisions, from spending to saving. The situation changes entirely in retirement: Once you leave the workforce, you have to make important decisions about how to draw upon the money you saved during your working years. Those decisions, along with the combination of accounts you hold with different tax treatments, will help determine whether the assets you've carefully accumulated over your lifetime will last you throughout retirement.
Planning how much of your savings to withdraw can be challenging, in both practical and emotional terms. The psychological effect of converting from saving to spending can be difficult. Although some investors may be cautious about drawing down savings they've spent their lives building up, there is a logical approach to the process that can increase the likelihood of preserving assets over time.
When saving for retirement, you may own three primary types of accounts: taxable, tax-deferred, and tax-free. Dividing your investments among these accounts potentially provides you with more flexibility and control over your taxes in retirement.
You save after-tax dollars and pay ordinary income tax each year on any interest payments and nonqualified dividends and capital gains taxes on qualified dividends and the sale of appreciated securities.
Contributions to Traditional 401(k)s, 403(b)s, and Traditional IRAs usually are deductible and not included in taxable income in the year that they are made. But withdrawals of pretax contributions and any associated earnings in the account generally will be taxed at ordinary income tax rates
Contributions to Roth IRAs and employer Roth accounts—Roth subaccounts within 401(k)s, 403(b)s, and (as of 1/1/11) governmental 457 plans—are made with after-tax dollars, and withdrawals of contributions and any associated earnings can be income tax-free (certain rules apply).
There's another important difference among the various account types. Traditional IRAs and employer-sponsored plans (both Traditional and Roth accounts) require you to withdraw a minimum amount—your required minimum distribution (RMD)—each year, generally beginning by April 1 of the year after the year you reach age 70½. Roth IRAs and taxable accounts do not have this requirement.
Having multiple options for income withdrawals in retirement may help you minimize the taxes you pay in a given year, while maximizing the long-term benefits of the tax-deferred and tax-free accounts you own. However, this isn't to suggest that you need to change your strategy every year to save additional tax dollars. Under most circumstances, we encourage investors to follow a specific withdrawal strategy.
After you've retired, you face a pressing question: How much can you withdraw from your accounts each year without risk of depleting your money prematurely? An effective approach is to use the "4% rule," which sets the withdrawal in your first retired year at no more than 4% of your retirement accounts, if you anticipate a 30-year retirement. Each year thereafter, you can maintain your purchasing power by increasing your withdrawal amount by an assumed rate of inflation—typically about 3% a year. For example, say you retire with $1 million in savings. You could withdraw 4% of that amount, or $40,000, in your first year of retirement. In year two, you could adjust for inflation by drawing 3% more, for a total of $41,200. The 4% rule has the virtue of simplicity. Consider reviewing your status annually to ensure that you are still "on track" with your strategy. For assistance, use our Retirement Income Calculator.
Generally, there is an order in which to take retirement withdrawals that can be financially beneficial. In fact, applying this strategy may make a significant difference in the after-tax income you'll receive—and how long your investments ultimately last. The following sequence provides a good starting point.
If you are retired and still under age 70½, sell investments from your taxable accounts first. This approach allows you to leave assets in your tax-deferred accounts longer, which maintains the tax-advantaged treatment of those assets and provides additional time for tax-deferred growth potential.
Once you reach age 70½, you will have to begin your withdrawal sequence by taking any RMDs from your employer-sponsored plans and Traditional IRAs.1 If you don't take these withdrawals, you'll pay a tax penalty equal to 50% of the difference between your RMD and any amount you did withdraw. If you require a larger withdrawal than your required minimum amount, you may want to consider taking the balance needed from your taxable accounts. Again, this strategy enables you to maintain the tax-deferred status for as long as possible.
Next, turn to your tax-deferred accounts. If you are married, start by first taking withdrawals from the accounts of the older spouse. This strategy allows you to maximize the years of tax deferral available to you as a couple.
Leave your Roth IRA for last. By leaving your tax-free Roth IRA untouched for as long as possible, you may be able to maximize the after-tax money available to you. Remember that with your Roth IRAs, you are not required to take any minimum distributions, which enables any growth to continue over the course of your retirement. This can provide you with a potentially large, tax-free income source for your later years, when you may need additional money to cover medical and long-term care expenses. In addition, Roth IRAs can be a significant estate planning tool if you won't need the income from these assets during your lifetime. Your beneficiaries will be eligible to transfer the assets they inherit from the account to inherited Roth IRAs, enabling them to continue the potential growth of the assets tax-free over time. However, beneficiaries of Roth IRAs are subject to RMDs.
Continuing employment to at least age 65 or older and delaying your retirement account distributions provides several long-term advantages for retirees. If you aren't yet eligible for Medicare benefits, you or your spouse maintaining employer-provided health benefits for you until age 65 can save you a significant amount of money. You may also be able to add to your nest egg during these years. But even if you don't make additional contributions to retirement, every dollar you make during these years is a dollar you won't need to pull out of retirement savings to cover living expenses. That money potentially can continue to grow, helping to support the retirement lifestyle you've been planning.
In addition, working longer may enable you to delay taking Social Security benefits. Every year you wait to take benefits increases your initial payment from Social Security by about 8%, plus a possible inflation adjustment, up to age 70. As a result, your benefit at age 70 could have almost twice the buying power as the amount you could have received if you had started at age 62. And in terms of actual dollars, the amount could be considerably more than double, thanks to adjustments in most years for inflation.
Just as no one knows what the markets will do in the future and how any fluctuations might affect your finances, no one can be sure what changes there will be to the tax code in the years ahead. For this reason, holding assets in each type of account can help you prepare for the uncertainty that lies ahead during your drawdown years.
Also, depending on your personal circumstances, in some years you may want to deviate from the suggested withdrawal sequence described above. For example, you may benefit in certain situations by structuring your withdrawals in retirement in a way that would enable you to avoid relatively high marginal tax brackets.
For instance, suppose you are single, have just retired, and would like to withdraw $45,000 from your investments in 2012. (This example assumes that you are receiving other income up to the amount of any deductions or exemptions for which you qualify, and that the Roth IRA withdrawal is a qualified, tax-free distribution. The federal tax rates used in this example are hypothetical. You also will need to factor in your state taxes and regulations, which vary.)
Assuming you have contributed to a Traditional IRA and a Roth IRA, and you have no investments in a taxable account, consider the following strategy:
You withdraw $34,500 from your Traditional IRA and the remaining $10,500 from your Roth IRA. This strategy would allow you to remain in the 15% marginal income tax bracket. Your total tax would be $4,750, with $40,250 to spend after tax.
|Account Type||Withdrawal Amount x Tax Rate||Taxes Paid|
|$8,500 x 10%||$850|
|$26,000 x 15%||$3,900|
|Roth IRA||$10,500 x n/a||$0|
Regardless of your choice of withdrawal strategy, there are always trade-offs that must be made. There is no one-size-fits-all strategy. At any given time in retirement, the appropriate investment withdrawal strategy for you will depend on your individual situation. Holding a tax-diverse collection of accounts gives you the flexibility to tailor your strategy to your personal circumstances.
Beginning in 2010, new tax regulations allowed all investors to make full or partial conversions from a Traditional IRA to a Roth IRA. With the significant benefit of tax-free withdrawals, Roth IRAs provide you with the greatest flexibility of all retirement accounts. If you are still accumulating assets for retirement and have money in a Traditional IRA, you may want to consider converting some or all of it to a Roth IRA. To do so, however, you will be paying taxes before otherwise being required to do so. Below are some factors to consider when deciding whether to perform a conversion.
Your Tax Situation
If you are concerned about being in a higher tax bracket upon retirement, it may make sense for you to pay taxes now at a potentially lower rate. Be careful, however, that the Roth IRA conversion will not push you into a higher tax bracket now, increasing the tax bill you will owe.
Paying Taxes Due on Conversion
Consider whether you have sufficient funds available to pay the tax on the conversion. In general, it makes sense to pay any tax from an account other than your retirement investments so that you can take full of advantage of the tax-deferred and tax-free growth potential they provide. However, if you don't have those extra funds for paying the taxes and if you are not planning to tap your Roth IRA anytime soon, you might consider taking a withdrawal of principal from the same Roth IRA (an early withdrawal penalty may apply) to pay the taxes. This approach would result in a lower balance in the Roth, but with future opportunities for the assets to grow, without being subjected to RMDs and without paying taxes on any distributions from the account thereafter, assuming certain requirements are met.
Your Time Horizon
A Roth IRA conversion may be a good idea if you expect to hold the assets in the account for several decades. That means younger investors with more time until retirement may find conversions more beneficial than older investors who are closer to taking distributions. But if it is likely that when you retire you will leave these assets to your heirs, converting could still be very beneficial.
T. Rowe Price (including T. Rowe Price Group, Inc., and its affiliates) and its associates do not provide legal or tax advice. Any tax-related discussion contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i.) avoiding any tax penalties or (ii.) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this article.