After retirement, you're likely to find your retirement savings include several different vehicles, which might include 401(k) plans, individual retirement accounts (IRAs), profit-sharing plans, and taxable investments designated for retirement. When withdrawing funds, you need to decide the order in which to tap those accounts. Withdrawing your funds in the most tax-efficient manner can add years to their life, thus increasing your lifetime withdrawals. Typically, you'll want to consider this strategy:
- First, withdraw funds from taxable investments designated for retirement. You don't pay taxes on your principal or on any dividends or interest, since taxes were already paid on those sums. Capital gains taxes will be due on capital gains, but as long as you've held the asset for over a year, that tax rate is 15% (5% for those in the 10% or 15% tax bracket), which is likely to be lower than your ordinary income tax rate. When deciding which assets to sell, consider those with lower capital gains.
- Next, make withdrawals from your tax-deferred investments, including 401(k) plans and traditional IRAs. If some of your traditional IRAs were funded with nondeductible contributions, withdraw those first, since a portion of your withdrawal won't be taxed. Withdrawals from these accounts are subject to ordinary income tax rates. Keep in mind that you'll typically need to start taking minimum required distributions by age 70 1/2. The only exception is that those still working can delay distributions from qualified plans (not IRAs) until retirement.
- Last, use funds in your Roth IRA. Since those funds grow tax free, let them continue to grow as long as possible. You may even want to convert all or a portion of your traditional IRAs to a Roth IRA. Even though you'll have to pay income taxes on the taxable portion when you convert the balance, your funds will grow on a tax-free basis. Since you aren't required to take minimum required distributions from a Roth IRA after age 70 1/2, this option may be more appealing to those who don't need the funds for retirement and are interested in tax-advantaged ways to transfer those assets to heirs.
Of course, your specific situation may dictate a different method of withdrawal. For instance, it may make sense to use your tax-deferred accounts first if your assets have very large capital gains. You may want to bequeath the assets with large capital gains to your heirs so that the asset's basis will be stepped up to market value after your death. Or, in years with low income, you might lose some of your itemized deductions or personal exemptions unless you make withdrawals from your tax-deferred accounts to recognize additional income for tax purposes. Individuals in high marginal tax brackets with large tax-deferred balances may find it makes more sense to spread out withdrawals from these accounts to minimize lifetime tax payments.
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