One of the most important decisions in retirement planning is how to withdraw your retirement savings in a way that maximizes income and minimizes taxes. In this newsletter (Part 1), we will discuss the tax laws that govern retirement account withdrawals. In a subsequent newsletter (Part 2), we’ll outline a strategy based on these tax laws for determining which assets to tap and in what order. Ideally you should have three buckets of money from which to withdraw funds in retirement: 1) taxable accounts; 2) tax-deferred accounts; and 3) Roth accounts. Understanding the tax laws that govern withdrawals from each of these accounts can help optimize the use of these assets.
Withdrawals from taxable accounts are subject to capital gains tax. The realized capital gains on assets held for one year or less are taxed as ordinary income, while realized gains on assets held longer than one year are taxed at the lower long-term capital gains tax rate. As a general rule, it is better to sell long-term capital gain assets from your taxable accounts for retirement income before withdrawing assets from tax-deferred accounts, which are presently taxed at a higher rate. An exception to this rule may apply if your primary objective is to leave assets to your heirs. Under current law, the deferred tax liability from embedded capital gains is forgiven at death, referred to as a step-up in cost basis. As a result, your beneficiaries can sell inherited taxable assets soon after they are received and owe little or no capital gains tax. This powerful incentive for holding onto your taxable assets has been referred to as "free life insurance from the IRS."
Traditional Tax-Deferred Accounts (Traditional IRAs, 401k and 403b Accounts)
Withdrawals from traditional tax-deferred accounts are taxed as ordinary income. Any withdrawal from these accounts before age 59½ is considered an early or premature distribution by the IRS resulting in a 10% early withdrawal penalty, unless an exception applies. There is a golden period between ages 59½ and 70½ when you can withdraw as much or as little as you like from traditional tax-deferred accounts without penalty, although these withdrawals are still taxed as income. Beginning at age 70½, tax-deferred accounts are subject to required minimum distributions (RMDs). Failure to take these withdrawals in the specified time frame results in a 50% excise tax on the amount not distributed as required. By waiting until age 70½ to withdraw money from these accounts, you can prolong the period of tax-deferred growth and delay paying income tax until you are potentially in a lower tax bracket, although this strategy could be undermined if future tax rates go up.
Roth Accounts (Roth IRAs, Roth 401k/403b Accounts)
In some ways, this is your most valuable bucket since these assets not only grow tax-free but are also tax-free upon withdrawal. By delaying your Roth account withdrawals, you can maximize their growth potential. Once you are past age 59½, you can generally avoid an early withdrawal penalty, although there is an additional stipulation that Roth accounts must be held at least five years before you can withdraw earnings without penalty, regardless of your age. This rule applies specifically to investment earnings; after-tax Roth contributions can be withdrawn any time without penalty.
While Roth 401k and 403b accounts are subject to required minimum distributions beginning at age 70½, Roth IRAs have no RMDs until after the death of the account holder. It can therefore be advantageous to roll your Roth 401k/403b assets into a Roth IRA when you retire. However, it is important to be aware of a tricky little IRS rule which specifies that the holding period of a Roth 401k/403b rollover does not carry over. If you roll these assets into a new Roth IRA, you have to wait an additional five years to avoid the early withdrawal penalty on earnings. This waiting period can be avoided, however, if you roll the assets into an existing Roth IRA that is at least five years old.
Based on the above tax rules and your own unique financial goals and circumstances, a retirement withdrawal strategy can be developed to optimize the use of your retirement assets while minimizing taxation. A general set of retirement distribution rules based on these tax laws will be presented in a subsequent newsletter.
As always, please feel free to contact me if you have any questions.
Jeffrey J. Brown, MD MBA CFA CFP®
Principal, Shearwater Capital