4 Tips to Optimize Your Retirement Account Withdrawals (And Reduce Taxes)
From: smartasset.com
This is how to make sure your savings lasts the longest.
If you’re planning to retire within the next few years, you’ve undoubtedly considered when you should start making withdrawals from your retirement accounts.
However, the order in which you withdraw from your accounts is also important — it could let your tax-advantaged accounts grow to their full potential, make your savings last and even save you money on taxes.
Throughout this guide, we’ll look at generic examples to give you an idea of how to start withdrawing from your investments, your 401(k)/traditional IRA and your Roth IRA, as well as when to begin accepting Social Security.
To make this guide as straightforward as possible, we’ll assume you’re above age 59.5. If you withdraw from most retirement accounts before then, you’re subject to paying tax on the additional income, as well as up to a 10% early withdrawal penalty.
Regardless of when you retire, once you hit age 70.5, you’ll be subject to required minimum distributions (RMDs — the amount you’re required to withdraw from your retirement accounts each year) from most retirement accounts.
The Optimal Order to Withdraw From Your Retirement Accounts
First things first: This is not meant to serve as a one-size-fits-all approach for everyone. Figuring out a strategy that works best for your specific situation is complicated and personal.
To make sure you get the best advice possible, we recommend speaking with a financial advisor. These experts can help you analyze your accounts and determine the best way to allocate your savings withdrawals as you age. In many cases, they can keep you from making simple mistakes that could result in higher taxes and fees.
If you want to get matched with an advisor to optimize your retirement-savings plan, try our simple financial advisor matching tool. All you have to do is answer these few questions and we’ll match you with as many as three advisors in your local area.
1. Start With Your Investments
By withdrawing from your investments first, you’re giving your retirement accounts more time to compound interest and keep growing.
Whether you have mutual funds, a brokerage account, ETFs, stocks or bonds, they’re all taxable, so you’ll have to pay capital gains taxes on any withdrawals. Additionally, some investments also require you to pay taxes on distributions each year, like some mutual funds. Therefore, it makes sense to use the money in these accounts first.
If you can get by on what’s in these accounts first, it allows your money in other tax-advantaged, interest-accruing accounts to keep growing, without you having to pay tax on their growth each year.
This step is especially important if the money can carry you until you turn 70 ½, when you have to start taking RMDs from your retirement accounts.
Here’s an example: Let’s say your investment portfolio has $100,000 in it (and started as $1,000 — nice gains!). Assuming you’ve had the investment for longer than a year, you’ll be assessed the long-term capital gains rate of 15%. At this rate, you’d pay $14,850 in taxes (plus applicable state and local taxes — so about $25,046 if you live in New York City).
Obviously, the more valuable your investments, the more you’re likely to pay in capital gains tax. However, this tax burden could be offset by the growth that’s still occurring in your other retirement accounts that you’ve yet to tap into.
For comparison: While not advisable, if you have $500,000 in your 401(k) and were to take out $100,000 at 65, it’d be taxed as income. Assuming it’s your only source of income (which is unlikely), you’d pay just under $24,000 in tax, technically less than the capital gains tax.
However, if you were to leave the $500K in your account and make no more contributions to it, the balance could grow to over $700,000 by the time you turn 70 (at a 7% rate of return). Basically, your account will miss out on the chance to keep compounding interest and growing until you have to start taking RMDs.
A financial advisor can help guide you through the best way to withdraw from your portfolio in the most tax-efficient way and further explain the benefits of letting your 401(k) continue to grow.
