When it comes to retirement planning, a common question
these days is “in light of all that’s going on, how should I take my retirement
drawdowns?” By “going on,” consumers are mainly referencing the potential
increase in income taxes and concerns with the future of Social Security. Add
the recent spate of early retirements due to the pandemic, and there’s a
heightened interest in how best to effectively draw down retirement
capital.
The answer to the pressing retirement planning question is
that it depends on individual circumstances, but a way to start the process is
to determine where you plan to be in terms of taxable income at retirement. The
admittedly overgeneralized strategies below can serve as a starting point for
further inquiry:
If you anticipate having relatively low taxable income in
retirement, you should withdraw from your Individual Retirement Accounts (IRAs)
first, your after-tax investments next, and your tax-exempt Roth IRAs last.
If you are affluent, a starting point is to take IRA
withdrawals up to the top of your current income tax bracket, withdraw
after-tax investments next, and distribute your tax-exempt Roth IRAs last.
If you are wealthy, begin by withdrawing your tax deferred
IRAs first and then drawdown a combination of your tax-exempt Roth IRAs and
after-tax investments last.
For all levels of retirement income, the best approach for
filing for Social Security is generally to wait as long as possible, ideally
until age 70.
This odd sequence of drawdowns from one demographic group to
the next is attributable to the interworking of different tax-based variables.
By drawing down from one account, you may be able to permanently lower the
taxes on another. It’s important to understand that your particular
circumstances can quickly detour you from these general strategies. You may be
expecting a unique spike in income in a particular year, anticipating special
expense needs at a specific time, or foreseeing longevity concerns that change
the trajectory of your anticipated retirement. So, start with these rules of
thumb, and then adapt as your particular situation dictates.
Let’s begin by focusing on individuals who expect to be in
comparatively low-income levels in retirement. In future posts we will consider
higher income retirees.
Starting The Process For Low-Income Retirees
2021 is a year where prospective retirees are worried about
the future of Social Security benefits and the prospect of increased taxes. For
low-income retirees, both issues are legitimate concerns, but they are not a
reason to radically change strategy.
First, even though existing funding is an existential threat
to continuing Social Security benefits at current levels, taking a “get it
while you can” approach is unlikely to pay off. From a political standpoint,
reducing benefits for low-income individuals who are at or near retirement
would be wildly unpopular. To be safe, however, you might assume a haircut in
the benefits you expect to receive, but it’s unlikely that you’ll lose by
waiting to claim your benefits. As for the issue of income tax increases, it
currently appears that higher-income individuals are the more likely target for
added taxes. Still, because taxes may increase in general, using Roth IRAs in
retirement income planning makes more sense than ever.
According to a 2019 Gallup poll, 57% of retirees rely on
Social Security as a major source of income, and for those who will rely on it
as the primary source of retirement income, the issues of drawdown strategies
are largely moot – as there will be little in other income sources from which to
draw down. If, however, you anticipate additional retirement funds – say, a
roughly $50,000 minimum of before-tax income in retirement – the order you use
for drawing your excess savings can make a difference in your net retirement
income.
You should start by asking yourself some baseline questions.
First, do you anticipate your expenses in retirement will be in-line with your
anticipated income? For example, do you expect your Social Security, 401(k)
income and investment returns to be enough to support your necessary and
discretionary expenses? If not, your retirement focus should be more on
increasing income or reducing expenses than on the order of withdrawals to
take.
If, however, your anticipated retirement income and expenses
reasonably line up, the order in which you draw from these accounts can
significantly affect the amount of after-tax income you can enjoy each year.
For determining the order of drawdowns, use this process as a guide:
1. First, assess
how much of your anticipated retirement income will be derived from Social
Security, tax deferred accounts (such as IRAs and 401(k)s), tax-exempt Roth IRA
accounts, and after-tax accounts (CDs, and stock and bond mutual funds, etc.).
The likely mix of these accounts can be a moving target, but it helps to have
an initial idea of the sources of your retirement income.
2. Plan to defer
filing for Social Security for as long as possible. The advantages of this
strategy for low-income retirees are particularly compelling. Primary among these
is that you increase your benefit by approximately eight percent for each year
you wait, plus the benefit has a cost of living feature that will come in handy
later in life. There are more subtle considerations as well. For example, you
can lessen or even avoid the Social Security tax torpedo by using other
retirement income sources first, allowing you to escape having your benefit
lowered by the Social Security earnings test. Additionally, if you’re married,
delayed filing for the highest earning spouse assures that the surviving spouse
will maximize his or her benefit.
3. Next, consider
the level of taxable income you will have in retirement. Though it may sound
counter-intuitive, if you anticipate that you will be in a low tax bracket, you
should first draw retirement income from your tax-deferred IRAs and 401(k).
You’ll be paying tax on these accounts at a low marginal tax bracket and, at
the same time, depleting your tax-deferred accounts for the future. When you
finally start taking Social Security, you can then start withdrawing from your
after-tax investments to supplement your income. This strategy will keep your
provisional income for Social Security purposes low, avoiding some or all of
your Social Security payments from being subject to income tax. While this
strategy may increase income taxes a little in the early years of retirement,
you will save a lot in overall retirement taxes over time.
4. By drawing down
your tax-deferred accounts early in retirement, you also avoid being forced to
take required minimum distributions (RMDs) at age 72. By this age, you may have
lowered your IRA balance and might even be drawing down from your after-tax
investments. To the extent you need further income at that time, you can begin
to take distributions from your tax-free Roth IRA account.
5. If you have
retirement assets left over at your death, employing the above strategies will
mean your remaining savings will likely reside in after-tax investments and/or
tax-free Roth accounts. Both of these asset locations translate to a
tax-advantaged legacy for your heirs.
Make Drawdowns A Part Of Your Plan
Creating your drawdown strategy for retirement should not
exist independent of other retirement planning considerations. First and
foremost, you should ensure that you’ve adequately addressed retirement risks
such as health insurance, long-term care, and the risk of living too long.
Further, you should coordinate your overall investment strategy with your
intended drawdown approach. Work on both your asset location and asset
allocation – this likely means concentrating high-taxed investments such as
bank accounts, bonds and rentals in your tax-deferred IRA account while placing
capital gain and dividend paying securities in your after-tax account.
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