The Right Way to Withdraw Money From Your Retirement Accounts During Retirement


If you've been a diligent saver, you've probably recognized the importance of having a mix of retirement accounts: a tax-deferred IRA or workplace retirement account like a 401(k), a tax-free Roth 401(k) or Roth IRA, and maybe even a taxable brokerage account. And you probably already know that one way the government "persuades" you to keep your money in your IRA and 401(k) accounts is by imposing a penalty on most withdrawals before age 59½, at which time you can begin taking penalty-free distributions.

When you're finally ready to retire and start taking your distributions, you may wonder how to do it and which accounts you should draw from first. While avoiding taxes shouldn't be your only focus — after all, you've already spent years sheltering your retirement savings — here are some basic tax strategies that can guide you during the drawdown process.

Tax-deferred savings

One of the most popular ways to save for retirement is through the use of a tax-deferred retirement account, such as a traditional 401(k) or traditional IRA. You may have the majority of your savings in these accounts. Contributions to these accounts are made on a pretax basis. This allows you to keep more of your money during the saving and investing years, with the idea being that, although you will eventually be taxed on your withdrawals, you may be in a lower tax bracket than when you contributed the money.

At age 70½, the government requires you to begin withdrawing money from these accounts and to begin paying ordinary income taxes on any untaxed contributions and earnings that you withdraw. This can create a cycle of withdrawing your required minimum distribution (or RMD) or your own determined income need, and then having to withdraw more money to cover the income taxes due, and then having to pay even more taxes on the money you withdrew to cover the taxes due. Anyone inheriting a tax-deferred retirement account will owe taxes on the money as well. (See also: What Every Retirement Saver Should Know About Required Minimum Distributions)

Tax-free savings

Another popular retirement account is a Roth IRA or Roth 401(k), and while there are some significant differences between these two accounts, the fundamental structure of how they work is the same. You contribute after-tax money to the account and, assuming you follow all the rules, your money will grow tax-free and remain tax-free even when you begin qualified withdrawals.

Unlike a traditional IRA, there are no required minimum distributions you must take from a Roth IRA at a particular age. However, a Roth 401(k) does come with RMDs, so it's worth considering rolling this money over to a Roth IRA in retirement, where it will lose the RMD requirement. (Be sure to do this before your RMDs begin because you cannot roll over any amount already required to be withdrawn in the year you're in. So, if you have $10,000 in a Roth 401(k), and are already supposed to take $1,000 as an RMD in 2018, you can roll over $9,000 into a Roth IRA, but will have to take the $1,000 RMD this year.) Because of its tax-exempt and RMD-free status, a Roth IRA can be left untouched to build completely tax-free income for yourself or your heirs for as long as you like. (See also: 3 Financial Penalties Every Retiree Should Avoid)

Taxable savings

To round out your retirement accounts, you may have used a regular taxable brokerage account to invest above yearly retirement contribution limits. When you sell investments in a brokerage account, you may still owe taxes on your earnings. If you sell investments that you've held for more than one year, earnings will be subject to long-term capital gains tax. That rate depends on your tax bracket, but is 15 percent for most taxpayers.

By contrast, when you sell investments that you've held for less than a year, any earnings are considered short-term capital gains and will be taxed at ordinary income tax rates. If your investments have lost money, you may be able to claim those losses on your tax return.

Even though funds withdrawn from your regular investment accounts are taxable, they're still valuable during your retirement years to cover any large expenses or even to pay the income taxes due on RMDs from your other retirement accounts. (See also: Where to Invest Your Money After You've Maxed Out Your Retirement Account)

The years between age 59½ and age 70½

The years between when you turn 59½ and when you turn 70½ can be crucial to your retirement plan. This is the time when qualified distributions are penalty-free, yet it's before you're actually required to take any distributions. If you've left the workforce for full retirement or are working part-time and are now in a lower tax bracket, consider taking distributions from your tax-deferred accounts to both live on and possibly to roll over into a Roth IRA, an account that does not require RMDs.

With little to no income coming in, you can withdraw from your tax-deferred and taxable accounts and pay the ordinary income taxes due at a lower tax rate, or convert some of your 401(k) or traditional IRA funds, which will also be taxable at the time of conversion, to a Roth IRA for further tax-free investment growth. Doing so can help prevent you from being in a position where you have an outsized tax-deferred portfolio from which you have to take those RMDs (or risk paying a 50 percent penalty), whether you need the money or not. (See also: 6 Age Milestones That Impact Your Retirement)

Note that while you can convert a tax-deferred account to a Roth IRA if you're not working, you cannot contribute to a Roth IRA outright unless you or your spouse are earning income from a job.

Figuring out how to spend your retirement savings can be trickier and more complicated than it was saving all of that money, but understanding the different tax implications of your various accounts can assist you in finding the strategy that works best for your situation.

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