Scenario 1: Pretax vehicles
In this scenario, Bankrate's hypothetical couple has invested all $600,000 of their nest egg in a traditional, pretax 401(k) plan and traditional IRA, or they have a traditional pension plan with annuity payments.
"This scenario has the least number of moving parts and leaves little opportunity for planning. When all your retirement savings is pretax, income over and above Social Security simply comes from your IRA," says Rob O'Blennis, Chartered Retirement Planning Counselor at The Retirement Planning Group in Overland Park, Kan.
"This is by far the most tax-inefficient of the scenarios, as every dollar that is distributed from the retirement plans will be taxable," says Certified Financial Planner professional Richard Reyes of The Financial Quarterback in Maitland, Fla.
Because amounts are contributed to the IRA or 401(k) plan on a pretax or tax-deferred basis, when monies come out of the plan, they will be fully taxable at the ordinary income tax rates in effect at the time of distribution. In this arrangement, Uncle Sam has allowed you to delay paying tax on your contributions, as well as the earnings on those contributions, until you take them out.
When it's time to take retirement plan distributions, however, the government wants its tax money. It's the same with distributions coming from a defined benefit plan, otherwise known as a pension. Pension payments are taxable at the time of receipt.
For IRAs and 401(k) plans, required minimum distributions, or RMDs, take effect for everyone who owns these accounts. This rule is slightly different depending on whether you have an IRA or a 401(k). For IRAs, RMDs must begin no later than April 1 of the year following the calendar year in which you reach age 70 ½.
For defined contribution plans, RMDs must begin no later than April 1 following the later of the calendar year in which you reach age 70 ½ or at retirement. However, to take advantage of the delay to actual retirement (assuming you retire after age 70 ½), the plan itself must allow you to do so. If not, then the default rule applies.
"If the retiree was 62 when they retired and that $600,000 is growing at a rate of 6 percent while taking an $18,000 yearly distribution, the account will grow to approximately $810,000 by age 71," says Reyes.
At age 70 ½, the retiree will have to withdraw approximately 3.8 percent yearly (according to the Internal Revenue Service Uniform Lifetime RMD Table), which equates to about $30,000 per year."
If payments come from a pension in the form of annuity payments, there's an additional wrinkle to consider. Does it have cost-of-living adjustments? "If not, over time inflation will eat into distributions," says Reyes.
If there are no cost-of-living adjustments, the value of the distributions remains constant over time. As prices of goods increase with inflation, the purchasing power of those dollars will go down.
With respect to assets held in a 401(k) or IRA, Dan Yu, managing principal, CFP professional and Certified Investment Management Analyst at EisnerAmper Wealth Advisors, recommends that you "make sure that the asset allocation in your accounts are addressed and adjustments made the closer you get to retirement." By the time you approach age 70, your fixed-income holdings should range from 70 percent to 75 percent, he says.
When deciding how much of a distribution to take from a traditional IRA, it is important to determine how much tax to withhold first. "If your effective tax rate is 10 percent, you would need to withdraw $20,000 to get $18,000 after tax; the other $2,000 could be set up to go to Uncle Sam," says Mike Piershale, Chartered Financial Consultant and president of Piershale Financial Group.
"It is critical to take into account any state income taxes, in addition to federal income taxes, to which you may be subject," adds John Graves, author of "The 7% Solution."
As for how much should be withdrawn annually from a portfolio, O'Blennis recommends that distributions be kept below 4 percent of total assets. "It's easy to go above that 4 percent mark if you treat your IRA like an ATM machine."
"It's good to have the money in the first place," says O'Blennis, "but having other money saved in Roths or after-tax accounts simply gives one some options."
That brings us to our next scenario.