Saving for retirement during your career is the easy part of planning for your future. Figuring out how to withdraw retirement funds in a tax-savvy way once you stop working is a bigger challenge.
“As much as 70 percent of your hard-earned retirement funds can be eaten up by income, estate and state taxes,” says IRA guru Ed Slott, author of the retirement-planning books “Fund Your Future: A Tax-Smart Savings Plan in Your 20s and 30s” and “The Retirement Savings Time Bomb … and How to Defuse It.”
Here are nine smart withdrawal strategies that will help you avoid costly traps and maximize opportunity.
With a Roth IRA, you invest with after-tax dollars, and your earnings grow tax-free. Financial advisers love Roth IRAs because you aren’t subject to required minimum distributions. But if you do make withdrawals, you don’t have to pay any taxes. An exception: Taxes are due only on earnings if you withdraw assets before you turn 59 1/2 or if the Roth is fewer than 5 years old.
But traditional IRAs, simplified employee pension plans (SEPs), SIMPLE IRAs, 401(k) plans, 457 plans and 403(b) plans are different. These generally involve a tax deduction upfront, but you have to start taking required minimum distributions, or RMDs, after you turn 70 1/2. And when you do, you’ll owe ordinary income taxes — as much as 39.6 percent for the top tax bracket.
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Rules for RMDs are rigid
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You have to take RMDs annually by April 1 of the year after you turn 70 1/2 and by Dec. 31 in subsequent years. In other words, if you turn 70 1/2 in 2017, you have until April 1, 2018, to take your first RMD.
Failure to make on-time RMDs triggers a whopping 50 percent excise tax.
That’s true if you underpay, too. Let’s say your RMD for the year is $20,000, but you only take a $5,000 distribution because of a miscalculation. The IRS will levy the 50 percent penalty — in this case $7,500, or half of the $15,000 you failed to withdraw.
When you compute your RMD, be aware that it will change from year to year. That’s because it’s determined by your age, life expectancy (the longer it is, the less you have to take out) and account balance, which will be the fair market value of the assets in your accounts on Dec. 31 the year before you take a distribution.
Check out the “Uniform Life Table” in IRS Publication 590 to see what you owe.
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Spend accounts in the right order
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If you need retirement savings to get by, and you’re wondering whether to take them from an IRA, 401(k) or a Roth, don’t be tempted by instant gratification. Sure, the Roth IRA withdrawal will be tax-free, but you may wind up paying more in lost opportunity.
Instead, withdraw from taxable retirement accounts first, and leave Roth IRAs alone for as long as possible.
Skeptical? Consider what happens if 72-year-old Joe Retiree takes $18,000 out of a traditional IRA, and he’s in the 25 percent tax bracket: He’ll owe $4,500 in taxes. If he withdraws the same amount from a Roth, he won’t pay a dime. But Joe doesn’t have to take an RMD from a Roth, so if he doesn’t withdraw the $18,000 from the Roth and earns 5 percent annually for another 10 years, it would grow to $29,320. Those earnings also would be tax-free when withdrawn from the Roth.
If you have several retirement accounts because of frequent job changes and you’re approaching 70 1/2, you now have the task of figuring out how to withdraw the money.
Will you have to tap all of your accounts? Probably not.
If you own a handful of traditional IRAs, you can withdraw from each of them. But the more efficient move is to add up the assets from all your accounts, and take one withdrawal from a single IRA.
You can pool your distributions for 403(b) plans, too, but you can’t mix them up, say, by making withdrawals from an IRA to meet your RMD requirements for a 403(b) plan. Similar accounts have to be pooled together. Also, 401(k) plans can’t be pooled to compute a single RMD, says George Jones, a senior federal tax analyst for CCH/Wolters Kluwer. To streamline those, roll them into an IRA.
Also, rather than owning several IRAs, consider consolidating them into a single account to simplify paperwork, make it easier to compute future withdrawals and gain greater control over your asset allocation, Slott says.
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RMDs smaller for some married couples
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If your significantly younger spouse will inherit your IRA, you may be able to reduce your required distributions, thereby trimming taxes and making your retirement funds last longer.
Recall that RMDs are calculated using factors that include your life expectancy as determined by the IRS. But if you’ve named a spouse as the sole beneficiary of your IRA and he or she is at least 10 years younger than you, then your RMD is computed using a joint-life expectancy table. That will reduce the amount you need to distribute in any given year.
For example, a retiree who turned 70 1/2 in the previous year and who would have to take his first RMD by April 1 of the current year would have a life expectancy of 26 1/2 years in the eyes of the IRS. So if his IRA were worth $200,000, his first RMD would be $7,547 ($200,000 divided by 26.5).
But let’s say he designates his 56-year-old wife to be the sole beneficiary of that retirement account. In that case, their joint life expectancy would be 30.1 years. So the first RMD would be trimmed to $6,645. The IRS provides a table for this situation in its Publication 590.
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Making a charitable contribution
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If your dreams for a lifetime of savings include helping a charity, it may be worth using your retirement funds to make a difference.
The Consolidated Appropriations Act of 2016 made qualified charitable distributions permanently available from IRAs.
This law lets individuals 70 1/2 or older make tax-free donations, known as qualified charitable distributions, of up to $100,000 directly from their IRAs to a charity. Such a distribution doesn’t count as income, reducing any income tax liability to the donor.
But be aware that individuals who make tax-free charitable distributions from their IRAs won’t be able to itemize them as a charitable deduction.
“You get one or the other,” Slott says. “Whoever uses this strategy will pay less in taxes, so if you’re charitably inclined, it’s the best way to make donations.”
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‘In kind’ withdrawals qualify as RMDs
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It’s easier to take withdrawals in cash, but that doesn’t mean you have to — or should. So-called in-kind distributions are taken out in the form of stocks or bonds, and they may make more sense for people who want to keep assets for various reasons. You’ll simply move the assets from your IRA into a taxable account. These in-kind withdrawals will be assigned a fair market value on the date they are moved.
An in-kind withdrawal may be easier and less expensive than triggering transaction fees by selling the securities in the IRA and buying them back in a brokerage account.
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RMDs can be delayed for some workers
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If you’re still working at 70 1/2 and still contributing to a 401(k) or 403(b), you’re entitled to an RMD reprieve.
As long as you don’t own more than 5 percent of a company and your retirement plan lets you, you can delay the RMDs until April 1 after the year that you “separate from service,” at which point you’ll have to start taking withdrawals.
This is true as long as you work during any part of a year. So if you’re 71 1/2 and thinking about retiring by the end of the calendar year, reconsider if you don’t want to make a withdrawal. If you keep working after Jan. 1 — even if it’s just a day — you’ll push off the date for taking that first RMD by one more year.
Keep in mind that the delay only counts for the 401(k) plan of the company you’re still working for. If you have other 401(k) plans from previous jobs, you’ll need to take distributions from them if you’re 70 1/2.
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Consider a Roth conversion
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Tax pros and retirement advisers often push clients to roll retirement accounts into Roth IRAs, where time and tax-free growth can work their magic.
The conversion will generally trigger a tax bill. However, once you make the move, all the funds grow tax-free and can remain untouched. With the possibility of higher taxes looming, it may make sense to pay up now.
For example, a 43-year-old gets a new job and decides to move $150,000 from his 401(k) into a Roth IRA. He’s in the 33 percent tax bracket, so he’ll owe roughly $49,500, which he’d be wise to pay with funds outside of the IRA. If he leaves the entire amount untouched in the Roth and it grows at an annual rate of 7 percent, it will be worth $1.14 million in 30 years.
What about someone who’s close to retirement, or possibly even already 70 1/2? If you need the retirement funds for yourself and don’t plan to pass them on to heirs, then it may be smart to leave them where they are.
“But if you want to preserve that retirement asset for heirs,” says Slott, “it’s a great move because it removes the uncertainty of what future taxes will be. Converting to a Roth is a great thing to do for the next generation.”
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Funding an IRA today can result in financial freedom tomorrow.