If you’ve been a diligent saver, you likely recognize the importance of having a variety of retirement accounts: a tax-deferred retirement account like a traditional 401(k) or IRA, a tax-free Roth 401(k) or Roth IRA, and perhaps even a taxable brokerage account. Moreover, you may be aware that the government incentivizes keeping money in IRA and 401(k) accounts until you reach 59½ by imposing penalties on most withdrawals before that age.
As you prepare to retire and initiate withdrawals, questions may arise about the best approach and which accounts to tap into first. While tax efficiency shouldn’t be your sole concern—after all, you’ve spent years safeguarding your retirement savings—here are some fundamental tax strategies to guide you through the withdrawal process.
Utilizing tax-deferred retirement accounts like a traditional 401(k) or IRA is one of the most popular ways to save for retirement. Chances are, a significant portion of your savings is stashed in these accounts. Contributions to these accounts are made on a pre-tax basis, allowing you to retain more money for savings and investments during the earning years. While eventual withdrawals are taxed, they may occur at a lower tax bracket than when the funds were contributed.
At 70½, the government mandates that you start withdrawing from these accounts, subjecting any untaxed contributions and the income generated from withdrawals to ordinary income tax. This may create a cycle of withdrawing your Required Minimum Distribution (RMD) or self-determined income needs, then having to withdraw more to cover the required income taxes, leading to additional taxes on the funds used to pay those income taxes. Anyone inheriting tax-deferred retirement accounts will also face taxation on these funds.
Another popular retirement account is the Roth IRA or Roth 401(k), with some significant differences between the two despite their similar structures. Contributions to these accounts are made with after-tax funds, and, if all conditions are met, the funds grow tax-free, even when qualified withdrawals begin.
Unlike traditional IRAs, Roth IRAs don’t require withdrawals of a minimum distribution at a specific age. However, Roth 401(k)s do have RMDs, making it worth considering transferring this money to a Roth IRA upon retirement, eliminating the RMD requirement. Ensure this is done before the RMD kicks in, as you cannot transfer any amount that has already been required to be withdrawn in that year. So, if you have $10,000 in a Roth 401(k) and were supposed to withdraw $1,000 as an RMD in 2018, you can transfer $9,000 to a Roth IRA but must still withdraw the $1,000 RMD this year. Due to its tax-free and RMD-free status, a Roth IRA can provide a steady stream of entirely tax-free income for yourself or your heirs.
To supplement your retirement accounts, you might have invested in a regular taxable brokerage account, surpassing the annual retirement contribution limits. When selling investments in this account, you may still owe taxes on your gains. If you sell investments held for more than one year, the gains are subject to long-term capital gains tax, which varies based on your tax bracket but is generally 15% for most taxpayers.
In contrast, selling investments held for less than a year results in short-term capital gains, taxed at ordinary income tax rates. If your investments incur losses, you may be able to report these losses on your tax return.
Although funds withdrawn from your regular investment account are taxable, they remain valuable during your retirement years. They can be used to cover significant expenses or even pay the income taxes required for other retirement accounts’ RMDs.
Ages 59½ to 70½: Navigating the Years
The years between turning 59½ and 70½ are crucial for your retirement plan. It’s the time when you can make penalty-free qualified distributions but before you are actually required to withdraw any distributions. If you’ve left full-time employment, work part-time, and are in a lower tax bracket, consider withdrawing allocations from your tax-deferred accounts, potentially converting them to a Roth IRA. This eliminates the need for RMDs and allows you to pay taxes at a potentially lower rate.
During years of little or no income, you can withdraw from both your tax-deferred and taxable accounts, paying ordinary income tax at a lower rate or converting a portion of your 401(k) or traditional IRA funds to a Roth IRA, which incurs taxes upon conversion. This prevents you from being forced to withdraw RMDs (or risk a 50% penalty) regardless of whether you need the money. (See also: 6 Age Milestones Affecting Your Retirement)
Note that while you can convert tax-deferred accounts to Roth IRAs if you’re not working, direct contributions to a Roth IRA are not allowed unless you or your spouse has earned income.
Navigating how to spend your retirement savings can be trickier and more complex than saving all that money, but understanding the different tax implications of your various accounts can help you devise the most suitable strategy for your situation.