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You Spent 40 Years Building Your Retirement. Now Comes the Hard Part: Taking the Money Out
For most of your working life, the financial advice surrounding retirement is relatively simple: save consistently, invest wisely, take advantage of retirement plans, and don't panic when markets decline.
Then retirement arrives — and suddenly the rules change.
Instead of asking, "How much should I save?" the question becomes, "Where should my income come from?"
Should you withdraw from your IRA or your taxable investment account? Should you spend Roth dollars? Should you convert part of your traditional IRA to a Roth? When should you begin Social Security? And could one of those decisions unexpectedly increase your Medicare premiums?
These decisions don't exist independently. They interact with one another, sometimes in ways that aren't obvious.
That's why we believe one of the most important parts of retirement planning isn't simply accumulating enough money.
It's developing a strategy for how to efficiently turn those assets into income for the rest of your life.
The Accumulation Phase Is Actually the Easier Part
During your working years, most investors have a fairly straightforward objective: accumulate assets.
You earn money, save a portion of it, invest those savings and hopefully allow compounding to work over several decades.
Retirement changes the equation.
Now you're drawing money out rather than putting money in. And your assets may be spread among several different types of accounts:
- Traditional IRAs and 401(k)s
- Roth IRAs and Roth 401(k)s
- Taxable investment accounts
- Bank accounts and CDs
- Pensions
- Social Security
- Real estate or business interests
A dollar isn't necessarily a dollar when it comes to retirement income.
A dollar withdrawn from a traditional IRA will generally be taxable as ordinary income. A qualified withdrawal from a Roth IRA may be tax-free. Selling an investment from a taxable account could produce a capital gain — or potentially no taxable gain at all if the investment's cost basis is close to its current value.
The source of your retirement income can therefore matter almost as much as the amount you withdraw.
Consider Two Retired Couples With the Same $2.5 Million
Imagine two hypothetical couples. We'll call them John and Susan and Bob and Mary.
Both couples retire at age 65.
Both have accumulated $2.5 million.
Both need approximately $120,000 per year to maintain their desired lifestyle.
At first glance, you might assume their retirement plans would look very similar.
But let's say John and Susan simply withdraw whatever they need from their traditional IRA each year. They start Social Security relatively early and don't give much consideration to Roth conversions or future required minimum distributions.
Bob and Mary take a different approach.
They develop a multi-year income strategy. During the early years of retirement, they use a combination of taxable investments and IRA withdrawals. They evaluate whether partial Roth conversions make sense during years when their taxable income is relatively low. They coordinate those decisions with when they plan to begin Social Security.
Same starting wealth.
Same lifestyle.
Very different strategy.
Over a 20- or 30-year retirement, those seemingly small decisions can potentially create meaningful differences in taxes, Medicare premiums, account balances and the assets ultimately passed to heirs.
The goal isn't simply to minimize taxes in any one year.
The goal is to make intelligent decisions across many years.
The Retirement "Tax Window"
One of the most overlooked planning opportunities may occur immediately after retirement.
Suppose you retire at 65.
Your salary disappears, but you haven't yet started Social Security. Required minimum distributions from your retirement accounts may still be years away.
For perhaps the first time in decades, your taxable income could be significantly lower.
We sometimes refer to this as a retirement tax-planning window.
Instead of automatically trying to report the lowest possible income during those years, it may make sense to intentionally recognize some income at relatively favorable tax rates.
One way to accomplish that can be through partial Roth conversions.
With a Roth conversion, money is transferred from a traditional IRA to a Roth IRA. The amount converted is generally taxable in the year of conversion, but future qualified Roth distributions can be tax-free.
Why would anyone voluntarily pay taxes sooner?
Because paying taxes at a known or potentially lower rate today may be preferable to being forced to recognize more income later.
That doesn't mean everyone should do Roth conversions. Far from it.
The appropriate amount — if any — depends on your income, deductions, investment assets, future RMDs, Social Security, Medicare considerations, charitable intentions and estate plan.
That's why we believe Roth conversion planning should be viewed as a multi-year strategy rather than a December transaction.
Required Minimum Distributions Can Change the Picture
Eventually, the IRS requires most owners of traditional retirement accounts to begin taking required minimum distributions, commonly called RMDs.
Once RMDs begin, you lose some control over how much taxable retirement-account income you recognize each year.
Imagine reaching your RMD years with a very large traditional IRA.
You may not actually need all of the required distribution to support your lifestyle, but you generally have to take the required amount anyway.
That additional taxable income could potentially:
- Push some income into a higher tax bracket
- Cause more of your Social Security benefits to become taxable
- Increase your Medicare premiums
- Reduce your flexibility for other tax-planning strategies
This is why waiting until RMDs begin to think about retirement taxes can be a missed opportunity.
Sometimes the best RMD strategy begins years before the first RMD is ever taken.
Don't Forget About Medicare
One of the more surprising retirement "taxes" isn't technically a tax at all.
It's Medicare's Income-Related Monthly Adjustment Amount, commonly known as IRMAA.
Higher-income Medicare beneficiaries can pay additional premiums for Medicare Parts B and D. That means a financial decision that increases your income — even temporarily—can potentially affect what you pay for Medicare.
For example, a large Roth conversion might make perfect sense from a long-term income-tax perspective but push income high enough to increase future Medicare premiums.
Does that automatically make the Roth conversion a bad idea?
Not necessarily.
It simply means the Medicare impact should be included in the analysis.
Retirement planning often involves tradeoffs. Paying somewhat higher Medicare premiums for a period of time could still make sense if a strategy produces greater long-term tax benefits.
The key is knowing about the tradeoff before making the decision.
Social Security Is Part of the Tax Strategy Too
Social Security decisions are often discussed as if they exist in isolation.
"Should I take Social Security at 62, full retirement age or 70?"
But that's only part of the question.
Delaying Social Security may increase your eventual monthly benefit, but it may also create additional years during which you can draw from retirement accounts or complete Roth conversions before Social Security income begins.
Once Social Security begins, up to 85% of your benefits may be subject to federal income tax, depending on your other income.
That creates yet another interaction between your investments, retirement-account withdrawals and tax strategy.
The best Social Security decision isn't necessarily the one that produces the largest monthly check.
It should be evaluated as part of your overall retirement plan.
The Surviving-Spouse Tax Problem
There's another issue married couples frequently overlook.
Eventually, one spouse may be managing the same retirement assets — but filing taxes as a single taxpayer.
When one spouse dies, household expenses don't necessarily fall by half. Property taxes, utilities, insurance and many other costs remain.
But one Social Security benefit generally disappears, and the surviving spouse may eventually be subject to less favorable single-filer tax brackets.
A surviving spouse could therefore find themselves paying a higher effective tax rate on similar income.
This is another reason tax planning during the early years of retirement can be so valuable.
The question isn't simply, "How much tax can we avoid this year?"
A better question may be:
"What can we do today to give both spouses greater financial flexibility later?"
There Is No Universal Withdrawal Order
You've probably heard rules such as:
"Spend taxable accounts first, then IRAs, and save Roth accounts for last."
That may be appropriate in some situations.
But we don't believe retirement planning works well with universal rules.
For one retiree, spending taxable assets first may make sense.
For another, deliberately taking IRA distributions earlier may help reduce future RMDs.
Someone with significant charitable goals might benefit from preserving IRA assets for future qualified charitable distributions.
Someone concerned about leaving assets to children may place greater value on building Roth assets.
And someone expecting their future tax rate to be lower may have little reason to accelerate taxes today.
The right withdrawal strategy is personal.
More importantly, it can change from year to year.
Retirement Income Planning Is Really Tax-Bracket Management
This is one of the biggest shifts in thinking we encourage clients to make.
The objective isn't necessarily to pay the least amount of tax possible this year.
It may be to pay the least amount of tax reasonably possible over your lifetime.
Those are very different goals.
There may be years when intentionally recognizing more taxable income makes sense.
There may be years when realizing capital gains is advantageous.
There may be years when Roth conversions make sense and years when they don't.
And there may be years when charitable giving strategies can help satisfy both personal and tax-planning objectives.
That's why retirement income planning should be revisited regularly.
Tax laws change.
Markets change.
Your portfolio changes.
Your spending changes.
And life certainly changes.
The Question Isn't Just "Do I Have Enough?"
For decades, retirement planning centered on one primary question:
"Have I saved enough to retire?"
That's still an important question.
But once you've accumulated enough assets, a new set of questions becomes equally important:
How should I create my retirement paycheck?
Which accounts should I draw from?
When should I claim Social Security?
Should I convert any of my IRA to a Roth?
How much taxable income should I intentionally recognize this year?
Could my decisions affect Medicare premiums?
What happens to the plan if one spouse dies?
And how do today's decisions affect what I eventually leave to my children or grandchildren?
These are not simply investment questions.
They're financial-planning questions.
Building Wealth Was Only Half the Plan
You may have spent 30 or 40 years accumulating the assets that will fund your retirement.
You may spend another 20, 30 or even 40 years distributing them.
That deserves a strategy too.
At LFS Wealth Advisors, we believe retirement income planning should bring investments, taxes, Social Security, Medicare, estate planning and your personal goals together into one coordinated strategy.
Because the goal isn't simply to retire with a large account balance.
The goal is to use what you've accumulated to create the life you want, manage unnecessary taxes where possible, provide for the people and causes important to you, and maintain confidence throughout retirement.
Building the wealth was only the first half of the plan.
The second half is deciding what to do with it.
Important Disclosure:
This material is provided for educational and informational purposes only and should not be construed as individualized investment, tax, legal or accounting advice. The examples provided are hypothetical and are intended solely to illustrate general financial-planning concepts. Roth conversions, retirement distributions, Social Security claiming strategies and other planning techniques involve tax and financial considerations that vary based on individual circumstances. Consult with your financial advisor and appropriate tax and legal professionals regarding your specific situation.
LFS Wealth Advisors — Wealth Management Simplified.
Advisory Services are offered through Creative Financial Designs, Inc., a Registered Investment Adviser. Securities are offered through cfd Investments, Inc., a Registered Broker/Dealer, Member FINRA & SIPC, 2704 S. Goyer Rd., Kokomo, IN 46902. 765-453-9600. LFS Wealth Advisors is not affiliated with the CFD Companies. All investments involve risk, including the potential loss of principal.