Heading into retirement can lead to a lot of financial questions.
You’ve just spent much of your working career prioritizing saving, accumulating assets, and preparing for the future — including retirement.
As that day edges ever so close and you finally reach the point of being comfortable enough to shut off your income spigot, you may ask yourself, “How should I tap into my retirement assets so I can live on that wealth?”
Whenever this topic comes up in conversation, I always respond that there is no one-size-fits-all approach; retirement distribution planning is unique to your personal situation based on your goals and priorities.
So, let’s discuss the different types of investment accounts and how you should go about creating a paycheck in retirement.
Retirement income sources
For most individuals, the most common forms of retirement income sources will come from two main buckets:
Investment Sources
- Cash
- Taxable accounts (brokerage/investment management agency account)
- Tax-deferred investment accounts [pre-tax IRA, 401(k), and 403(b)]
- Tax-free Roth IRA and Roth 401(k)
Income Sources
- Social Security
- Defined benefit pension income
Drawing from retirement accounts can be a very complex process and oftentimes requires a combination of several buckets throughout.
Depending on your tax bracket, however, a general rule of thumb would be to start with cash and then spend down taxable accounts first, tax-deferred accounts second, and tax-free accounts last.
Start with cash
Cash is your first line of defense when heading into retirement.
For example, if your desired retirement income is $100,000 annually, you would ideally have your first one to two years’ worth of expenses set aside in cash or cash equivalents [savings, money market, certificate of deposit (CD), etc.].
Tapping into cash first allows your investments additional time to grow and prolongs distributions from your designated retirement accounts. Over time, your investments will typically outearn your cash reserves.
Drawing from cash will also keep your taxable income lower during those first years of retirement, which could open other doors like Roth IRA conversions since you would be at a lower tax rate.
Drawing down cash to fit your financial circumstances is a great option to consider.
First: Withdraw from taxable accounts
Taxable Accounts (Brokerage/Investment Management Agency Account)
Like cash accounts, your taxable accounts are generally the next best place for retirement distributions.
Using your taxable accounts first, or a portion from your taxable bucket, allows your tax-deferred and tax-free accounts more time in the market to further compound.
Distributions from taxable accounts may also be taxed more favorably, with any capital gains taxed at 15 to 20%, assuming the underlying assets are held for more than a year. Assets held for less than a year will be subject to ordinary income taxes.
Taxable accounts are also a great investment vehicle to have, especially if you plan on retiring before 59 ½, which is the earliest you can take penalty-free distributions from qualified retirement accounts.
Your tax impact on a taxable account would be less than a qualified retirement asset since those distributions would be taxed as ordinary income.
It’s important to note that taxable accounts like an investment agency account currently receive a step up in basis at death, which, depending on your planning goals, you could use as a tax-efficient wealth transfer tool when leaving money to your heirs.
Second: Withdraw from tax-deferred accounts
Tax-Deferred Accounts [Pre-Tax IRA, 401(k), and 403(b)]
Now that it’s time to make distributions from your qualified accounts, remember that withdrawals from your tax-deferred accounts will be subject to ordinary income tax rates.
The IRS will mandate required minimum distributions (RMD) beginning at age 73 or 75, depending on the year you were born.
Also note that deferring distributions from qualified retirement accounts will likely increase your RMD in retirement, even if you don’t need the income.
Keeping this in mind while creating a distribution plan will be important so you can reduce the probability of kicking out too much income during those RMD ages.
Third: Withdraw from tax-free accounts
Tax-Free Accounts [Roth IRA and Roth 401(k)]
Leaving your Roth accounts untouched allows them to continue to grow tax-free, meaning you can maximize tax-free growth for as long as possible. Remember that you already paid taxes on these contributions, so qualified withdrawals will also be tax-free.
In addition to tax-free withdrawals, there are several other benefits to having a Roth account: they are a great wealth transfer tool, are not subject to an RMD, and can be a great lever for chunk expenses that may arise throughout retirement, such as a new vehicle.
Don’t forget about those income sources!
Social Security and Defined Benefit Pension Income
Lastly, don’t forget about the income sources we mentioned earlier. Social Security and pension benefits are important factors to consider when creating your retirement paycheck.
Social Security benefits can be claimed anywhere between age 62 and 70. The age at which you take your benefit will determine your monthly benefit amount.
Pensions may also have benefit periods and distribution options to consider. Determining when you should take your benefits is dependent on your own household circumstances.
Yes, the longer you defer, the greater your benefit will be. However, there are other factors to consider, such as personal health, family longevity, and your reliance on your investment portfolio.
All of these considerations should factor into your decision on whether to take your benefit or continue to defer. I encourage you to talk this through with your financial planner before making any decisions.
Taking that next step
There are several factors to consider as you work on creating a distribution plan, which may include any combination of these different buckets at times.
When going through distribution planning, you should ask yourself: What is my goal?
Is it creating the most tax-efficient distribution plan for yourself, legacy planning for beneficiaries, or both?
Whatever your goal, it’s essential to create a plan that works for your situation and investment strategy.
Conversations matter, and it’s important to understand your plan heading into that next stage of life. Taking the time to match up your goals and objectives is a vital piece of the financial planning process.
Our team of experts at First National Wealth Management is here to help guide you through these conversations.
If you are starting to have these discussions around retirement or are considering taking that next step, reach out and I’d be happy to help!
