How to Advise Your Clients To Withdraw From Their Retirement Accounts

After working hard to build retirement savings, don’t let taxes take a big bite out of them

Chances are you contributed to a 401(k) or IRA as you saved for retirement. Now the time has come to use that money.

Withdrawing from your retirement savings with an eye toward reducing taxes is important. Not only do taxes reduce your income, they can diminish potential future earnings and growth, which affects how long your savings may last.

“The important thing to keep in mind is that managing your withdrawals with taxes in mind can help boost your income in retirement,” explains John Sweeney, executive vice president of retirement and investing strategies at Fidelity.

Let’s start by reviewing the types of investment accounts and then some tax-efficient ways to withdraw from them. Of course, everyone’s situation is unique, so it is important to consult a tax professional.

Three types of investment accounts

A typical retiree may have three types of accounts—taxable, tax deferred, and tax exempt. Each has an important but different role to play in helping you manage your tax exposure in retirement.

• Taxable accounts like bank and brokerage accounts
  You generally pay taxes on any earnings from these accounts, including interest, dividends, and capital gains, in the year they’re generated. In the case of capital gains, keep in mind that any increase in value of the accounts’ investments, such as mutual fund shares or an individual stock, isn’t a taxable event in itself. It’s only when an appreciated investment is sold that it generates a taxable capital gain or loss. When you own a mutual fund, however, capital gains may be realized by the fund manager and distributed to you—often subjecting you to a tax liability—even if you haven’t sold your fund shares.
• Tax-deferred accounts like traditional IRAs, 401(k)s, 403(b)s, or SEP IRAs
  Most, or all, of your contributions to these accounts were likely made “pretax.” That means you’ll also owe income taxes on those contributions when you withdraw them in retirement. Any earnings from these accounts are also typically taxed as ordinary income when they’re withdrawn.
• Tax-exempt accounts like Roth IRAs, Roth 401(k)s, and Roth 403(b)s
  Contributions to these accounts are typically made with after-tax money. That means the contributions—and any earnings—are not taxable provided certain conditions are met.¹

Manage withdrawals to help reduce taxes

The aim is to manage your withdrawals to help reduce the amount that is taxed, while maximizing the ability of your remaining investments to grow tax efficiently.

The basic withdrawal strategy is to use money from your savings and retirement accounts in the following order, with one important caveat. For certain retirement accounts, if you are 70½ or older, minimum required distributions (MRDs), also known as required minimum distributions (RMDs), come first. If you’ve inherited a qualified account like a traditional IRA, MRDs may come before age 70½, but the rules are complex, so be sure to check with a tax professional.

1. Taxable accounts (brokerage accounts)
   Money in taxable accounts is typically the least tax efficient of the three types. That’s why it usually makes sense to draw down the money in those accounts first, allowing your qualified retirement accounts to potentially continue generating tax-deferred or tax-exempt earnings.
   You’ll likely have to sell investments when you make a withdrawal. If you have any growth, or appreciation, of the investment, you’ll pay capital gains tax. If you’ve held the investment for longer than a year, you’ll generally be taxed at long-term capital gains rates, which currently range from 0% to 20%, depending on your tax bracket (a 3.8% Medicare tax may also apply for high-income earners). Long-term capital gains rates are significantly lower than ordinary income tax rates, which in 2016 ranged from 10.0% to 39.6%. These are federal taxes; be aware that states may also impose taxes on your investments. (Get your federal tax rate with our tax-rate chart.) If you have a loss, you can use it to reduce up to $3,000 of your taxable income, or to offset any realized capital gains. Read Viewpoints: “Harvesting losses.”
2. Tax-deferred, such as traditional IRAs, 401(k)s, 403(b)s, and SEP IRAs
   You’ll have to pay ordinary income taxes when you withdraw pretax contributions and earnings from a tax-deferred retirement account, but at least you’ve given these assets extra time to grow by taking withdrawals from a taxable account first. You may find yourself in a lower income tax bracket as you get older, so the total tax on your withdrawals could be less. On the other hand, if your withdrawals bump you into a higher tax bracket, you might want to consider withdrawals from tax-exempt accounts first. This can be complex, and it may be a good idea to consult a tax professional.
   And remember, the IRS generally requires you to begin taking MRDs the year you turn 70½. For employer-sponsored accounts, like a traditional 401(k), you may be eligible to delay taking MRDs if you’re still working at the company and do not own 5% or more of the company or business. You cannot, however, delay starting MRDs for retirement accounts for employers you no longer work for. Read Viewpoints: “Smart strategies for required distributions.”
3. Tax exempt, such as Roth IRAs, Roth 401(k)s, and Roth 403(b)s
   Last in line for withdrawals is money in your tax-exempt accounts. The longer you can leave these savings untouched, the longer the potential for them to generate tax-free earnings. These withdrawals won’t be partially eaten up by taxes. They’re totally tax free, as long as certain conditions are met.¹
   And leaving any Roth accounts untouched for as long as you can may have other significant benefits. For example, if you have a large unexpected bill, you can withdraw money from the Roth account to pay for it without triggering a tax liability (as long as certain conditions are met1). Qualified Roth withdrawals are not factored into your adjusted gross income (AGI), which in turn may help reduce taxes on Social Security and other income.
   For Roth IRAs, it is important to note that MRDs are not required during the lifetime of the original owner, but for Roth 401(k)s and Roth 403(b)s, the original owners do have to take MRDs. Moreover, Roth accounts can be effective estate-planning vehicles for those who wish to leave assets to their heirs. Any heirs who inherit them generally won’t owe federal income taxes on their distributions. Be sure to consult an estate planner if leaving money to heirs is important to you.

Creating your plan

While the traditional withdrawal hierarchy of taxable, tax-deferred, and tax-exempt assets is a good starting point for many retirees, your situation and changing circumstances may require making adjustments. That’s why it is important to have an overall retirement income plan and regularly revisit it and update it when necessary.

Suppose, for example, that your tax rate will be higher later in retirement than in the first few years. For instance, you move from a low-tax state to a high-tax state. If so, you might want to consider strategies where you pay taxes on your retirement savings earlier in retirement in order to potentially lower your taxable income later. One way to do that, depending on your situation, would be to shift more of your savings to a Roth IRA by converting a portion of your traditional IRA. Learn more about this in Viewpoints: “Four tax-efficient strategies in retirement.”

You may also have a significant portion of your investments in taxable accounts and be looking for ways to lower your tax bill on the earnings as you gradually draw down the principal to cover your retirement living expenses. One consideration that might help is to invest the bond portion of your taxable accounts in a diversified mix of municipal bonds, the earnings from which are generally exempt from federal income tax, in a taxable account.

Another situation that many retirees experience when they begin withdrawing money from their traditional IRA or 401(k) is that the amount pushes them into a higher tax bracket. In that case, you might consider withdrawing from a tax-deferred account until your taxable income reaches the top of your tax bracket, and then tapping a Roth or other tax-exempt account for any additional income you require.

If you’re 70½ or older, you might also consider making a qualified charitable distribution to satisfy all, a portion of, or even an amount greater than your MRD—up to the IRS limits ($100,000 in 2016). Because the amount donated directly from your IRA to a qualified charity isn’t considered taxable income, this move can help avoid being pushed into a higher tax bracket.

Other factors that could play a significant role in your retirement tax strategy are whether you intend to continue working, the income tax rate in the state and locality where you plan to retire, and how much of an inheritance you would like to leave for your family members or to a charity.

Know your situation

The keys to managing withdrawals from retirement accounts is to know your situation and tax exposure, to understand the basics of smart tax planning, and to consult a trusted professional to get the help you need in designing a tax-efficient retirement income plan.

You’ve worked long and hard to build your retirement savings; now, a little smart tax planning can help you maximize its value.