It’s time to quit your job and retire. Other than Social Security, you likely have no other steady income stream (old-style defined-benefit pension plans are increasingly rare nowadays). That means you must turn to your investments to finance your life.
You likely have much of your retirement kitty in mutual funds, whether in taxable funds or in IRAs,that were rolled over from your workplace 401(k). The IRAs are tax-deferred funds, meaning you plugged money into them during your working life and could deduct the contributions from your income. And you may have Roth funds, where you put in money after it had been taxed.
Which of these fund types should you milk first? The short answer is taxable first, then IRAs, then Roths.
First, of course, we’re assuming that you have enough to fund your retirement expenses. A Northwestern Mutual survey last year found that a scarily small amount of adults, both Gen X-ers (ages 39 to 54) and baby boomers (ages 39 to 54), have sufficient amounts saved. If you’re among the farsighted band of savers, good.
Taxes are very important when it comes to withdrawing from retirement plans. They can reduce your post-work income and hold down future portfolio growth. To be sure, everyone’s situation is different. You could still be working, which allows you to postpone drawing from your retirement nest egg. And you may have other income, from something like rental property you own.
These usually mean mutual funds not under an IRA or 401(k) designation. Also included are brokerage accounts, which contain individual stocks or other securities. Taxable accounts are, for the most part, the least tax-efficient. By withdrawing from these first, you allow the tax-advantaged vehicles more time to grow without the government creaming off their proceeds.
One advantage: Withdrawing from taxable accounts subjects them to capital gains taxes. Cap gains levies often are lower than ordinary income taxes, which you must pay for cash-outs from tax-deferred funds. Capital gains range from 0% to 20%, depending on your tax bracket—that’s lower than the 10%-37% cut for ordinary income. High-income earners also may be subject to a 3.8% Medicare surcharge. To qualify for cap gains treatment, you need to hold an asset for longer than six months.
One vexing aspect to owning taxable mutual funds is that they are taxed the entire time you hold them. So when a fund manager sells stocks in the fund portfolio for a profit, you must pay a capital gains tax on that, even though the cash that the sale generates doesn’t end up in your pocket, at least not directly.
The category encompasses traditional IRAs, 401(k)s, 403(b)s, SEP IRAs and annuities. The beauty of these is that, while you were working, you could deduct your contributions to these accounts and lower your taxable income. The IRS, though, will get you at the back end.
Two ages are key for tax planning regarding these accounts. After 59½, you are allowed, albeit not required, to take out money from your traditional IRA without penalty. Before that point, you will be subject to an early-withdrawal penalty of 10%—although exceptions exist. Example: You can pull out money without penalty if you lost your job and need the cash to meet your medical insurance premium.
And for those who turned 70½ in 2019 or before, you must start taking what are called required minimum withdrawals, or RMDs, based on your expected average longevity. Note that, under a new law, that required date to withdraw is moved to age 72 for people who turn 70½ after Dec. 31, 2019. The new legislation, called the Setting Every Community Up for Retirement Enhancement (SECURE) Act, should make it easier to figure out when to withdraw money.
For illustration purposes, let’s look at the group turning 70½ in 2019. Say you are retired and your 70th birthday was June 30, 2019. You reached 70½ on Dec. 30, 2019. You must take your first RMD (for 2019) by April 1, 2020. Later RMDs must be completed by the end of each year.
With these accounts, you must pay ordinary income tax on the proceeds. On the plus side, people usually are in a lower tax bracket after they quit working. If you as a retiree are in a higher tax bracket, look at taking from the tax-exempt accounts instead.
Roth IRAs, 401(k)s and 403(b)s can more than make up for the subtraction of taxes you made before you plugged the money into them. The longer these vehicles go untapped, the longer they can pile up tax-free money.
Even better, Roths are not subject to RMDs. What’s more, you can will them to heirs and they still stay tax-free. And of course, in retirement, the proceeds from a Roth aren’t counted as taxable income, so you don’t have to worry about a higher IRS bill.
Once everything else is exhausted, the hope is that the Roth has compounded so much that it will see you to the end of your days, with Uncle Sam not visiting its bounty.