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[Video] Which Accounts Should You Take Funds From First In Retirement Thumbnail

[Video] Which Accounts Should You Take Funds From First In Retirement

Which accounts will serve you best in retirement? I'm here to guide you through, some of the complexities of income management in retirement. I'll break down the key factors to consider during your retirement planning.

Understanding where and when to pull income is crucial because making the wrong moves could lead to unnecessary tax burdens during your retirement years, which would then decrease the amount you have to spend over the course of your retirement.

We’re going to dive into the strategic approach of where to pull funds from first in retirement. Creating your own tax-efficient paycheck becomes imperative post-retirement because your job income ceases, and the responsibility falls on you to determine the sources of your income. It's not just about pulling money from various accounts; it's about combining various income streams to create the lifestyle you desire in retirement, while also minimizing your lifetime tax liabilities. 

Strategic Withdrawal Approach

Now, a common and antiquated spending approach starts with spending down taxable accounts first, like any individual or joint accounts you may have, followed by tax-deferred accounts, like 401(k)s, 403(b)s, and IRAs that you have, and preserving tax-free accounts, like Roth IRAs or Roth 401(k)s, for as long as possible.

However, a more specific approach should be driven by tax considerations and the tax brackets you will be in. Because what you want to do, is use the tax code to your advantage by filling up certain brackets and paying attention to certain thresholds. 

Now I’m going to discuss the 3 basic steps to create a tax-efficient income stream in retirement. These first couple of steps are mostly common sense, but it’s always beneficial to be thorough. 

Step 1: Assess Your Fixed Income Sources

First, begin by understanding your fixed income sources like Social Security, pensions, annuities, any rental or farm income, or maybe you have some passive business income. These are your foundational income sources that don't come from your investment accounts.

Step 2: Calculate the Shortfall

Second, you need to determine the gap between your fixed income sources and your desired expenses for retirement. This shortfall is going to tell you the amount you need to get from your investment accounts to sustain your ideal lifestyle. [In my previous video, How Much Do I Need to Retire, I help you calculate your own retirement expenses.]

Step 3: Evaluate Your Account Types

Now you need to decide which account to pull from to make up for that shortfall, and this is where it gets a bit tricky. You need to understand the nature of your 3 account types: taxable, tax-deferred, and tax-free. 

Because your tax rate in retirement is going to depend significantly on where your income comes from.

As I’ve mentioned, we have three account types that will be taxed very differently:

  1. Taxable Accounts: These include individual or joint brokerage accounts. They are subject to long-term capital gains tax, but the rates are generally favorable or preferred to our higher, ordinary income tax rates.
  2. Tax-Deferred Accounts: Any IRAs, 401(k)s, 403(b)s and any similar pre-tax accounts. Money in these accounts has not been taxed yet, but when withdrawn, it's fully taxable at ordinary income tax rates.
  3. Tax-Free Accounts: These are your Roth IRAs and Roth 401(k)s. Any contributions to these have already been taxed, and qualified withdrawals are entirely tax-free.

Knowing how these different account types are taxed when you withdraw money from them, and knowing your tax brackets, will affect how much you take from each account type. 

For example, let’s say you need $100,000 from your investment accounts on top of whatever amount you will receive from your fixed income sources.

  • If you take $100,000 from your IRA or any pre-tax account, it’s going to be taxed at our ordinary 7-bracket income tax rates. 
  • If you take $100,000 from a Roth account, that money has already been taxed so you won’t have to pay any taxes on that. 

So, the amount that hits your checking account to spend can vary tremendously based on account type.

Now, here are some more factors and what you need to consider in order to minimize your lifetime tax liabilities:

1. Tax-Free Growth: Let your Roth IRAs or any Roth accounts grow as much as possible. The longer they compound tax free, the more you benefit from this tax advantage.

2. Required Minimum Distributions (RMDs): Be mindful of future RMDs because remember, Uncle Sam is going to get his share of taxes one way or another. But spending down your traditional IRA early or using Roth conversions, might be strategic to manage your tax brackets effectively. This can prevent significant mandatory distributions in the future, which could cause you to end up in a much higher tax bracket than was necessary and can help prevent Medicare premium surcharges.

3. Social Security Taxes: You will need to understand the Social Security provisional income formula along with the 50% and 85% thresholds to determine how much of your Social Security benefits are taxable. Because your income sources are going to impact how your Social Security is taxed. 

Another important consideration is determining when to activate your Social Security benefits. Because knowing how it will be taxed and how it will affect your total tax situation with other income sources can have a large impact. 

4. IRMAA (aka Medicare Surcharges): Be aware of Medicare premium surcharges based on your income. Many times, we come across individuals or couples that haven’t considered this, so they keep their income as low as possible in the first few years of retirement. Then they’re forced to withdraw from IRAs or other pre-tax accounts when they reach RMD age. And then not only do they end up paying a higher tax rate than was necessary, but they also end up paying a lot higher parts B and D Medicare premiums, which really seems to infuriate them, and it should because it’s often preventable. 

5. Impact on Other Tax Strategies: You’re going to have to consider how your income sources impact other tax strategies like Roth conversions, or tax loss harvesting or tax gain harvesting, or asset location, etc. because combining these strategies is what will help you minimize taxes even further.

Bottom Line

In conclusion, there isn't a one-size-fits-all approach to income management in retirement. In other words, you will have to consider how to thread the proverbial needle of retirement income and tax planning if you want to optimize your income in retirement. 

Understanding your fixed income sources, strategically pulling funds, and considering the tax implications are key elements in managing your finances effectively. 

And by taking a comprehensive and intentional approach, you can create a stable income, keep your taxes lower, and enjoy a fulfilling retirement.

A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your situation. 

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