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Retirement Withdrawal Strategies

Written by Guest Contributor - 8 Comments

This is a guest post from Mike Piper, author of Investing Made Simple and proprietor of The Oblivious Investor. If you like what you see here, please consider subscribing to his RSS feed.

The Roth IRA vs. Traditional IRA question gets a lot of press, and that makes sense. By choosing correctly, you can significantly reduce the total taxes you’ll pay over your lifetime.

In a similar fashion, you can reduce your overall tax burden by planning your withdrawals strategically. That is, once you’re retired, how should you order your distributions? Should you take money out of your Roth first? Your 401(k)? Some combination of both?

The strategy: fill the lower tax brackets

The overall goal with planning your withdrawals is to take sufficient distributions from tax-deferred accounts to fill up the low tax brackets. The reasoning is that it’s better to pay 10% or 15% in taxes now rather than wait, take all the money out over the course of just a few years, and have the distributions bump you up into a higher tax bracket.

In fact, it can sometimes make sense to take distributions even if you don’t need the money to cover living expenses. (If that’s the case, it’s likely a good idea to use them for a Roth conversion, if you’re eligible.)

How about an example?

Martha and Mark are retired, and they’re both 60 years old (so they’re not yet receiving social security). Between interest income and Martha’s freelance writing work, they earn $13,000 over the course of the year. They only need $30,000 to cover their living expenses. They could take the extra $17,000 out of a taxable account, Martha’s Roth IRA, or out of Mark’s traditional IRA.

What should they do?

Without knowing the rest of the details of their situation, it’s impossible to say with absolute certainty what they should do. But the following analysis should provide a decent starting point.

Due to the standard deduction and personal exemptions, a married couple’s first $17,900 of income is free from income taxes. So it’s a no-brainer that they should take at least $4,900 ($17,900 minus their $13,000 of other income) from their traditional IRA because it’ll be entirely tax free.

They still need to come up with another $12,100 to pay their bills. If Mark and Martha expect their income tax bracket to be above 10% later in retirement (e.g., due to social security or required minimum distributions from their tax-deferred accounts), it makes sense to take that from the traditional IRA as well, thereby paying tax at 10% now rather than at a higher rate later.

[Note: Because of the 10% tax, they'll have to take out $13,444 in order to have $12,100 left to pay bills.]

And by the same reasoning, it’s likely a good idea to take an additional $3,255 distribution from their traditional IRA in order to fill out the 10% tax bracket. They can then move that money into a Roth IRA, thereby paying tax at their 10% rate now and avoiding tax at a higher rate later.

In fact, if Mark and Martha expect to be in (or above) the 25% tax bracket later in retirement, it’s probably a good idea for them to take another $51,200 out of their traditional IRA and move it into a Roth, thereby filling out their 15% tax bracket this year as well.

Social security income complicates matters

Once an investor begins receiving social security income, things become more complicated, and the benefits of tax planning increase even further. The reason for the additional complexity is that, as your income proceeds through the 15% bracket, the portion of your social security income that is subject to income tax increases as well.

By strategically planning which accounts you take money out of each year, you can reduce the tax on both your retirement account distributions and on your social security income.

Takeaway lesson

Making small adjustments to your plans could potentially save you thousands of dollars in taxes each year. Unless you have a tax adviser who plays an active role in planning your finances (that is, he/she does more than just prepare your tax returns), it’s essential to have a solid understanding of taxation.

Published on October 19th, 2009
Modified on January 12th, 2012 - 8 Comments
Filed under: Retirement, Taxes

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8 Responses to “Retirement Withdrawal Strategies”

  1. 1
    Paul @ FiscalGeek Says:

    Fantastic article, forwarding on to my soon to retire parents for their own planning.

  2. 2
    Matt Jabs Says:

    Someday I’ll better understand this convoluted IRS taxing system! This post helped put it in perspective – thanks.

  3. 3
    KC Says:

    I like the new format!

  4. 4
    Dan Says:

    Glad to see a post that touches on Minimum Required Distribution when comparing Roth vs Traditional IRA’s. It’s an important topic that IMHO doesn’t get much (if any) discussion.

  5. 5
    Patty Says:

    Nice analysis for a single year – They would be taking (or should be taking) social security at 63ish. They should seek advice – 1st to do a small projection on the IRA account – moving as much as possible out of it into ROTH is adviseable; looking at the RMD amount, effect of the social security taxability, it all makes a difference.

    And yes – you can save quite a few dollars!

  6. 6
    John DeFlumeri Jr Says:

    It always seems that the government is in take-away mode.

  7. 7
    Kathy F Says:

    How can they take another $51,200 from traditional IRA and put it into a Roth IRA? I thought you can only contribute earned income from wages or salary to a Roth IRA and their earned income is only $13,000? Plus their are limits on how much you can contribute to a Roth IRA each year- limit is $6,000.

  8. 8
    Mike Piper Says:

    I know it’s almost a year later, but I just saw Kathy’s comment and figured I’d reply for anyone else who comes cross this article. :)

    When I suggested moving money from the traditional IRA to a Roth, I wasn’t talking about making regular Roth contributions, but rather about a Roth conversion–for which the $6,000 contribution limit doesn’t apply.

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