There’s a lot of concern among industry experts about whether the popular 4% withdrawal rule can provide enough income during retirement, but little discussion on the important role taxes play in how much cash you will actually have on hand. That’s why talking to a Financial Professional with tax knowledge should be a critical part of your wealth management strategy if you want to help ensure that you have enough money as you pursue the retirement you have envisioned.
The 4% Withdrawal Rule
One of the most popular approaches to how much you can withdraw annually without running out of retirement funds has been the 4% rule. Stated simply, you withdraw 4% of your retirement savings the first year and then increase that amount 1% to 2% each year to adjust for inflation. It is an easy strategy to apply, but lately, there’s a lot of concern that it won’t keep up with inflation or offer a predictable amount of income for retirees.
Which Accounts You Draw From Can Make All The Difference
While most agree that diversifying retirement savings across accounts with different tax treatments is ideal, the consensus often stops there when it comes to which accounts to draw from first. That’s when the recommendation of a tenured professional can help you plan the most appropriate strategy for your unique situation. For example:
When Accumulation is a Priority
You could withdraw from your investment accounts first — giving more time for assets to accumulate in your 401(k) and IRA accounts. This approach lets you take advantage of tax-free compound earnings as long as possible. Note: You will need to take your Required Minimum Distributions (RMDs) before any investment account withdrawals or face potential penalties.
When Your RMDs Push You Into a Higher Tax Bracket
If you have substantial funds in taxable, tax-deferred and non-taxed accounts, you run the risk of paying considerable taxes when RMDs hit. By taking any additional retirement income from your Roth account, you can potentially avoid significantly higher capital gains tax than you would with the first approach.
When you want to avoid an unexpected tax bill
Withdraw a portion of your income from both taxable (investment) and tax-deferred traditional and 401(k) accounts and leave any Roth IRA accounts for last. This approach helps avoid a potentially higher tax bracket during the middle of retirement due to RMDs. Instead, you will spread taxes more evenly across your retirement years for a more predictable budgeting process.
When Your Current Tax Bracket is High
With this approach, you will pull from tax-free accounts when you are in your highest anticipated bracket and from tax-deferred accounts when you are in your lowest bracket. Much like the previous strategy, the goal is to minimize your tax liability and balance tax payments over a longer period of time.
When You're Worried About the Impact of Taxes on Heirs
Clients with significant wealth who aren’t concerned about having enough money in retirement might do better to focus on the impact their estate may have on heirs. By taking from Traditional IRAs and 401(k) s first, you can leave your Roth IRA to loved ones to minimize their taxes.
Tax-Smart Strategies Apply No Matter What Your Approach
Applying tax-smart strategies can help build wealth and safeguard your retirement no matter what type of withdrawal method you use. A tax-focused Financial Professional will not only help you determine how much money you can safely spend, but which accounts to withdraw from to help as you pursue your goals. Some alternatives you might discuss include:
- Using the fixed withdrawals method, you simply take the same amount annually as a flat rate or a percentage of your investments. This approach doesn’t account for inflation, however, and if you need to withdraw money during a down market, you could deplete your income more quickly than they want. That’s when withdrawing from investment accounts first can help you accumulate more with compound earning in your retirement accounts.
- The total return strategy means you take out enough living expenses for 3-12 months at a time and leave the rest to benefit from potential Additional funds are taken only as needed. This strategy can help build assets, but it is also subject to market risk and not a good candidate if you are uncomfortable with risk or do not have enough to forgo withdrawals during a market dip. Your Financial Professional can help you determine if you have enough assets to safely meet your income needs and weather market volatility.
- The bucket strategy is a way of dividing retirement assets among three “buckets” — one for more immediate spending, one for money needed over the next 7-36 months, and one where assets will not be needed for at least 24 months. The first bucket holds extremely liquid assets like a savings account. The second bucket is moderately liquid such as a high-yield CD and the third bucket is invested for growth in the stock market. Once the first bucket is depleted, money is shifted from bucket 2 to 1 and so forth. This approach splits the difference between safety and growth but can be time-consuming and difficult to apply without the help of a tenured tax expert.
Don't Wait to Start the Conversation
Building a tax-smart strategy for retirement account withdrawals isn’t something that should wait until you hit retirement. Meeting with a Financial Professional now could make a significant impact on your overall wealth. With tax-smart guidance, you can structure your accounts to potentially maximize your assets in both the accumulation and withdrawal stages, and as your needs change, so should your approach.
Let our tenured Financial Professionals put you on a path that could lead to more financial confidence with ways to build wealth and minimize taxes so you can pursue the lifestyle you envision — both now and in retirement. Contact us today to start the conversation.