Develop a Tax-Smart Withdrawal Plan
You probably already know that retirement planning doesn't stop at retirement. Of course, reaching that important milestone means that you've "arrived." But the real challenge for retirement savers is figuring out how to make their retirement income last all the way through retirement.
With that goal in mind, it's important that those who are about to retire make the right choices concerning how and when to withdraw their retirement income. That’s because a well-thought-out withdrawal strategy can help retirement investors achieve greater financial freedom in their retirement years.
Following are some factors you may want to consider when determining your own retirement income withdrawal strategy.
Distributions: Choose a Smart Way To Keep What's Yours
If you made your plan contributions with before-tax dollars, you’ll want your tax-deferred investments to grow for as long as possible—because all contributions and any investment appreciation grow tax-free until you withdraw your money.
Look to Your Taxable Accounts First
You may wish to consider withdrawing money from your taxable accounts (such as mutual funds, regular savings accounts, CDs and individual securities) first. Here’s why:
- The tax rate you’ll pay on these withdrawals may be lower than the ordinary income tax rate you will pay when withdrawing from tax-deferred investments…like your retirement plan.
- If you are planning to begin withdrawing your retirement funds before age 59½, retirement accounts have regulations and penalties that may apply to the early withdrawal of your money.1
Special Rules for Those Age 70½ and Older
The year you reach age 70½, and each year thereafter, you are required by the Internal Revenue Service to withdraw a portion of the assets in most types of retirement accounts.2 The distribution for the first year can be deferred until April 1st of the following year, but that means taking two distributions within the same tax year. This withdrawal is commonly called a "required minimum distribution," or RMD.
- You must take RMDs from the following accounts:
Traditional and Rollover IRAs, SEP-IRAs, SIMPLE-IRAs, and SAR-SEPs
- Employer plans, including 401(k), 403(b), 457, profit sharing, and money purchase pension plans
- Your RMD is determined based on IRS-published life expectancy tables. You must include and report your RMD amount each year as part of your earned income when you file your tax return.
- The dollar amount of each RMD can be substantial—and has the potential to bump you into a higher tax bracket. To plan for these distributions from a tax perspective, it’s helpful for you to be in a lower bracket when you’re retired (than when you were working).
THE ROTH FACTOR
If possible, you may want to consider delaying any withdrawals from a Roth IRA, particularly if you plan to pass along these assets to your heirs. Qualified distributions from a Roth IRA are income tax-free and have no minimum distribution requirements—so Roth IRA assets can grow income tax-free, even beyond the owner’s death.
Traditional IRAs can also be converted to Roth IRAs to help minimize the impact of your RMDs. You'll have to pay income taxes on the dollar amount being converted, but after that, you'll never face IRA-related RMDs again—and your money will grow tax-free for your lifetime and that of your beneficiaries.
Unlike Traditional IRAs, Roth IRAs do not offer any up-front tax benefits (such as tax-deductible contributions), so you will need to ensure that converting your Traditional IRA fits into your overall tax plan.
IT DOESN’T HAVE TO BE ALL OR NOTHING
You may achieve a better overall result by taking distributions from various categories to maximize your after tax results. For example, taking some money from your IRA and some from your Roth IRA may enable you to stay in a lower tax bracket or cause less of your social security benefits to be taxed. Beginning in 2013, when a new 3.8% tax on investment income comes into play for higher income tax payers, this strategy could help reduce taxable income and subject less investment income to the tax.
BE TAX-SMART ABOUT SOCIAL SECURITY
Approximately one-third of Social Security recipients have to pay income taxes on their benefits. But if you delay taking Social Security, you’ll not only receive a higher benefit payment when you ultimately collect; you may also have to pay less in income taxes.
YOUR SOCIAL SECURITY BENEFITS STATEMENT
After the end of each calendar year, you will receive a Social Security Benefit Statement that shows the amount of benefits you received during the prior year. Use this statement when you complete your federal income tax return to determine if you have to pay taxes on your benefits—and to help yourself plan for the current year.
For more information, visit the Social Security website and click on “Retirement” in the upper left corner of the page. When the “Retirement Benefits” page appears, click on “Use our retirement planner” to learn more about Social Security programs, estimate your benefit—and more.
BEING TAX SMART MEANS PLANNING WISELY
Sorting through the tax implications of your future can be complicated—and difficult to do alone. Since retirement means major life changes, when it comes to your personal retirement strategy, be sure to consult a qualified financial professional.
1 Generally, withdrawals are taxable at ordinary income tax rates. Amounts withdrawn before age 59½ may be subject to a 10% federal income tax penalty, applicable taxes, and plan restrictions.
2 Roth IRAs do not have RMDs at the end during the owner’s lifetime.
Neither Prudential Financial nor any of its representatives are tax or legal advisors and encourage you to consult your individual legal or tax advisor with any specific questions.