We spent our lives working hard, saving for retirement, and building our nest eggs. One day the time comes when we stop working and start spending our saved assets. But we need to be smart about taking money out of our retirement funds, otherwise, the big chunk of it might be eaten by taxes.
A general rule to remember – keep the money in your 401(k) or IRA until you reach age 59 ½. If you withdraw any money before that age, you’ll be hit with a 10% penalty fee on top of the regular income tax.
In this post, I want to show you smart ways to take money out of your retirement accounts and help to avoid costly mistakes.
What is RMD?
There are certain rules to follow when you start taking money out of your retirement funds. The rules are about when you can withdraw money and how much you MUST withdraw every year. It is called Required Minimum Distribution (RMD).
The IRS requires to start taking a minimum distribution from tax-deferred accounts when we turn 70 ½ years old, unless you’re still working. If you don’t make it on time and failed to withdraw the required amount each year, you’ll owe to IRS a large penalty fee. In addition to the penalty fee, you’ll still need to withdraw the required amount and pay an ordinary income tax on it.
The recent changes to retirement savings law has affected RMD rules. The changes include increasing to 72 from 70 1/2 – the age at which retiree must begin taking required minimum distributions (RMDs) from their retirement accounts.
RMD rules are set up by the IRS and it will be a bad idea to follow those rules. The withdrawal amount is determined by your age, life expectancy (the longer your life expectancy is, the less money you must take out) and your account balance.
It’s good to remember that many financial firms can help you with calculating RMD.
For example, Roman and I have our IRA accounts set up with Fidelity and Vanguard. When we retire, we are planning to consolidate all our retirement funds and roll-over 401(k) money to IRA accounts. When the time comes, and we need to start taking RMD from our IRAs both Fidelity and Vanguard offer a service of calculating our RMD and send it to us automatically.
In what order to withdraw money from multiple retirement accounts?
The saying “it’s not what you earn, but what you keep” is true when it comes to withdrawing money from your various accounts.
The minute you start taking money out of 401(k) or IRA, you will have to pay taxes on your withdrawals. If you’re in a high tax bracket, you’ll owe a good chunk of money to IRS. Although, if you are wealthy enough and don’t need money from your retirement accounts, you still must withdraw them to follow the rules of RMD.
The best part of the Roth IRA money is that it would be tax-free when withdrawn from the Roth account and doesn’t fall under RMD rule.
Even, you must take money out and pay taxes on tax-deferred accounts, your Roth IRA money will stay intact, grow and accumulates with years. It could be used as an emergency fund or pass on to your heirs.
What is the smart way to take money out of the multiple retirement accounts?
- First – take money out of tax-deferred accounts – 401(k) and IRA
- Second – take money out of Roth IRA
How to consolidate multiple retirement accounts?
A simple way to control multiple retirement accounts and how much money to withdraw from each will be to consolidate them into a single account. It will help you to have better control over your future withdrawals and to simplify paperwork.
Over the lifetime you have accumulated multiple retirement accounts – traditional IRAs, 401(k) and maybe Roth IRAs. Before you turn 72 years old, you need to figure out how much and in what order to withdraw money from all these retirement accounts.
The good advice is to consolidate all your accounts into one. Why?
It will be much easier to manage your portfolio of assets in one account than in multiple with different financial firms. But keep in mind that you cannot combine IRA and 401(k) accounts into one. You can only put similar accounts together. For example, you can consolidate all traditional IRA accounts into one single IRA account.
As I mentioned before, you cannot combine 401(k) and IRA accounts into one, but you can roll-over 401(k) into IRA.
If you have several 401(k) accounts from your previous jobs, you should be able to merge old 401(k) into your current employer 401(k) plan as long as it is permitted by an employer plan. However, if you cannot combine old and new 401(k) accounts, you can roll-over old 401(k) accounts into IRA account.
I am many years away from applying RMD rules, but I already start thinking about merging our IRA accounts into one. Roman and I have multiple retirement accounts with different financial institutions:
(2) 401(k) accounts, (1) Roth 401(k), (3) Traditional IRAs, and (2) Roth IRAs
The idea of pulling all IRA accounts into one sound practical because it’s much easier to keep track of all our investments. I just need to do more research and calculations on how it will affect our taxes.
Consider a Roth IRA conversion
What is a Roth IRA conversation and how it works?
Roth IRA conversation is a process of switching between retirement accounts. You take money from 401(k) tax-deferred account and roll it into Roth IRA.
The Roth account is funded with after-tax money, so when you go with the conversion it will trigger the tax bill. You will pay taxes only on the converted money. Once you make the move, all the funds in Roth will grow tax-free.
The best part that you are not required to take a minimum distribution on the Roth IRA money, so it will grow and accumulate longer.
Several years ago, Roman and I converted a portion of our traditional IRA funds to the newly opened Roth IRA accounts. The conversion didn’t trigger a high tax bill, because we used a small portion of our IRA money. Yet, the transaction allowed us to open an after-tax retirement account with our savings. We let it grow and accumulate over the years into a nice and tidy sum.
When we turn 59 ½ we can withdraw money tax-free. However, we are not planning to use Roth funds, unless there is an emergency. It will be a smart way to leave them where they are. If we live long enough, the Roth money might grow into a substantial sum tax-free.
Also, the Roth IRA conversion is a great tool to preserve the retirement asset for heirs or survival spouse. It’s a great move because it removes the uncertainty of how much you need to pay taxes in the future.
Is Roth IRA conversion good for everyone? What about someone who’s close to retirement or even retired?
The Roth IRA conversion is a personal decision. If you are very close to retirement, or already retired and you need the retirement funds for yourself right now, I wouldn’t recommend going with Roth conversion. The same applies if you don’t plan to pass the retirement funds on to heirs.
Taxable vs. Tax-deferred accounts
As a general rule, it’s better to sell investments held in taxable accounts first instead of taking money out of tax-deferred accounts.
The reason is that the withdrawals from traditional IRAs and 401(k)s are taxed as an ordinary income. Typically, ordinary income is taxed at a higher rate than the long-term capital gains in a taxable investment account.
On another hand, if you withdraw retirement savings from your taxable accounts before tax-deferred it can increase the required minimum distributions rate and that reduce your tax efficiency.
Before writing this post, I made a lot of research and tried to find the answer to this question. The best strategy I found was on the Vanguard.com website:
“Take your withdrawals in a tax-efficient order.
Unfortunately, you never get to retire from taxes. If you’ve saved pre-tax dollars in a retirement plan or IRA, the bill comes due after you retire. When you withdraw pre-tax contributions and earnings, you owe ordinary income taxes on that money.
If you have different types of accounts, you may be able to prolong your tax savings by withdrawing your money in a tax-efficient order:
- Withdraw from any taxable accounts before touching your tax-advantaged accounts.
- Consider withdrawing money from tax-deferred accounts, such as an employer’s plan or a traditional IRA.
- Withdraw money from tax-free accounts, such as qualifying Roth contributions to an IRA or employer’s plan.
Consider setting aside a portion of each withdrawal to meet your income tax obligation. If you’re withdrawing from an employer’s plan, most plan providers are required to withhold 20% of each withdrawal for federal taxes, though your actual tax bill may be higher or lower.” (Vanguard.com website)
The general order of withdrawing money for tax efficiency is:
- First – pull money from your taxable accounts
- Second – withdraw money from your tax-deferred accounts – IRA and 401(k)
- Lastly – take money out of tax-free accounts – Roth IRA or Roth 401(k)
Putting it all together
There is so much information out there on how to save and invest for retirement. But when it comes to the withdrawal strategy things start looking complicated. There are many strategies, ideas, and rules to remember when you start planning for retirement. Having a retirement income plan that incorporates taxes is important. You need to see a real picture of how long your retirement funds will last.
Do you have multiple retirement accounts? Did you consider the ways to withdraw money from them? Share your thoughts with us.
The intent of this post is to be only educational and provide a simple guideline for a very complicated matter. I would recommend discussing your retirement plan with an accountant, financial planner or tax professional.