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Here's the best order for tapping your retirement accounts

The Motley Fool logo The Motley Fool 2/18/2019 Kailey Fralick

By the time you reach retirement, you'll probably have racked up several different kinds of savings accounts to support you in old age. You may have 401(k) accounts from different employers, a few other tax-advantaged accounts like an IRAs and HSAs, and lastly, plain old investing accounts where you've socked away money for a nice return. 

Being strategic about which of these accounts to use first and ordering your withdrawal plans with purpose will serve you well in retirement by making your money go the furthest. 

There are three types of retirement savings vehicles:

  1. Traditional IRAs and 401(k)s are tax-deferred, which means your contributions reduce your taxable income in the year you earn the money, but then you owe tax on your withdrawals, or distributions, when you take them.
  2. Contributions to a Roth IRA or a Roth 401(k) are made with after-tax dollars, meaning they don't reduce your income in the year you make the contribution, but they are allowed to grow tax-free. The withdrawals from a Roth IRA or Roth 401(k) are taxed differently, though. 
  3. Investment accounts offered by a brokerage are taxable accounts, rather than the aforementioned tax-advantaged retirement accounts, but they are still a great place to stash your nest egg if you've maxed out your tax-advantaged retirement accounts, or if you want access your retirement funds before you're 59 1/2 without paying a 10% early withdrawal penalty. 

Below, I discuss each type of account in more detail and explain a simple strategy to help you determine the order in which you should use them to keep your tax bill as low as possible.

Tax-deferred and Roth retirement accounts

Contributions to tax-deferred retirement accounts like 401(k)s and traditional IRAs reduce your taxable income in the year you make the contribution, so they're often called tax-deductible contributions. When you eventually withdraw the money from your account during retirement, you'll pay your ordinary income tax rate on your initial investment and any interest earned.

Roth accounts, either IRAs or 401(k)s, work the opposite way. The money you contribute to Roth accounts does not come off of your taxable income for that year, but it grows tax-free. You don't have to pay any tax when you take the money out, with a few exceptions. For example, you will pay a 10% early withdrawal penalty if you take any money out before 59 1/2, unless it's for a qualifying reason like a permanent disability. The money must also remain in your Roth account for at least five years before you withdraw it, otherwise you may owe taxes on any earned interest.

When choosing how much to withdraw from each type of account in retirement, you need to be aware of required minimum distributions (RMDs).

All retirement accounts have RMDs except for Roth IRAs. Once you reach 70 1/2, the government requires you to begin withdrawing money from your retirement accounts in order to ensure it gets its tax cut. The amount you must withdraw depends on your age and the value of the account at the time. This worksheet helps you figure out your RMDs. Divide the total value of each retirement account by the distribution period listed next to your age to figure out how much you need to withdraw from each account this year. Failure to take out at least this much will result in a 50% penalty on the amount that should've been withdrawn.

It's important to be mindful of these RMDs because they could force you to withdraw more money than you were anticipating, which might push you into a higher income tax bracket in your later years. Drawing more heavily upon accounts subject to RMDs during the early years of your retirement helps reduce the amount of your RMDs when you reach 70 1/2, but it could also raise the amount of taxes you'll pay early in retirement. The key is to understand the rules and plan accordingly, to minimize your taxes and maximize your savings.

Taxable investment accounts

You can open a taxable investment account with any brokerage firm. This is not a retirement account per se, but that doesn't mean you can't put some of your savings there. The money in these accounts is not subject to early withdrawal penalties or RMDs, so you have more freedom to choose when to withdraw this money.

You'll pay taxes on any contributions to these accounts in the year that you earn the money, and you'll pay taxes on capital gains as well, but how much you'll owe depends on how long you've held the asset that you're selling. If you've owned it for less than a year, it will be taxed at your income tax rate, which ranges from 10% to 37% based on your income and tax filing status. If you've owned the asset longer one year, though, it becomes subject to the rules of long-term capital gains tax, which is different.

Long-term capital gains are taxed at 0%, 15% or 20%, depending on your taxable income and your tax filing status for the year. 

Capital Gains Tax Rate

Single Taxable Income Range

Married Filing Jointly Taxable Income Range

Head of Household Taxable Income Range

 

0%

Up to $39,375

Up to $78,750

Up to $52,750

15%

$39,376 to $434,550

$78,751 to $488,850

$52,751 to $461,700

20%

Over $434,550

Over $488,850

Over $461,700

Data Source: Tax Foundation.

How you handle your taxable investment accounts in retirement will depend on where your taxable income falls. If you were to use this as your sole source of income for the year and you can keep your withdrawals below the 15% tax threshold, then you won't pay any taxes on those distributions. But if you're above this threshold, you'll lose a sizable chunk of your earnings, though far less than if withdrawals were taxed at the standard income tax rate.

The best strategy for tapping your retirement accounts

Your goal when withdrawing money from your retirement accounts is to keep your taxable income as low as possible while allowing your tax-advantaged accounts to continue growing. You can accomplish this by using the proportional withdrawal strategy: Withdraw a proportional amount from each of your accounts based on the proportion of your retirement savings in each account type. 

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Here's an example to show you how this works: You're a 60-year-old single adult and you're relying on your retirement accounts for all of your income for the year. You need $30,000 to cover your living expenses, and you have $200,000 in a taxable investment account, $400,000 in a 401(k) and another $150,000 in a Roth IRA for a grand total of $750,000 in retirement savings.

Let's examine the proportions: About 27% of your savings is in a taxable investment account, 53% in a tax-deferred retirement account and 20% in a a Roth account. If you need $30,000 for living expenses, using the proportional withdrawal strategy, you'd withdraw $8,100 (27% of $30,000) from your taxable investment account, $15,900 (53% of $30,000) from your traditional retirement accounts and $6,000 (20% of $30,000) from your Roth accounts. You wouldn't pay taxes on the Roth distributions and the remaining $24,000 of taxable income is low enough to fall into the 0% capital gains tax bracket, so you would only end up paying taxes on the $15,900 you withdrew from your 401(k).

This proportional withdrawal strategy helps stretch your savings by spreading out the tax advantages that your retirement accounts offer so you don't have some years where you owe little or nothing and others where you owe a lot. Using this approach, you should end up paying a similar amount in taxes every year, which makes taxes easier to budget for. Plus, this strategy could save you as much as 38% in taxes over the course of your retirement, according to research by Fidelity.

But you have to be willing to adapt your strategy with the times. RMDs may force you to take out more from your traditional retirement accounts than you planned or tax brackets may change and give you a little more breathing room if you want to withdraw some extra cash without paying a lot more in taxes.

At the beginning of each new year, create your budget and decide where you're going to get that money from. First, total up how much money you think you'll need to cover your living expenses for this year. This includes housing costs, groceries, utility bills, insurance premiums and any other expected costs. Then, subtract any money that you're getting from sources other than your retirement accounts, like a part-time job, Social Security, or a pension. Remember, these may count toward your taxable income. The difference between your total living expenses and the income you expect to receive from other sources is the amount that you need to withdraw from your retirement accounts this year.

Figure out how much money you have in each type of retirement account and what proportion of your total retirement savings each account makes up. Then, multiply these percentages by the total amount you need to withdraw from your retirement savings to determine how much you should take from each account. Remember to be mindful of the tax brackets and don't be afraid to make adjustments as needed. With careful planning, you can still get the money you need without losing too much in taxes.

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