In planning for retirement, most of the emphasis is on accumulation—how to save and invest as much as you can in your company’s retirement plan, traditional and Roth IRAs, and other accounts. But what happens when you leave work and need to start using what you’ve saved? How can you deploy your assets as efficiently as possible, so that they’ll be there to sustain a comfortable lifestyle for the rest of your life? And when it’s time to tap your retirement nest egg, where should you begin?
Although there are several economic and personal factors involved—including your level of assets, the investment mix of your portfolio, and your age and health status—decisions about retirement spending often boil down to questions of tax efficiency. And, with tax increases looming, making the right choices is crucial.
To begin that process, make sure you know the basic tax rules for different types of accounts. Here’s a quick rundown.
Personal accounts. Investment income that you earn outside of your retirement accounts and IRAs—for example, in brokerage and interest-bearing accounts—is generally taxable in the year you receive it. If you sell securities or other capital assets, any profits will be taxed as capital gains—at your regular income rate if you held the asset for a year or less, but otherwise at a more favorable long-term capital gains rate.
401(k)s and other company retirement plans. The 401(k) is by far the most popular type of “qualified” retirement plan, but SIMPLEs, SEPs, and pension plans also work the same way. These plans offer pre-tax contributions and tax-sheltered investment growth, but payouts during retirement are taxed at ordinary income rates. Other rules penalize early withdrawals before age 59½, unless a special exception applies, and retirees must begin “required minimum distributions” (RMDs) after age 70½.
Traditional IRAs. Here, too, the amount of any distribution representing tax-deductible contributions and earnings is taxable at ordinary income rates, and comparable rules for early withdrawals and RMDs also apply.
Roth IRAs. Unlike money that you withdraw from a traditional IRA, qualified distributions from a Roth in existence at least five years are 100% tax-free. Another advantage is that you don’t have to take RMDs during your lifetime.
Understanding the tax implications for each kind of account will become even more significant next year, if scheduled tax increases take effect. Ordinary income tax rates are set to rise, cresting at a top tax rate of 39.6% (up from 35% in 2011). And whereas long-term capital gains and qualified dividends have been taxed at a maximum rate of 15%, the rate for long-term gains will jump to 20% and dividends will be taxed at ordinary income rates. Finally, a new 3.8% Medicare surtax will also affect some high-income investors. The surtax applies to the lesser of your annual net investment income or the amount by which your modified adjusted gross income (MAGI) exceeds $250,000 ($200,000 for single filers).
With rates going up, future distributions from retirement accounts could result in much higher tax liability. Against that backdrop, the general rule of thumb calls for taking retirement funding from your savings in this order:
1. Personal accounts
2. Company retirement plans and IRAs
3. Roth IRAs
Tapping your accounts in that sequence is designed to produce the lowest possible tax bill, to allow for maximum tax-deferred growth, and to provide optimum portfolio longevity. The main thrust is to keep tax-advantaged accounts growing for as long as possible. Also, this approach reflects the necessity of eventually taking RMDs from qualified retirement plans and traditional IRAs. The Roth IRA, which can deliver tax-free income and isn’t subject to the rules for RMDs, is normally the last resource to use.
But this sequence assumes that you’ll be in a higher tax bracket in the future—and unless Congress acts to renew expiring tax breaks, it’s very likely you will be. In 2013 or later, you could be taxed at a rate as high as 43.4% if you’re hit by the 3.8% Medicare surtax.
If, on the other hand, you anticipate that your future tax rates will be lower than your current rate, you might take distributions first from your tax-free accounts. And there are other times when you might deviate from the typical approach, depending on your circumstances.
The analysis is tricky, so don’t jump to conclusions. We would be glad to provide the guidance you need to choose an approach that works best in your situation.