Retirement often ushers in a host of changes, from where you live, to what you do with your time, to where you get your income. You’ve likely saved for this phase for years, but now putting a solid plan together for how to best use those savings is key to ensuring the rest of your retirement vision becomes a reality.
Here are three smart steps for building a distribution strategy that maximizes your savings and minimizes your tax bill:
1. Take a deep dive into your expenses
For many people, a lot of retirement planning is focused on how much they need to save. However, as you get closer to retirement, you’ll also want a comprehensive understanding of your expenses and how much income you’ll need to sustain your lifestyle. Start by examining the cost of your necessities such as your housing, utilities, and any debt you currently have including car payments or credit cards. Keep an eye on things that will remain unchanged, even as your life stage shifts—these could include car insurance premiums, subscriptions to services, and regular maintenance on your home.
Once you have a handle on your static expenses, consider what costs may change. For instance, work-related expenses from transportation costs to dry cleaning may disappear. In addition, some costs may actually increase with retirement. These may include insurance costs if you're retiring before you're eligible for Medicare or expenses related to moving to a different part of the country.
2. Pay attention to Required Minimum Distributions
When you reach age 70 1/2, the IRS mandates you take Required Minimum Distributions (RMDs) from your employer-sponsored retirement accounts and your traditional IRAs. Roth IRAs don’t require distributions until after the account owner passes away. Your annual RMD amount takes into account your life expectancy and how much you have saved in retirement accounts in total. The amount will vary by person, and you do need to calculate it every year because it can change.
While you may not need to tap into your IRA or 401k immediately, it's important that you not miss the deadline for taking your RMDs. Retirees who don’t take their required distributions face a steep penalty: 50% of the amount not taken. But what if you immediately those funds? You still need to withdraw the appropriate amount. But you can reinvest your RMDs into other types of non-qualified savings vehicles or even create a charitable giving plan that provides some additional tax benefits.
3. Aim for a tax-efficient distribution strategy
Funding your retirement is certainly a bit of a puzzle. You likely have savings in different types of accounts and perhaps you even have income coming in from consulting, part-time work or other kinds of investments. How the income from different assets is taxed varies, and as you put together your distribution strategy, you want to keep taxes top of mind. That's because for retirees, finding the sweet spot between taking out as much income as you need and remaining in the lowest tax bracket possible is key to saving money.
While there are many ways to organize tax-efficient distributions, a basic withdrawal strategy looks like: RMDs first, if you’re over age 70 1/2. Then taxable accounts such as brokerage accounts, followed by tax-advantaged accounts such as traditional IRAs and employer-sponsored 401ks. Why this order? Well, retirees, as noted, need to take RMDs to avoid penalties so those have to happen. But then prioritizing income from your taxable investment accounts usually results in a lower tax bill because your investments are likely subject to long-term capital gains tax instead of income. The difference in rates is stark: 15% or 20% compared to up to 37% respectively.
Preparing for retirement is an accomplishment in of itself. Ensure all your planning and hard-fought savings last as long as you need by creating a distribution strategy that makes the most of your dollars.