You've spent years saving and investing money for retirement — most likely, in various types of accounts and investments. Now you're faced with a new dilemma that you may have never realized until now — Which Money Should You Spend First In Retirement?
This is a question I often receive and while the answer will vary a bit based upon your situation, the general rule of thumb is:
1. Taxable Income/Assets
2. Tax-Deferred Assets
3. Tax-Free Assets
This allows you to spend down the least tax efficient portion of your nest egg first while preserving tax-deferral (and the benefits of tax-deferred compounding growth) as long as possible. Here's some additional factors to consider.
Social Security and Pension Income
These are core sources of income for many retirees. The main decision to make here is when to claim your benefit. This is true for Social Security with the largest benefit being available to those who wait until age 70 to claim their benefit. Public and private employer pensions might also offer an increased benefit level if you wait until a later age to start payments.
Related Post: When Should You Claim Your Social Security?
Income From Employment
If you work during retirement, this income will likely be among the first money that you spend. This might include income from a part-time job or perhaps income from consulting work or a business that you started once you left your last job.
Required Minimum Distributions
For those that are at least 70 ½, you must take required minimum distributions from retirement accounts such as Traditional IRAs and 401(k) plans. The penalties for failing to take the full required amount are steep so you will want to be sure to get this right.
Related Post: Required Minimum Distributions- What You Need To Know!
In many cases it makes sense to spend the money in taxable brokerage accounts first. The logic here is that this allows the money in your tax-deferred accounts (i.e. IRAs, 401ks) to continue to grow on a tax-deferred basis. Another reason to consider spending this money first is that investments held for at least a year are taxed at lower capital gains rates. These rates are often lower than the ordinary income tax rates that are tied to withdrawals from retirement accounts. Of course, it can get even more detailed than that. You'll want to liquidate your assets with a loss first, then assets with minimal gain, and finally assets with significant gains.
Tax-deferred Retirement Accounts
As mentioned above, you have no choice when it comes to the required minimum distribution (RMD). You might find yourself in a lower tax bracket as you get older so the income tax bite might be less than the earlier years in retirement.
It can be tempting to take withdrawals from a Roth IRA or a Roth 401(k) right off the bat as this money is tax-free if you are at least 59 ½ and have met certain time-period requirements, but this isn’t always the best way to go. Since Roth IRA accounts are not subject to the RMD requirement, this makes them an excellent estate planning vehicle to leave to a spouse or other beneficiaries. The money in the account can continue to compound tax-free allowing for continued growth.
More Complicated Than You Think
For regular readers of my blog, you know that things are not always as simple as a cookie cutter formula when it comes to managing your finances. I write these posts to provide you with the "need to knows" without having your eyes glaze over. There's numerous additional factors to consider on this topic that aren't covered (and would quite frankly, bore you).
Developing a withdrawal plan from your various accounts in retirement is an important and often-complex task. The advice of an unbiased, fee-only financial advisor can help. Give me a call at (785) 256-9150 or schedule your FREE initial consultation to review your situation.
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Desmond Henry is a fee-only CERTIFIED FINANCIAL PLANNER™ professional and founder of Afflora Financial Life Planning in Topeka, Kansas. He helps the retiring/retired plan their finances and invest their money. CLICK HERE to learn more.