When it comes to retirement planning, a common question these days is “in light of all that’s going on, how should I take my retirement drawdowns?” By “going on,” consumers are mainly referencing the potential increase in income taxes and concerns with the future of Social Security. Add the recent spate of early retirements due to the pandemic, and there’s a heightened interest in how best to effectively draw down retirement capital.
The answer to the pressing retirement planning question is that it depends on individual circumstances, but a way to start the process is to determine where you plan to be in terms of taxable income at retirement. The admittedly overgeneralized strategies below can serve as a starting point for further inquiry:
– If you anticipate having relatively low taxable income in retirement, you should withdraw from your Individual Retirement Accounts (IRAs) first, your after-tax investments next, and your tax-exempt Roth IRAs last.
– If you are affluent, a starting point is to take IRA withdrawals up to the top of your current income tax bracket, withdraw after-tax investments next, and distribute your tax-exempt Roth IRAs last.
– If you are wealthy, begin by withdrawing your tax deferred IRAs first and then drawdown a combination of your tax-exempt Roth IRAs and after-tax investments last.
– For all levels of retirement income, the best approach for filing for Social Security is generally to wait as long as possible, ideally until age 70.
This odd sequence of drawdowns from one demographic group to the next is attributable to the interworking of different tax-based variables. By drawing down from one account, you may be able to permanently lower the taxes on another. It’s important to understand that your particular circumstances can quickly detour you from these general strategies. You may be expecting a unique spike in income in a particular year, anticipating special expense needs at a specific time, or foreseeing longevity concerns that change the trajectory of your anticipated retirement. So, start with these rules of thumb, and then adapt as your particular situation dictates.
Let’s begin by focusing on individuals who expect to be in comparatively low-income levels in retirement. In future posts we will consider higher income retirees.
Starting The Process For Low-Income Retirees
2021 is a year where prospective retirees are worried about the future of Social Security benefits and the prospect of increased taxes. For low-income retirees, both issues are legitimate concerns, but they are not a reason to radically change strategy.
First, even though existing funding is an existential threat to continuing Social Security benefits at current levels, taking a “get it while you can” approach is unlikely to pay off. From a political standpoint, reducing benefits for low-income individuals who are at or near retirement would be wildly unpopular. To be safe, however, you might assume a haircut in the benefits you expect to receive, but it’s unlikely that you’ll lose by waiting to claim your benefits. As for the issue of income tax increases, it currently appears that higher-income individuals are the more likely target for added taxes. Still, because taxes may increase in general, using Roth IRAs in retirement income planning makes more sense than ever.
According to a 2019 Gallup poll, 57% of retirees rely on Social Security as a major source of income, and for those who will rely on it as the primary source of retirement income, the issues of drawdown strategies are largely moot – as there will be little in other income sources from which to draw down. If, however, you anticipate additional retirement funds – say, a roughly $50,000 minimum of before-tax income in retirement – the order you use for drawing your excess savings can make a difference in your net retirement income.
You should start by asking yourself some baseline questions. First, do you anticipate your expenses in retirement will be in-line with your anticipated income? For example, do you expect your Social Security, 401(k) income and investment returns to be enough to support your necessary and discretionary expenses? If not, your retirement focus should be more on increasing income or reducing expenses than on the order of withdrawals to take.
If, however, your anticipated retirement income and expenses reasonably line up, the order in which you draw from these accounts can significantly affect the amount of after-tax income you can enjoy each year. For determining the order of drawdowns, use this process as a guide:
1. First, assess how much of your anticipated retirement income will be derived from Social Security, tax deferred accounts (such as IRAs and 401(k)s), tax-exempt Roth IRA accounts, and after-tax accounts (CDs, and stock and bond mutual funds, etc.). The likely mix of these accounts can be a moving target, but it helps to have an initial idea of the sources of your retirement income.
2. Plan to defer filing for Social Security for as long as possible. The advantages of this strategy for low-income retirees are particularly compelling. Primary among these is that you increase your benefit by approximately eight percent for each year you wait, plus the benefit has a cost of living feature that will come in handy later in life. There are more subtle considerations as well. For example, you can lessen or even avoid the Social Security tax torpedo by using other retirement income sources first, allowing you to escape having your benefit lowered by the Social Security earnings test. Additionally, if you’re married, delayed filing for the highest earning spouse assures that the surviving spouse will maximize his or her benefit.
3. Next, consider the level of taxable income you will have in retirement. Though it may sound counter-intuitive, if you anticipate that you will be in a low tax bracket, you should first draw retirement income from your tax-deferred IRAs and 401(k). You’ll be paying tax on these accounts at a low marginal tax bracket and, at the same time, depleting your tax-deferred accounts for the future. When you finally start taking Social Security, you can then start withdrawing from your after-tax investments to supplement your income. This strategy will keep your provisional income for Social Security purposes low, avoiding some or all of your Social Security payments from being subject to income tax. While this strategy may increase income taxes a little in the early years of retirement, you will save a lot in overall retirement taxes over time.
4. By drawing down your tax-deferred accounts early in retirement, you also avoid being forced to take required minimum distributions (RMDs) at age 72. By this age, you may have lowered your IRA balance and might even be drawing down from your after-tax investments. To the extent you need further income at that time, you can begin to take distributions from your tax-free Roth IRA account.
5. If you have retirement assets left over at your death, employing the above strategies will mean your remaining savings will likely reside in after-tax investments and/or tax-free Roth accounts. Both of these asset locations translate to a tax-advantaged legacy for your heirs.
Make Drawdowns A Part Of Your Plan
Creating your drawdown strategy for retirement should not exist independent of other retirement planning considerations. First and foremost, you should ensure that you’ve adequately addressed retirement risks such as health insurance, long-term care, and the risk of living too long. Further, you should coordinate your overall investment strategy with your intended drawdown approach. Work on both your asset location and asset allocation – this likely means concentrating high-taxed investments such as bank accounts, bonds and rentals in your tax-deferred IRA account while placing capital gain and dividend paying securities in your after-tax account.
Do you eat your appetizer, main entree, and dessert at the same time? Presumably not. That would diminish the enjoyment of your meal. Likewise, indiscriminate timing of the assets you use for drawdowns can diminish your after-tax enjoyment of retirement income. Take steps now to be an informed connoisseur of retirement income drawdown strategies.