So, you’ve managed to save enough to retire and spend the rest of your life doing things that really matter to you. If you’re like most Americans, and did not work in the public sector, you probably don’t have a pension from your prior employer(s). Instead, you saved in your employer-sponsored retirement plan. You probably also saved outside of these work-related retirement plans. You paid taxes during your working years and, as a result, you’ll receive Social Security benefits. You might also have some rental property income. Think of these various forms of savings and income as buckets.

You have spent 40+ years saving in these buckets. Now, at retirement, it’s time to start taking distributions from them. What’s the best way (i.e. when? and how much? and in what order?) to take money from them to pay for the things you wish to have and want to do? When and how should you take Social Security? How do you minimize the amount of taxes you pay?

The answers to these and other related questions are what we at Springwater call “distribution planning”. Done properly, distribution planning can add tens of thousands of dollars to your retirement. So, let’s consider how to create a sound retirement distribution strategy.

Let’s start by noting the tax characteristics of your savings and income buckets. Workers typically save money in employer-sponsored retirement plans by deferring income into accounts such as a 401(k), 403(b) or Simplified Employee Pension plan. These monies are contributed before tax, and they grow tax-deferred. However, when withdrawn, they are subject to ordinary income taxes.

In reality, most people will “roll” their workplace savings accounts into an Individual Retirement Account (IRA) when they retire. When distributions are taken from an IRA, they are taxable as ordinary income.

It is possible to save in an IRA, in addition to a retirement plan at work, as long as your income is below certain limits, which vary depending on your tax-filing status (i.e. single, married filing jointly, etc). So, at retirement, your IRA could include money you accumulated both through a work-related plan like a 401(k), and outside work.

Some people have saved for retirement in a Roth IRA. Unlike a traditional IRA, the contributions to a Roth IRA are taxed before they’re deposited into the account. As with the IRA, the dollars inside a Roth IRA grow without being subject to taxation. The attraction of the Roth IRA is that the distributions you eventually take at retirement will not be subject to taxation as ordinary income. Like the traditional IRA, there are eligibility rules for the Roth IRA that are based on income levels and tax-filing status.

If you have a taxable investment (or “brokerage”) account, the earnings it generates are taxed in different ways. Interest is taxed as ordinary income. Generally, dividends are taxed as ordinary income. However, “qualified” dividends are taxed as capital gains. (We will defer the definition of “qualified”.) Short-term (less than one year) capital gains are taxed as ordinary income. Long-term capital gains (one year or more) are taxed at their own (comparatively) lower rate.

Social Security benefits may be taxed, depending on your other income and your tax-filing status. Up to 85% of Social Security benefits can be subject to taxes. The decision about when to take Social Security benefits is directly related to a person’s income needs, other financial resources (those buckets we mentioned earlier) and anticipated life expectancy. In general, it is advantageous to wait as long as possible (i.e. to age 70) to take Social Security, because the amount of the benefit will increase by approximately 8% for every year that you wait.

Rental income is generally taxable. However, it is possible to deduct from gross rental income certain expenses that directly relate to the property.

Let’s consider an example. Joe and Mary are both 65, and they are ready to retire. Joe worked for Intel and Mary was a nurse. They have $2 million total in their IRAs, $250,000 total in their Roth IRAs, and $1 million in their brokerage account. Joe anticipates his Social Security benefit will be $2,800 per month at age 66. Mary expects her Social Security benefit will be $2,000 per month at age 66. With the help of their financial advisor, they’ve concluded that they’ll need $10,000 per month to maintain their desired lifestyle. They expect to live to 90 (Joe) and 95 (Mary), respectively. They do not own rental property.

In consultation with their advisor, Joe and Mary have decided that they would like to defer taking Social Security until they are both age 70. (There may be a better strategy. But, for the purposes of simplification, we will ignore it.) How should they take distributions from their buckets in order to generate the income that they need?

Should they just take $10,000 per month from their IRAs? Probably not, because those withdrawals would be subject to ordinary income tax. Should they instead take $10,000 per month from their brokerage account? That would depend on the nature of the investments inside their brokerage accounts and the cost basis of those investments. What about taking money from the Roth IRAs? While those withdrawals would be tax-free, there may be a better time to use that bucket.

The best plan will likely involve Joe and Mary taking their total income need of $10,000 from more than just one bucket. They should probably first take a distribution from their IRAs, until their income reaches the lowest federal tax brackets (10%, 12% and perhaps up to the 22% bracket). Then, they should then probably take distributions from their brokerage account, as needed, until they meet their total monthly income requirement. They will likely want to defer taking money from their Roth IRAs, at least for the next several years. Once their Social Security benefits begin, their need to take distributions from the other buckets will be greatly reduced.

As you can see, tax-efficient retirement distribution planning can be complex. Springwater uses sophisticated software to model distribution scenarios that will minimize taxes and maximize total resources. If you are interested in learning more about this service, and how we can work with you and your CPA to improve your financial future, please contact us at your convenience.

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