When it comes to retirement planning, much ado is made of how much to save. But often, the real difference lies in shrewd distribution planning. By withdrawing funds from certain account types in a certain order, you might significantly reduce your taxes and lower your annual withdrawal rate. What should you consider now when planning your retirement distributions?
Assigning Your Money to "Buckets"
Many investors who are getting closer to retirement may worry about the impact of a sudden stock market drop. But while it's important to protect some funds from major market moves once you've left the workforce, remember that your retirement funds will need to sustain you for several decades or longer.
By allocating your assets to different risk "buckets," you can maintain future growth while helping make sure you have enough funds on hand to cover short-term expenses. For example, your short-term savings may be entirely in cash or money market funds that have no risk of loss, while your more aggressive long-term bucket may be invested 100 percent in stocks. The right asset allocation for you will depend on your account balances, your retirement budget, your retirement wishes, and even your projected lifespan.
Creating Guaranteed Income
The key to a sustainable retirement involves providing yourself with flexibility. If you retire with one or more sources of guaranteed income, like a pension or Social Security, you can use this income to cover your everyday expenses while reserving your lump-sum retirement funds for larger expenses.
Having a guaranteed source of income to cover expenses can prevent you from having to cash out funds in a down market. This flexibility can help you preserve your nest egg for the future.
Sequencing Your Accounts
Not all retirement funds are created equal. Withdrawing from a 401(k) can leave you with a tax bill, while Roth IRA distributions are entirely tax-free. Balancing your withdrawals between these fund types can significantly reduce your tax bill. Often, it can make sense to withdraw from pre-tax funds like 401(k)s and traditional IRAs only up to the amount of your federal income tax deduction, supplementing your cash needs with tax-free withdrawals from a Health Savings Account or Roth IRA.
For example, a married couple that plans to spend $45,000 per year in retirement can withdraw $24,400 from a 401(k), using the standard deduction to completely offset this income, and then withdraw the remaining $20,600 from a Roth IRA. Through this approach, the couple will not owe federal income taxes on the $24,400 401(k) withdrawal (because of the standard deduction) or the $20,600 Roth withdrawal (because these funds aren't subject to federal income taxes).1
This means that if you haven't already been saving for retirement in both pre- and post-tax accounts, there's never been a better time to start. By having a healthy mix of funds that enjoy different tax treatment, you'll be better able to plan your distributions in the most tax-efficient matter.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal advisor.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
Asset allocation does not ensure a profit or protect against a loss.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
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