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How to Determine Which Accounts to Tap for Retirement Income


After decades of diligently saving and planning for retirement, the hard part should be over, right? After all, accumulating the wealth needed to fund your retirement lifestyle for 30 or more years has to be more complex and strenuous than simply spending it?

Think again.

The greater challenge is being able to create a lifetime income stream from multiple sources with varying tax implications - often in the face of uncertainty over future tax changes and economic conditions. Determining which accounts and assets to tap at various stages of retirement can mean the difference between enjoying your vision of retirement and struggling to maintain a lifetime of income.


No Simple Formulas

Financial planners have simplified at least one aspect of the retirement income equation by coming up with the evidence-based “4% rule,” which is the rate at which a retiree could safely take income from their investments without risking running out of money. Unfortunately, there is no simple formula for determining which retirement accounts or assets should be tapped because it is based largely on your individual circumstances, including the exact mix of accounts you have (taxable, tax-free or tax-deferred), your current and future tax situation, and your income needs.

There is, however, a less scientific common rule of thumb that advocates for selling long-term assets for capital gains first, the rationale being that the capital gains tax rate is lower than the ordinary income tax rate. As a bonus, if you can manage to keep your total taxable income within the 10% or 15% tax bracket, you won’t have to pay any taxes on your capital gains or dividends. By tapping your taxable accounts first, it allows you to continue to compound the growth of tax-deferred earnings in your 401(k) or IRA. In this first stage of draw down, you would also tap into any other taxable savings accounts you have allocated for retirement (except your emergency savings account which has a separate purpose of a cash reserve).

The danger in the common rule of thumb strategy of delaying withdrawals from your IRA is that you would have to increase the required minimum distributions (RMDs) you must take at age 70 ½. This would shoot you into a higher tax bracket when it could have been avoided. If you have a Roth IRA, you do not have to worry about RMDs, which makes a good case for converting your IRA into a Roth IRA before or early into retirement.


Finding the Right Blend of Tax-Diversified Income

Alternatively, you can shoot to achieve a blend of tax implications by layering the income from different income sources on top of one another. For example, you can take just enough income from your tax-deferred accounts to keep you under your minimum distribution requirement and add capital gains and taxable interest on top to fill your income need. This strategy requires a constant monitoring of your income sources and your tax situation because the blend of income could change depending on changing circumstances.

If you have tax-free accounts, such as a Roth IRA or tax-exempt bonds, you would want to maintain these for later withdrawals. They can help to keep you in a lower tax bracket, especially if you run into RMDs after age 70.


Don’t Forget Social Security Taxes

As if this weren’t enough to manage, there is still the issue of your Social Security benefits which can be taxed under certain circumstances. Depending on how much income you generate, up to 85% of your Social Security benefits can be taxable. Based on a somewhat convoluted formula, the IRS considers most of your other income sources plus half of your Social Security benefit in determining how much of your benefits are taxed.  Certain types of income are exempt from the formula, such as annuity income and income from a Roth IRA.

This is all the more reason to align yourself with a fee-only financial planner (like myself) who specializes in retirement income planning. Managing your retirement accounts and deciding from year-to-year which ones and how much to tap for the most tax-efficient income can be daunting. But, with your financial security at stake, it is well worth the time and effort.