By the time you hit retirement, you’ve probably acquired a variety of savings and income assets. From these you’ll withdraw income to live on and enjoy your retirement years.
But because the tax treatment of your various assets differs, you should know that ordering how you withdraw from them can help preserve them longer. In this article I suggest a sequential order you should withdraw from the six common assets categories and why.
The idea, here, is to arrange your withdrawals to maintain your wealth as long as possible by maximizing annual investment growth while minimizing annual taxation of income.
You draw income from three types of assets classes:
* income assets – pension and/or social security benefits,
* savings assets – government regulated retirement accounts or normal taxable investments
* home equity – and related real estate
Each of these asset types may include asset categories with different tax treatments. So I’ll comment on each category and when to consider withdrawing from them.
Both your pension and social security represent a stream of income that begins at your retirement. If both these income assets together easily cover all your living and enjoyment expenses, you needn’t worry about the order you tap into other assets for special occasions.
Your pension is taxed as ordinary income. This leaves no wiggle room for offsetting this tax. Social Security (SS) income, on the other hand, has some tax advantages.
SS is free of income tax if with your other income you stay under certain threshold amounts depending on your filing status. Above that only 50% of it is taxed. A higher threshold will subject 85% of your Social Security to income tax. So watch out.
If you have a lot of investments, try to minimize the amount of income (like taxable and tax free interest) they generate that pushes you into higher Social Security taxation.
You can also hold off receiving your SS benefits until your full retirement age – probably 66 for most of you. You take a cut in SS benefits when you begin receiving them before then – as much as a 30% cut at 62. But waiting beyond your full retirement age will increase them – as much as ~30% more if you wait ’til you’re 70.
Government-regulated retirement accounts have helped many save at work and at home. They include 401(k)s, 403(b)s, IRAs, and Roth versions. They come in two basic tax-advantaged flavors: traditional IRA-type and Roth Versions.
Your IRA-type investments grow tax-deferred. This allows their full annual investment return to compound – a key advantage. Anything you withdraw from them is taxed at ordinary income rates since you contributed to them with tax-deductible contributions.
Since they compound so well, let them ride and don’t touch them ’til last. If you turn 701/2, withdraw only the minimum required distribution (MRD) and let the rest grow.
Roth type investments contributions come from after-tax contributions. The key advantage is that they grow tax free – never to be taxed even when you withdraw money from them. So they also will compound at their annual investment return rate.
Since Roth IRAs have no MRD requirements you never have to touch them. They’re also the best form of IRA to leave to your beneficiary – since they’ll remain tax free forever. Be sure to convert any Roth 401(k) – which has MRDs – to a Roth IRA which doesn’t.
Regular taxable investment accounts are just those that aren’t government-regulated. The type of investment in them determines the character of taxation. Any earnings such as dividends or interest earnings are taxed yearly. So there’s not protecting taxation here. Withdraw from these first.
Most anything withdrawn from them beyond their earning will probably be untaxed or taxed at low capital gains rates. Take advantages of any capital losses to offset taxes too. Because of these tax effects, these investments will deplete slower than withdrawing from tax-deferred investments.
So in summary, investments that are tax-deferred or tax-free – under an equal investment growth scenario – will compound faster than those annually taxable investments that must forfeit some of their annual earnings to taxes. Withdraw from the latter first.
Home and real estate investments:
Home and other real estate investments generally offer their own tax-advantages. The tax-advantage of owning your home or those subject to capital gains can often present little or no taxation to you.
Use can access your home equity easily. As a tax-advantaged investment, you can sell it and buy down to get at the excess equity at little or no tax since the home sale tax exclusions is $500,000 for a married couple.