STRATEGIC IRA WITHDRAWALS

Kahler Financial Group writes: Last year I reached a significant milestone—age 59 ½, old enough to withdraw money from my IRA’s with no penalty.

While I experienced this milestone as bittersweet, it did remind me of the importance of timing when it comes to taking money out of retirement accounts. Making withdrawals at the wrong time can have serious tax consequences.

The basic concept of retirement accounts such as IRA’s and 401(k)s is simple enough: while you’re working you put money in, and when you retire you take money out. To get the maximum benefit from your retirement income, however, it’s wise to have a withdrawal strategy.

The standard approach to withdrawing retirement funds usually follows this progression:

1. First, if you are over age 70 ½, take any required minimum distributions (RMD’s) from your traditional IRA or 401(k) retirement accounts.
2. Second (or first, if you’re under 70 ½), spend down funds from any investment portfolio that are not part of a qualified retirement plan or tax deferred annuity. The reason for tapping these accounts first is that the total tax liability will be much less than funds withdrawn from a retirement account or annuity.
3. Next, start withdrawing from tax-deferred accounts like variable or fixed annuities or retirement plans, like a traditional IRA or 401(k), where the gains are taxable as ordinary income.
4. Finally, withdraw from tax-free accounts like Roth IRA’s and 401(k)s.

This strategy is a good starting point, but a more nuanced plan may help you make the most of your retirement income. Some factors to consider include: your projected spending needs at various stages of retirement, your total projected income and tax liability, whether withdrawals from various retirement accounts are taxable, and how much you expect your income to fluctuate over time.

It is important to pay attention to your tax bracket on a year-by-year basis. For example, suppose Liz and Frank expect their total 2015 taxable income from Social Security and investments to be just under $60,000. This puts them in the 15% bracket, where the top limit for 2015 is $74,900. It may make sense to fill up that bracket by selling appreciated assets with a $15,000 gain (the capital gain tax would be 0%) or withdrawing another $15,000 from a traditional IRA and paying ordinary income taxes at the 15% rate.

This would especially be a good idea if Frank and Liz expect their taxable income to go up in 2016. One of them might have to begin required withdrawals from a pension plan, or they might have income from selling their home or a small business.

On the other hand, if they were in a higher tax bracket today and expected their taxable income to go down significantly in 2016, they would want to wait until then to take money out of the traditional IRA.

Another strategy for a year when you’re in a lower tax bracket is to convert some of the funds in a traditional IRA to a Roth IRA. You pay taxes on the withdrawal at the lower rate, and the future gains in the Roth are not taxed.

These are very simplified and generic examples, of course. Any withdrawal strategy needs to be designed for your specific needs, preferably with the help of a tax advisor. But the key is to plan ahead. It’s necessary to do a trial balance and tax estimate toward the end of the year so you have time to make withdrawals or conversions.