I’m About to Retire. What Accounts Do I Withdraw From First?

It can vary, but there are a few rules of thumb to consider when it comes to paying taxes on your retirement funds.

Q. I’m confused about how to decide which accounts to take money from when I retire next year. I’m 61. I have $730,000 in my 401K, $129,000 in a Roth, $200,000 in taxable mutual funds and about $50,000 in cash accounts. I will have about $24,000 a year in Social Security but not until age 65.
— Almost there

A. Congratulations on your upcoming retirement.

The good news is that you are permitted to start taking distributions from your 401K without penalties once you reach age 59 1/2. So next year when you retire, you are permitted to take money out of all of these accounts without any tax penalties, said Marnie Aznar, a certified financial planner with Aznar Financial Advisors in Morris Plains, N.J.

She said you should keep in mind that distributions from your 401K will be subject to ordinary income taxes, while distributions from your Roth IRA will not be subject to income taxes upon distribution.

The money that you have accumulated in taxable funds is also available, but if there are embedded capital gains in these holdings, you will incur taxable capital gains upon sale of the funds, Aznar said. If you have any capital loss carry-forwards, you could use them to offset future capital gains on your tax returns.

If your taxable account is generating some interest and dividends that you could have transferred into your checking account automatically each month, Aznar suggests you start with that in terms of covering your basic living expenses.

“The longer that you are able to leave the money within your 401K plan or IRA rollover — if you choose to roll it over — the longer it will remain invested on a tax-deferred basis,” Aznar said. “This means that you can avoid paying taxes for longer which will result in accumulating more funds.”

She said you may want to consider withdrawing just enough from your 401K plan to keep your tax burden as low as possible.

Without knowing more about your situation, Aznar made some assumptions to give a more detailed example.

Let’s assume you file your tax return “married filing jointly” and have no other income starting next year.

If you then hypothetically earned $100 of interest income and $4,000 of dividend income annually and claimed the standard deduction, and if you were to withdraw $30,000 from your 401K you would be subject to a total federal and New Jersey tax bill of less than $1,500 for the year, she said. (Calculations can vary by state; consult a local tax accountant for a better understanding of the taxes you’ll be subject to.)

If you were to withdraw $20,000 from the 401K plan, this would result in avoiding federal taxes completely and paying less than $400 in New Jersey state taxes, she said.

And once you start taking Social Security, your tax situation will change.

“Determine how much you need to withdraw to live on each month and then ideally, pull from the various buckets in the most tax-efficient manner,” she said.

For more on taxes, visit out tax learning center.

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The Retirement Question Everyone Has to Answer: Roth or Traditional 401K

outlive our retirement savings

Many companies who provide 401K retirement plans are now starting to offer a Roth 401K option. How do you know which one to choose? Both savings vehicles allow you to make voluntary salary deferrals of the lesser of 100% of your pay or $18,000 (the limit in 2016) per year. And if you are 50 or older, you can typically contribute an additional $6,000. While the limits are the same, the deferrals and retirement distributions are taxed differently in the two plans.

A traditional 401K allows for pre-tax deferrals, meaning that they are deducted from the taxable income that is reported on your W-2 at the end of the year, reducing your taxable income and the income tax due in that year. As the investments grow, no tax is due on any gain until you withdraw money from the plan. At that time, you will pay ordinary income tax on all withdrawals (plus a 10% federal penalty if you are not at least 59½, or in the event of a few other less-common situations). You make pre-tax deferrals but receive taxable distributions.

A Roth 401K, named for the late Senator William Roth, requires that deferrals be made with after tax–dollars. This means that you will not save any income taxes at the time of the contribution. Similar to the traditional 401K option, the investments grow free of taxation. However, while traditional 401K withdrawals are taxable, all qualified distributions from a Roth 401K are income tax-free. Qualified distributions are those in which the account is at least five years old and the distribution is made due to disability, death or upon reaching age 59½. So your contributions are taxable but your distributions are generally income tax-free.

Which Option Is Better?

The answer is actually quite simple. If you are in a higher tax bracket when making contributions than the tax bracket you are in while taking distributions, you should choose the traditional version. If, however, you are in a lower tax bracket when making contributions than the one while taking distributions, you should choose the Roth version. If the tax rates are identical pre- and post-retirement, then it makes absolutely no difference.

When comparing the two options, it is necessary to adjust the contributions for taxation. Since the Roth contributions are after tax, for comparison purposes, the deferral must be reduced by the income taxes paid before the contribution is made. So an $18,000 contribution to a traditional 401K plan would be compared to a $15,300 contribution to a Roth 401K plan if the taxpayer is in the 15% tax bracket (15% X $18,000 = $2,700, and $18,000 – $2,700 = $15,300). Essentially, both contributions required $18,000 of gross pay. Upon retirement, the traditional 401K balance must be reduced by taxes due on distribution, while the Roth 401K balance is paid tax-free.

The chart below compares an $18,000/year-contribution for a traditional 401K to an after-tax contribution of $15,300/year to a Roth 401K, assuming a 15% pre-retirement income tax rate. It illustrates the after-tax retirement balances using 10%, 15% and 20% post-retirement tax rates. The investments are assumed to earn a hypothetical rate of return of 7% per year.

chart copy

These examples are hypothetical and for illustrative purposes only. The rates of return do not represent any actual investment and cannot be guaranteed. Any investment involves potential loss of principle.

Notice that when the pre-retirement tax rate of 15% is higher than the post-retirement rate of 10%, the traditional 401K plan has the advantage. When the pre-retirement rate of 15% is lower than the post-retirement tax rate of 20%, the Roth 401K is a better choice. However, when the pre- and post-retirement tax rates are equal at 15%, the net for the Roth and the Traditional 401K plans are identical.

So if you expect your income tax rate to decrease in retirement, choose the traditional 401K. If you expect taxes to increase during retirement, choose the Roth 401K. If you are not comfortable guessing what your tax rates will be at that time, then split your contributions evenly between the two options.

Remember, no matter what you’ve planned for retirement, it pays to know where your credit score stands and how everyday habits are affecting your credit. You can check your scores, updated monthly, for free on Credit.com.

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