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When preparing for retirement, considering how you'll spend down your assets is just as important as how much you've saved. Surprisingly, 56 percent of workers don't have a distribution plan in place, according to a 2015 study from Pentegra Retirement Services.
A clear-cut roadmap for drawing down assets, or the lack thereof, can directly impact the quality of your later years, says Jeffrey Powell, managing partner at Polaris Greystone Financial Group in San Rafael, California.
"Far too often, a retiree haphazardly withdraws money from this account or that account, unaware that the order in which money is taken out is exceptionally important to enjoying a financially successful retirement," Powell says.
Planning what to do with your various retirement accounts is something you should do sooner rather than later. Here are some important considerations if your goal is to make the most of your savings in retirement.
Understand where your money is invested. Not all retirement accounts are created equally. Recognizing the difference between tax-deferred, tax-free, and taxable assets is crucial says certified financial planner Maleah Stephens of Impact Planners in Brentwood, Tennessee.
"Withdrawing funds in the wrong order could diminish your retirement income at some point in the future," Stephens says, particularly if you're already receiving Social Security benefits.
Without proper planning, says Stephens, taking withdrawals from tax-deferred accounts could result in a higher taxation rate, reducing retirement income in the process. When you add in the effects of inflation, that can drastically affect your financial outlook.
Aside from the tax implications, you should also be aware of what kind of risk you're exposing yourself to when you have multiple investment accounts, says Brian Benham, president of Indianapolis-based Benham Advisory Group.
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"My theory is that the older you get, the safer your money should be," he says.
"By withdrawing from the riskiest accounts first, you're helping to maintain and preserve your other assets," Benham says. "If you withdraw your 'safer money' and there's a market correction, you may jeopardize your retirement."
Think about the timing. Considering when you plan to tap specific assets is another important piece of the puzzle, says Timothy Harder, managing director at United Capital in Irving, Texas.
"Easily the biggest mistake people make is draining their taxable investments early on in retirement to avoid present taxes," Harder says.
A more efficient strategy, says Harder, would be to take advantage of low tax rates today and minimize withdrawing IRA assets at higher tax rates in the future.
Blake Christian, a certified public accountant and tax partner at Holthouse, Carlin & Van Trigt in Long Beach, California, encourages savers to give serious thought to what their marginal tax rate may be once they retire.
"The worst thing someone can do is take taxable distributions in high marginal rate years when they could be using pre-tax dollars sitting in non-qualified accounts," Christian says.
He cautions that withdrawing funds too soon can be equally damaging if it means incurring a 10 percent early withdrawal penalty and paying regular income tax on the distribution.
Decide where Social Security fits in the picture. The Social Security Administration estimates that 97 percent of Americans age 60 to 89 either receive Social Security benefits or will at some point in the future. When you decide to take these benefits is one of the most impactful decisions you can make.
Powell offers a hypothetical example to illustrate just how much Social Security can influence your income streams in retirement.
Using internal research from Polaris Greystone Financial Group, he estimates that someone making $100,000 at retirement would receive approximately $2,200 per month if they begin taking Social Security at full retirement age. If they waited until age 70, however, their benefits would increase to $2,833 per month.
Assuming the retiree in question lives past 82, delaying Social Security would make the most sense. The question individual savers have to ask themselves is whether they have the financial means to bridge the gap leading up to their 70th birthday.
When you take Social Security becomes even more important if you're continuing to work in some capacity during retirement, Benham says.
If you begin drawing Social Security before full retirement age, there's a cap on how much you can earn without affecting your benefits. As of 2016, the earnings limit is set at $15,720 per year and your benefits are reduced by $1 for every $2 you earn over that threshold.
"Working part time is great but if you're not aware of how much you're earning, you may end up in a higher tax bracket," Benham says.
In that scenario, you could find yourself working simply to pay more taxes. Christian recommends that someone who's planning to work in retirement continue funding a 401(k) or IRA if possible, since that can mitigate any additional tax liability resulting from claiming Social Security.
Know when you're required to take distributions from certain accounts. Daniel Milan, managing partner of Cornerstone Financial Services in Birmingham, Michigan, says determining withdrawal order gets a bit more complicated when required minimum distributions are involved.
"A retiree would typically want to begin with non-qualified taxable retirement accounts, then move on to tax-deferred accounts, leaving tax-free accounts for last," Milan says.
That strategy doesn't account for retirement vehicles that require you to begin taking distributions at age 70.5, however. In that case, the most basic plan would be to take the required minimum distribution first, then withdraw the balance of what you need from taxable accounts.
Besides the ordering issue, retirees should also be aware of how skipping out on required distributions can affect their income. When you don't take RMDs on schedule, that can trigger a 50 percent tax penalty.
Look beyond your retirement years. Matt Brady, senior director of wealth planning for Wells Fargo Private Bank in San Francisco says plotting your withdrawal strategy means taking a look at your broader estate plan.
"Benefits in a retirement plan are subject to estate tax if your net worth exceeds the annual exemption limit," he says, leaving your beneficiaries with a potentially sizable tax bill when they withdraw money from those accounts.
Depleting your retirement accounts before death can ensure that your estate doesn't face a double tax burden. On the other hand, your beneficiaries could stretch distributions from an inherited IRA over their lifetime, allowing returns to compound over a long period of time.
When in doubt, assessing your exposure to estate tax and comparing that to what your long-term goals are is the best way to determine your optimal drawdown strategy, Brady says.