The worst way to withdraw money during retirement? No matter how old you are, retirement is approaching or is already here. This means that you are going to have to withdraw some of the money you worked your whole life to save.
But there’s a way to withdraw this money so that you don’t end up putting it in Uncle Sam’s pocket instead of your own. You need to minimize taxes, and keeping your investments working for you for as long as possible.In fact, if you withdraw money the wrong way, it could cost you tens or even hundreds of thousands of dollars in lost potential gains and unnecessary taxes.
First you should always withdraw from your taxable investment income first. This means withdraw the dividends and capital gains that you have earned on your investments every year. Why? Because you have already paid taxes on these, so keeping them in the investment is not saving you any taxes. And Municipal bond income, if you have it in your taxable account should be the first one to draw on because all interest is completely federal tax free. But otherwise dividends and interest income should be your first tap.
If you are seventy and a half, the federal government requires that you withdraw a certain portion of your IRA. This is called RMD or Required Minimum Distribution. Uncle Sam does this because they want their money, and they don’t want you to sit on it forever. They think that once you’re 70, you should start withdrawing it, so that you can pay your taxes on them before you die. And if you don’t withdraw, they will penalize you. So you have to do this first because otherwise you end up paying a hefty penalty if you don’t. It is almost never a good idea to not withdraw the required amount, and instead pay the penalty.
However, if you are not 70 and a half, and you don’t need to withdraw from an IRA, then don’t withdraw. The reason is that the Federal government is allowing this investment to grow tax free until you withdraw. This means that all the interest and dividends that you would have paid taxes on, remains tax free in an IRA, so you make interest on top of your interest. So you will maximize your returns if you leave it in there for as long as you can. The minimum age you can withdraw is 59 and a half, but if you don’t need the money, you should let it ride until you are 70 and a half.
Tap into your regular IRA before tapping into your Roth IRA. Your Roth IRA should be the last place you withdraw from. This seems counter intuitive because any withdrawal from your Roth IRA is tax free. So Why should you let it ride? Because the money you put into your Roth IRA was after tax, and the federal government has given you the gift of letting it grow tax free forever, and you can withdraw it tax free at anytime.
The reason you should touch this last is because it is the most efficient way let your money grow. And the ROTH IRA does not require any minimum distributions after you reach seventy and a half. So you can leave your money there for as long as you want with absolutely no tax consequences. Even your heirs can take it out tax free. So it has huge tax advantages. If you plan on leaving your kids an inheritance, a Roth IRA would be one of the most valuable assets you could give them.
And although you generally want to let your regular IRA grow tax deferred as long as possible too, if your assets in an IRA are very large, it could push you into a higher tax bracket. In that case, consider taking some money out before you reach 70 and a half, but after you reach the age of 59. You do not want to withdraw anything from an IRA before the age of 59 or you will pay a penalty to Uncle Sam.
Lastly, the way that you invest your money in taxable vs non-taxable accounts can also make a huge difference in the money you end up having. So If you have a mix of stocks and bonds, you should put investments with the highest tax consequences in tax deferred accounts such as IRA’s instead of taxable accounts. So for example, all your bond funds which pay high yearly dividends subject to taxes, should be located in IRA’s and your stocks, which usually pay much less in dividends should be in taxable accounts.
A study by Vanguard showed that a $100,000 portfolio where stocks were in taxable accounts, and bonds were in tax-deferred accounts would be worth about $170,000 in 10 years. Whereas if the stocks were in tax-deferred accounts, and bonds in taxable accounts – the account would be worth only $153,000 after 10 years.
Taxable accounts should hold the most tax efficient investments such as municipal bonds which are not subject to federal tax, and stock funds with low turnover which results in lower yearly capital gains taxes.
Non taxable accounts should hold the least tax efficient investments such as long term bond funds and high dividend-paying stocks.
