Check out our Video on this topic here!
Building a retirement nest egg is no easy feat. After years of working and saving, the ability for you to feel a sense of comfort that you are financially secure in retirement can bring fulfillment to your next chapter.
Now that you’ve saved the money, ensuring that you are withdrawing and spending it in a manner that works for you is imperative. This is because, the wrong withdrawal order could potentially cost you hundreds of thousands of dollars in unnecessary taxes and even worse- it could drain your savings much quicker than you think.
Today, we’re going to show you some mistakes we have seen drain retirement accounts and ways we help to navigate this situation. And just before we get started, we want to make clear that we are not tax professionals and that you should always discuss your individual situation with your tax and financial advisors.
Right now, there are retirees out there that are probably following advice that made sense a few decades ago, which could end up being detrimental today.
The reason is, following conventional wisdom when it comes to retirement withdrawals is not a one-size-fits-all strategy. And unfortunately, you might not realize that you could fall into this trap until it’s too little, too late.
Meet our fictional client Jane, a 68-year-old teacher from Ohio. She was confident that she had done everything right throughout her career. She saved diligently, maxed out her 403(b), and built up $1 million across her retirement accounts.
She followed advice that had been given to her years back which was to spend taxable accounts first and avoid touching her 403(b) to "let it grow."
Five years later, Jane got hit with a tax bill and she was sick to her stomach. Almost $15,000 in taxes on money she was forced to withdraw.
Money she didn’t necessarily need but had to withdraw for her Required Minimum Distribution, and now a significant portion of it was going to Uncle Sam.
Jane’s story isn't unique and in fact we see it on a regular basis with retirees who hadn’t planned well ahead of time.
Here's what Jane didn't know: As mentioned earlier, there's a mandatory withdrawal rule called Required Minimum Distributions that currently kicks in at age 73. And if you follow the old "let your tax-deferred account grow" advice, those RMDs can become a significant burden later on in life.
Research by Fidelity has shown that retirees who use a different withdrawal sequence can potentially cut their lifetime tax bills by almost 40%. Yes, you heard that right- Almost 40% less in taxes by planning and executing on different withdrawal sequences.
So what are they doing differently?
Instead of the sequential approach which is commonly taught, in these instances, retirees utilize what is sometimes known as the "proportional withdrawal" approach.
Think of it like this: if your taxable account represents 30% of your portfolio, your pre-tax accounts are 50%, and your Roth accounts are 20%, you withdraw from each account in those same proportions.
Another thing that Jane could’ve done differently is making partial Roth conversions during her lower-income years.
By converting just enough from her traditional IRA to fill up her current tax bracket, she could have paid taxes at today's rates instead of not acting and potentially being forced into higher brackets later on.
This strategy, sometimes known as "bracket filling," in certain instances can potentially save folks on taxes.
With this, we often find that timing can be crucial and there are certain windows of time to be on the lookout for.
The optimal timing we look for in a scenario like this is the potential to make these conversions before a particular retiree actually needs the money.
The reason being is that there is a caveat which could impact one’s plan: Roth conversions come with a five-year waiting period before you can access the converted money penalty-free.
With that, if you wait too long to start these conversions, you could find yourself in a cash crunch. When used alone, depending one’s personal situation, it can be an effective strategy for planning over the long haul. Having an understanding of your tax planning situation and what strategies you’ve implemented for your personal plan over time is important.
A simple way to think about this is breaking your retirement into 3 buckets.
Bucket one covers years 1-5 with more conservative, liquid assets. Bucket two handles years 6-10 with moderately growth-oriented investments. And bucket three is your long-term growth engine for years 10 and beyond.
This isn't just about the organization of your assets, it's a basic strategy that some use for psychological relief from market volatility among other things.
If a correction or even a significant drawdown occurs you may feel more confident in your plan knowing you have certain money allocated for different times in retirement.
Now combine the situations above by coordinating these different buckets with your particular tax strategy, and results could be surprising.
Although everyone’s situation is different, an example goes something like this: You use bucket one withdrawals to manage your tax bracket. Bucket two for strategic Roth conversions and bucket three to aim for long-term tax-free growth.
The Final Word:
The strategies we’ve shared today aren't just about saving money—they're about understanding the tools available and seeing if they make sense for you. Don't let the complexity intimidate you and don't let the perfect be the enemy of the good.
Start where you are, with what you have, and begin building a withdrawal strategy that works for your unique situation. Because at the end of the day, this isn't really about taxes or withdrawal rates or account types. It's about freedom.
Of course, everyone’s situation is different and we suggest working with your financial and tax professionals to navigate your individual situation.
Disclaimer:
Rockline Wealth Management (RWM) is a registered investment adviser located in Islip Terrace, NY. RWM is registered with the U.S. Securities and Exchange Commission. Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission.
Rockline Wealth Management does not offer tax or legal services. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.
All information presented is believed to be factual at the date of publication.
All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client's investment portfolio.
Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. The opinions expressed and material provided are for general information and should not be considered a solicitation of financial advice or for the purchase or sale of any security.
Real-life and fictional examples given in this blog should not be viewed as guaranteed outcomes when investing. Past performance is not indicative of future results and every individual’s investment circumstances are different. Individuals should consult their financial professional before implementing their investment plan.