For most of your working life you’ve been putting money into retirement savings. When you reach retirement age, you need to make a major shift and determine how to take money out of your savings. You’ll build a whole new vocabulary. Instead of trying to understand things like Roth vs. Traditional IRAs, you’ll need to begin thinking about things like required minimum distributions and the tax implications of qualified withdrawals.
Start With a Budget
Just as in your working days, when planning for post-career life it’s good to have a budget to understand what your retirement income and expenses will be. Build your budget with after-tax income. Many people incorrectly assume that all retirement income is tax free. You generally won’t pay taxes on withdrawals from contributions you’ve made to Roth IRAs or other post-tax savings accounts, but you may pay taxes on amounts you withdraw from your tax-deferred 401(k), SIMPLE or Traditional IRA and even social security payments. The assumption is that your retirement income will be substantially lower than your working income, so the taxes you’ll pay when you retire may be lower.
On the expense side of your budget, build in annual “cost of living” increases to match inflation. It’s also wise to plan for special considerations, such as:
- Increases in health care costs. Health care costs in general are rising higher than other costs; as a retiree, you will get the double whammy of health care inflation and increased health care needs as you age.
- Increases in leisure expenses. When you’re not working 40 or more hours a week, you’ll have that time free and you might find your self spending more money. You’re likely to want to take more vacation trips to visit grandchildren or simply enjoy your retirement.
- Changes in housing costs. Your mortgage may be paid, reducing monthly expenses, but you’ll still have ongoing maintenance, insurance and utilities costs.
Build a budget with a projection of your expected monthly retirement income and expenses and be sure to plan for a realistic life expectancy. If you’re 62 when you retire, you may live for another 30 or more years. Make sure your plan provides a comfortable living over your expected remaining lifetime.
How to Manage Retirement Income
Think carefully about when to make withdrawals from your various retirement accounts so that you can minimize your retirement tax burden.
Although you may be retired from your job, you may still be earning income from real estate investments, financial investments, self-employment or other “non-job” income. If so, you may want to start drawing from your already-taxed savings (general savings and Roth IRA) to supplement this income as needed.
If your “non-job” pre-taxed income sources will decline over time, you may want to delay taking distributions on any tax-deferred vehicle (e.g. 401(k) and Traditional IRA) for as long as possible. Then when you do pay taxes on this tax-deferred savings, your related tax rate will be lower. You should consult your tax advisor.
As with working income, the IRS has rules for retirement income. When it comes to social security, you can start taking withdrawals as soon as you reach age 62. However, if you delay your first withdrawals until 66 or 70, your monthly payment may be higher.
With retirement accounts such as 401(k)s and most IRAs, you’re eligible to start taking distributions without penalty as soon as you reach age 59½. If you don’t need the money for your ordinary expenses, you can continue to earn interest on your savings by keeping it in your account until you need it.
After you reach age 70½, you will likely have to start making required minimum distributions. Your first withdrawal must occur by April 1 of the year following the year in which you reach age 70½. In all years that follow, you must make a withdrawal by December 31. The IRS provides worksheets to calculate the amount of the required minimum distributions. If you don’t make the withdrawal, you will incur a 50% excise tax on the amount not distributed. That’s a big incentive to follow the rules!
Put thought into these requirements and trade-offs. Work with a tax and financial planner to help make the best decision for your self and your family so you can enjoy a long and happy retirement.
Discover Bank, Member FDIC