Navigating The Tax Implications of Retirement Withdrawals

Retirement planning is typically a lifelong, highly personalized journey. The process begins with identifying long-term financial objectives and matching those with current resources and obligations to develop a savings approach to help reach specific monetary goals — but it doesn’t end there. 

Successful retirement planning isn’t just about asking yourself, “Will I have saved enough?” when transitioning from labor to leisure. Retirement planning must also consider, “Will I spend wisely enough?” to ensure the retiree doesn’t outlive their savings. It’s not enough to have a consistent savings approach when preparing for the golden years. Individuals must also have a cohesive spending approach that considers tax implications when making retirement withdrawals.

Understanding Tax Implications on Different Retirement Accounts

Effective tax strategies play a critical role in any successful retirement approach. Additionally, retirement planning accounts come in various forms, each with its own distinctive benefits and tax considerations. By understanding the tax implications of various retirement planning accounts and implementing smart withdrawal practices, retirees can maintain their quality of life and overall financial well-being. Here’s a breakdown of some of the most common retirement accounts: 

Traditional 401(k)s, Traditional IRAs & Thrift Savings Plan

Traditional 401(k)s and IRAs are two of the most common retirement savings vehicles. A Thrift Savings Plan (TSP) is a similar retirement savings plan for federal employees and members of the uniformed services. These accounts offer several tax benefits that can help you save more efficiently for retirement. Contributions to these accounts are typically made with pre-tax dollars, helping to reduce total taxable income during working years when many individuals are usually in a higher tax bracket. 

Of course, tax implications for these accounts do eventually come into play. Retirement withdrawals from these accounts may be:

  • Taxed as ordinary income, including both original contributions as well as any investment gains
  • Subject to federal income tax and possibly state income tax
  • Subject to hefty penalties if Required Minimum Distributions (RMDs) are not met

Additionally, both 401(k)s, IRAs, and TSPs may have early withdrawal penalties. Current legislation outlines that retirement withdrawals taken before the participant reaches age 59½ may incur a 10% early distribution fee in addition to regular income tax.

Roth 401(k)s and Roth IRAs 

Unlike their traditional, pre-tax counterparts, Roth 401(k)s and Roth IRAs contributions are made using after-tax dollars, which eliminates the upfront deduction. While this may seem less appealing for some, especially during years when earning peak income, Roth accounts offer one significant advantage: qualified retirement withdrawals are tax-free

Potential tax implications to know about retirement withdrawals from Roth accounts include:

Qualified Withdrawals

Withdrawals from Roth IRAs and Roth 401(k)s are tax-free if they meet certain conditions. To qualify, these withdrawals must be taken after age 59½ and after the account has been open for at least five years.

Non-Qualified Withdrawals

If withdrawals are made before age 59½ or before the account has been open for five years, they may be subject to taxes and a 10% early withdrawal penalty on earnings. However, contributions (the principal amount) can be withdrawn at any time without taxes or penalties since they were made with after-tax dollars. Having access to these penalty-free funds can play a vital role in maintaining overall liquidity. 

Order of Withdrawals

In Roth IRAs, withdrawals are considered to come from contributions first, then conversions, and finally earnings. This can help minimize taxes and penalties on early withdrawals.

Taxable Investment Accounts 

Also known as non-retirement investment accounts, these products are often included in the retirement planning process because they offer flexibility in terms of contributions and withdrawals. These accounts are funded with after-tax dollars, meaning contributions are never taxed. Additionally, long-term capital gains and qualified dividends are taxed at preferential rates, which are generally lower than ordinary income tax rates. As a result, these investment options can prove a powerful and practical tool in any retirement planning strategy.

Retirement Planning Strategies To Minimize Tax Burden

Beyond understanding the different types of retirement accounts, it’s also important to include tax strategies during the savings process that can reduce your overall burden and stretch your income as far and as long as possible. To help minimize tax implications once you enter retirement, consider including some of the following strategies in your overall approach. 

Diversify Accounts

Diversification can play a key role in any financial strategy — and retirement planning is no exception. Holding a mix of traditional tax-deferred accounts and tax-free Roth accounts and taxable accounts allows participants to make strategic withdrawals from each account type to manage overall tax consequences. For example, withdrawing more from traditional accounts during the years when your taxable income is lower can significantly reduce tax impact. In years when your taxable income is higher, you can rely more on tax-free withdrawals from your Roth accounts or withdrawals from your taxable accounts to avoid pushing yourself into a higher tax bracket.

Consider Roth Conversions

Remember to take advantage of the years you find yourself in a lower tax bracket. This should be done even in working years. During years when your income is lower, and you find yourself in a lower tax bracket, consider converting a portion of your traditional IRA to a Roth IRA. This strategy, known as a Roth conversion, allows you to pay taxes on the converted amount at your current, lower tax rate. You will have to pay the required taxes in the year of the conversion. However, you can make tax-free withdrawals from these Roth accounts in the future. Roth conversions can be especially beneficial if you expect to be in a higher tax bracket later in retirement. There are a lot of factors and options to take into consideration. Working with a tax advisor or financial professional can help you determine the best way to get funds to pay taxes, the optimal amount to convert, and anything else that warrants attention when making a cohesive plan. 

Delay Social Security Benefits

If you have other sources of income, such as retirement account withdrawals or pension income, consider delaying your Social Security benefits until age 70. While you can start receiving benefits as early as age 62, waiting until age 70 results in a significant increase in your monthly benefit amount. Increasing the benefit amount can help with longevity planning and even help meet the financial needs of a surviving spouse. Additionally, delaying benefits may help you manage your tax liability by allowing you to rely more on other income sources during your early retirement years.

Donate Required Minimum Distributions (RMDs) 

As previously mentioned, not meeting an account’s Required Minimum Distributions can result in potentially hefty fees and penalties. However, some account owners are reluctant to take the mandated RMDs because these distributions are taxed as ordinary income and can potentially push an individual into a higher tax bracket. However, if you don’t need the income from RMDs and have a philanthropic spirit, you can consider making a Qualified Charitable Distribution (QCD) directly from your IRA to a qualified charity. 

QCDs can satisfy your RMD requirement without increasing your taxable income, effectively providing a tax-free distribution. This strategy can be particularly valuable for retirees who don’t itemize deductions, as they can still benefit from the tax savings of a charitable contribution. It’s important to note that you can start doing this at age 70.5 years of age, even before RMDs kick in. 

Planning Retirement Withdrawals for Optimal Tax Efficiency

Once you’ve entered retirement, it’s important to also have a withdrawal strategy in place to maximize retirement income and lower overall tax burdens. Here are some key considerations to include in your plan for retirement withdrawals:

Determine Tax Bracket

When building tax strategies around retirement withdrawals, it’s essential to recognize income ranges that won’t push you into a higher tax bracket. Work with a tax professional and financial advisor to project available income sources and estimate potential tax liability at different withdrawal levels. Understanding which tax bracket you’ll be placed in can help guide the decision on which accounts to tap into — and in what order. 

Prioritize Withdrawals

Speaking of “in what order,” — a general rule when creating retirement tax strategies is to withdraw from accounts in the following order:

  • Taxable accounts
  • Tax-deferred account
  • Tax-free Roth accounts

Withdrawing from taxable accounts first allows tax-advantaged accounts to keep growing tax-deferred or tax-free for as long as possible. Prioritizing how you’ll withdraw can help maximize long-term retirement savings growth. Note: While this is a general rule, it’s important to note that even general rules are meant to be broken. The best approach to determining withdrawal order is to work with your CFP(R) professional to create the most tax efficient strategy for your individual financial situation. 

Consider Asset Location

When deciding which investments to hold in which accounts, consider the tax efficiency of each investment. Place the most tax-efficient investments in your taxable accounts and the least tax-efficient investments in your tax-deferred accounts. This strategy can help you minimize your tax liability and keep more of your hard-earned retirement income.

Monitor Tax Situation Annually
It’s no secret that tax legislation is constantly evolving. However, many retirees don’t recognize that their personal finances can also significantly change from one year to the next. As a result, it’s important to review your withdrawal strategy annually and make adjustments as needed. 

Each year, work closely with your trusted tax professional and advisor to:

  • Assess current tax burden
  • Identify tax savings opportunities
  • Ensure retirement withdrawals align with overall financial goals.

Consistently monitoring and adjusting your approach can help you stay on track and avoid any unexpected, costly surprises.

Schedule a Call With a Good Life Financial Planning Advisor

Effectively navigating the tax implications of retirement withdrawals can ensure your years outside of the workforce are comfortable, fulfilling, and financially secure. If you’re feeling overwhelmed by the complexities of retirement planning, we can help. Our team of financial advisors can help you create a personalized retirement plan that considers your specific goals, income assets, and risk tolerance. Schedule a consultation today!