How to distribute the wealth during retirement
Considerations for individuals with different sources of retirement income
Editor’s note: This article has been reviewed for changes following the passage of the 2017 Tax Cuts and Jobs Act. The information provided in this article was not affected by the 2017 TCJA.
For nearly all our working lives, we are reminded to save for retirement: “Contribute to an IRA!” “Participate in your employer’s 401(k)!” or “Open a Roth!”
If people followed all this advice over the years, they would expect to have a nice nest egg in retirement. Everyone knows that saving for retirement can be hard but cracking into a nest egg can be downright complicated.
Unlike decades ago when retirement meant stopping work altogether (a boon to the rocking chair industry), retirement now means different things to different people. The once magic age of 65, the retirement goalpost of an earlier era, is almost irrelevant now as many more people are working past age 65.
For example, according to the Employee Benefit Research Institute (EBRI), in 1975, 13.7 percent of people age 65 or older were still working, but that percentage increased to 18.7 percent by 2013. Considering that 10,000 baby boomers reach age 65 every day, the higher percentage of senior workers also implies a much greater number of senior workers than in 1975. The reasons are many: the Great Recession of 2008, increased longevity, meager retirement savings, low interest rates, and more.
The decision to work full-time or not at all past age 65 is one of the most important considerations in developing and maintaining a retirement distribution strategy. Age, health, family situation, and retirement assets all play into the strategy, as well. Indeed, just as these factors vary from person to person, so should a distribution strategy be customized to meet individual situations and needs.
This article covers the most important considerations for individuals who might work during retirement and the impact of using more than one source of retirement funds.
Preserve wealth by working during retirement
“Working during retirement” sounds like an oxymoron, but it’s a real option that could help stretch individuals’ retirement assets; every dollar earned is a dollar that doesn’t have to be taken out of the nest egg.
However, taxpayers and their advisors should take a holistic approach to the decision to work or not. Working surely helps preserve retirement assets. And while preserving retirement assets is generally desirable, the longer taxpayers work during retirement, the greater their required minimum distributions (RMDs) will be in later years. That’s because the size of RMDs is based on the prior year’s ending retirement account balance. Larger RMDs usually mean higher tax bills.*
Example: Marcia, a 67-year-old widow, earns $25,000 per year working as an instructor at the local community college. She has saved $350,000 in qualified retirement accounts and traditional IRAs. If she can live off her earnings, Social Security benefits, and interest and dividends from her nonqualified accounts, she won’t have to touch her retirement assets for four more years, when she must start taking RMDs. Marcia’s investment returns will also continue to accrue on her retirement account balances. This sounds like a good plan.
However, there is a cost to this strategy. Leaving her retirement assets untouched during this period will also increase Marcia’s RMDs. If her retirement assets grew at 5 percent per year, they would be worth more than $420,000 when Marcia is 71, almost $116,000 more than if she had taken four annual distributions of $25,000 per year between the ages of 67 and 70. This will increase her first-year RMD by approximately $4,700.
So, should Marcia stop working and start taking distributions from her retirement accounts? From a tax perspective, her wages and retirement distributions both are taxed as ordinary income, but her wages are also subject to payroll taxes (7.65 percent). So, taking retirement distributions, rather than working, will eliminate payroll taxes. On the other hand, working will help her preserve her retirement assets, but her RMDs will be higher.
Despite payroll taxes and higher RMDs, Marcia will likely be better off financially if she continues to work. Quitting work only to avoid payroll taxes and higher RMDs is like buying a home just so you can deduct mortgage interest. Also, the decision to continue working after age 65 doesn’t come to an abrupt halt at age 70½, when RMDs must begin. That decision is often about more than finances or taxes, although many people who haven’t saved enough for retirement have fewer options.
Retirees’ distribution strategies may change when their retirement nest eggs are made up of pre-tax and after-tax (e.g., Roth) retirement assets, as well as other cash-flow sources, such as Social Security, nonqualified investment earnings, income from business interests, etc. Let’s take a look at how these could impact a distribution strategy.
Include potential Social Security payments in retirement distribution planning
People in their 50s should realistically include Social Security benefits in their retirement planning. However, a discussion about when to begin taking Social Security benefits is beyond the scope of this article.
Taxpayers receiving Social Security benefit payments should first understand the tax differences between Social Security income and earned income. Social Security is more efficient than earned income because:
- Social Security income isn’t subject to payroll or self-employment taxes, and
- Up to 85 percent of Social Security benefits can be taxed, but a full 100 percent of earned income is taxed.
Regardless of the tax differences, Social Security benefits and earned income have similar effects on retirement assets. That is, a dollar of Social Security benefits received may help preserve a dollar of qualified plan assets. An individual’s decision to work may be more focused on the taxation of Social Security benefits than on the preservation of retirement assets, but the effect on retirement assets is the same.
Combinations of Roth assets, ordinary assets, and nonqualified accounts provide flexibility
For retirement assets, “tax diversification” means that a taxpayer has a combination of Roth and ordinary assets, as well as nonqualified investment and savings accounts. Having a mix of assets allows more flexibility in establishing a retirement distribution strategy. Greater flexibility also means more complicated options, so working with a tax professional and financial advisor will produce the best results.
Example: Suppose Nina has a combination of pre-tax retirement assets, such as traditional IRAs and ordinary 401(k)s, as well as Roth IRAs and ordinary nonqualified investment accounts holding stock. As long as she takes her RMDs, Nina might also consider taking distributions from her assets in this order:
- Nonqualified accounts
- Pre-tax retirement accounts
- Roth accounts
Some considerations for Nina:
- If Nina’s nonqualified investment accounts hold long-term capital assets, distributions will be taxed at favorable capital gains rates (15 percent for Nina).
- Distributions from pre-tax qualified retirement accounts can help preserve the balance of Roth assets, allowing them to remain untouched and grow longer, tax free. Also, distributions from pre-tax accounts reduce their balances faster, which will reduce future RMDs.
- Distributions from nonqualified accounts and pre-tax qualified accounts increase Nina’s modified adjusted gross income (MAGI), which could increase the amount of Social Security included in income.
- Distributions from designated Roth accounts and Roth IRAs are purely tax free, with no RMDs.** Also, Roth distributions don’t increase MAGI, so they won’t affect the taxability of Nina’s Social Security benefits.
- Nina should consider taking distributions based not only on their tax impact, but also their effect on her portfolio. She may need to rebalance the portfolio to meet her investment objectives as she takes distributions.
This formula isn’t optimal for everyone. The sources for distributions will depend on the individual’s tax bracket, underlying portfolio, and more.
Taxpayers should consult with a financial advisor and a tax professional to build the best plan
Clearly, developing a strategy for distributing retirement assets is based on many factors, and depends on an individual’s unique situation. Some of the factors include age, longevity, potential Social Security benefits, as well as the size and mix of retirement assets, both qualified and nonqualified.
Any retiree’s goals should include maximizing cash flow, minimizing federal and state tax liabilities, preserving retirement asset balances, and satisfying all RMDs. To meet these goals, the expertise of a financial advisor and a tax professional is necessary to determine the optimum distribution strategy.
* Strategies for reducing the impact of larger RMDs, such as making qualified charitable distributions (QCDs), is outside the scope of this article.
** Non-spouse beneficiaries of Roth IRAs and designated Roth accounts are subject to RMDs.