Let's talk retirement it's time to enjoy all those bucket list items that you didn't get to do
while you were working you saved in your company retirement plan
have some additional income streams like maybe social security or a pension or
annuity or some rental income but now that your paycheck will soon be turned off how
exactly should you withdraw assets to use during retirement well this is a complex
question and every situation is different but if you stick with me I'll explain the optimal
strategies for generating retirement income and what not to do stick around
it's Colin Exelby here and I provide financial planning for business owners and their families
that makes sense by helping you see the forest through the trees
I'm the owner of a virtual financial advisory practice Celestial Wealth Management and
I provide advice to families all over the country part of that advice is retirement income planning
how do you turn these assets you accumulated into the most efficient retirement income stream
possible numerous studies have shown that with a little thought preparation and analysis you
can extend the life of your portfolio increase your distribution rate or pass on more wealth to
your heirs i'm going to talk about withdrawals from three types of accounts taxable accounts
tax deferred accounts and tax-free accounts now taxable are non-retirement accounts where
you've already been taxed and your only taxes would be capital gains when liquidating assets
tax deferred are retirement accounts where you received a tax deduction up front
and you will owe income taxes when you distribute those assets these accounts
are typically traditional or rollover IRAs SEP or SIMPLE IRAs 401(k)s or 403(b)s all right tax-free
assets are assets where there aren't capital gains or income taxes when you distribute them
these are typically a Roth 401k or a Roth IRA account where contributions were initially taxed
but growth and distributions are not taxed when you would draw them as long as the
account is open for at least five years and some simple age restrictions are met
okay the first step to figuring out how to distribute assets is to figure out how much
you need annually to live on after taking into account any other income sources so what do you do
first figure out your total retirement need after taxes of course and then subtract
any after-tax income flows that you have like social security pensions rental income
and annuity payments the remainder is the amount that's needed for retirement withdrawals
typically once you retire distributions are made from a combination of those three types of
accounts the goal of retirement income planning is to maximize after tax distributions you want to be
mindful of your tax brackets throughout retirement and both at the federal and the state level
currently there are 12 states who do not tax distributions from retirement accounts or pensions
if you are considering a move in retirement a state without retirement income taxes could be a
major help to your portfolio nine states don't currently levy any state taxes and another
three don't tax retirement distributions alabama taxes 401(k)s and IRAs but doesn't
tax pensions for a list of states that don't tax retirement income just check out the notes below
all right to analyze your federal and state income tax rates the first step is to project your income
levels and then use software to project your tax rates taking into account tax credits and
deductions ideally you want to be very mindful of the points where the tax brackets jump up there
are certain income levels where the marginal tax rate increases meaning your retirement income is
taxed at different rates depending upon how much total income you have all right let's
take a look at five strategies for withdrawing assets and who might typically use them for each
of these strategies it's important to know the age limitations and withdrawals and whether penalties
apply to you in most cases paying penalties for early withdrawals is the worst strategy the
government created these plans and gave incentives for you to save for retirement don't blow up these
benefits in early withdrawal penalties if you need distributions prior to the appropriate age
there are additional strategies that may limit the impact of those penalties let's dive in
the first strategy is what i will call the baseline income strategy it typically is the least
tax efficient but often it's the easiest one to employ it's called pro rata and means that you
equally distribute assets from your taxable your tax deferred and your tax-free accounts
for example let's say you need six thousand dollars per month to live on
after your other income sources have been used the pro rata strategy would be to take two thousand
dollars each from your taxable account your tax deferred account and your tax-free account
if your investment strategy is to hold the exact same asset allocation in each type of account then
as you would draw assets your asset allocation stays consistent over time the assumption is that
by withdrawing equally from each type of account you diversify your tax burden over time this
strategy is ideal for someone who would not change marginal tax brackets based on distributions on
the surface this isn't a bad strategy if you don't know what to do don't wish to do deeper analysis
or don't really have a desire to pass along assets strategy number two i'm going to call
this the taxable pro rata this means distributions are funded with the taxable account first until it
is completely depleted then distributions are funded equally by the tax deferred
and the tax-free accounts this strategy typically keeps tax rates lower in the early years because
the only taxes you're paying are on capital gains from the investments not any principal
distributions from the retirement accounts this also allows the tax deferred and the tax-free
accounts to grow without taxes for a longer period of time this strategy could be ideally employed
by someone with a larger taxable account in smaller retirement accounts the downside with this
strategy is that you may be exchanging lower tax rates now for future taxes at much higher rates
depending upon how large the distributions are and what the heck future tax rates are
all right strategy number three is to use tax deferred accounts first followed by the taxable
and then finally tax-free this strategy aims to keep the tax-free assets growing
as long as possible and more evenly spread the tax obligation over time typically in the early years
of retirement or if you retire early your income levels are much lower than while you were working
using tax deferred assets first capitalizes on the fact that while your income is lower usually
before mandatory retirement distributions take effect and potentially before receiving social
security you can distribute assets that will be taxable and still stay in a lower marginal
tax bracket this strategy could be ideal for someone who retires early with a large amount in
tax deferred retirement assets like in the IRA or 401(k) and having smaller amounts in taxable and
tax-free accounts especially if those assets are invested in higher growth areas it allows those
assets to grow for a longer period of time before liquidation and then liquidation could be at lower
tax rates strategy number four is to distribute taxable assets first then tax free assets
and finally tax deferred assets this strategy is designed to defer the largest amount of tax
for as long as possible and this strategy would be ideal for someone who either has a shorter life
expectancy maybe due to some medical condition or some family issues or someone with a larger
tax-free and taxable account by distributing taxable assets first of course you only pay
capital gains taxes and you defer the larger income taxes from tax deferred distributions
so far into the future that you may not even be distributing them at all before passing away
the fifth strategy is to use taxable assets first then tax deferred and finally tax-free
now by default this is the most often used retirement income strategy and intuitively it
makes sense especially if your asset allocation is aligned meaning your investments across the
different accounts are aligned first allow your tax-free roth assets to grow as long as possible
you'll want to distribute all your taxable assets first where only capital gains taxes are paid
you next would withdraw all your tax deferred assets this is when you would most likely be in
your highest marginal income bracket in retirement and finally when all of those other assets are
gone then you distribute your tax-free roth assets this strategy would be ideal for someone with
larger taxable assets who desires to pass on assets to their heirs because tax-free roth
assets are often the most desirable assets to pass on because of their tax-free nature
the problem with this strategy is that in your early retirement years when your income is
often the lowest you're not taking advantage of those low marginal tax rates you often end up in
much higher tax brackets than needed in the years when you're distributing your tax deferred assets
so what's the ideal strategy in my opinion the ideal strategy is to be fluid not rigid look tax
rates change your distribution needs change we all make assumptions but we don't know what's going to
happen in the future and market conditions change i'm a big believer that maintaining flexibility
makes a lot of sense in my experience retirees often spend the most in the early years of
retirement you do all those things that you wanted to do and you didn't have the time and you pay
a lot of expenses in the later years when health care costs are significant both in the home and if
you need additional care the years in the middle are often when you have lower spending needs
because retirement spending isn't often a straight line your withdrawal strategy should reflect those
changing needs i firmly believe that based on much analysis that attempting to maintain a consistent
income tax rate throughout retirement rather than lower and then higher later on makes a lot
of sense the most tax-deferred assets that you can distribute in the early years of retirement
at lower tax rates the better even if you don't need the assets right away they could potentially
be reinvested in tax-free roth accounts through a conversion or in a taxable account where only
the capital gains taxes would be due or maybe some combination of both this is a strategy that
many people miss out on i see it all the time they miss out due to the desire to delay taxes as long
as possible and this creates potential tax bonds in retirement accounts and if tax rates increase
in your retirement you could be in for a rude awakening these are the most common distribution
strategies but they're not the only ones every family situation and their needs are different
and this should not be construed as specific advice thankfully nowadays powerful financial
planning software exists to examine each of these strategies as it relates to your own situation
and determine the best course of action currently in my practice i use some incredible software
from RightCapital that helps me analyze this with my clients if you're getting close to
retirement and wish to analyze your withdrawal strategies feel free to reach out to me at my
website celestialwm.com or speak with your trusted advisor if you enjoyed this video just hit that
little like button and make sure you smash that subscribe button so you're notified whenever i
produce a new financial planning video and youtube loves engagement so you really help the channel
if you have any comments and questions you'd like to add please do so in the comments below