Out of order
When you spend different dollars in retirement can have an impact.
Good morning,
Today’s letter was prompted by an email I received from a client recently (thanks, Mike!).
He asked about waiting on required minimum distributions (RMDs) which essentially force you to take money out of your IRA and 401k accounts at a certain age versus starting to use your IRA and 401k dollars sooner.
When it comes to your retirement savings and investments, they generally fall into 3 tax “buckets”:
After-tax
Tax-deferred
Tax-free
After-tax dollars are those in a savings or brokerage account. These dollars have already been taxed. Thus the name 😉
Tax-deferred dollars are in a traditional IRA, 401k, or other similar retirement account. These dollars haven’t been taxed yet. Any future growth and earnings on these dollars doesn’t create a tax liability. However, once you start using these dollars and remove them from an IRA or 401k account, you’ll pay current income taxes on any amount you use.
Finally, tax-free or tax-exempt money is typically going to be in a Roth IRA or Roth 401k when it comes to your retirement planning. Generally speaking, these accounts are funded by after-tax dollars but won’t be taxed again in the future, including any growth and earnings.
Note: 529 college savings accounts are also considered tax-free if the funds are used for qualified education expenses. So are Health Savings Accounts (HSAs) when used for qualified medical expenses.
Given the 3 tax buckets above, it’s generally assumed you’ll spend your after-tax dollars first, then your tax-deferred dollars, and finally your tax-free dollars.
This assumption is based on the belief that you want to preserve the benefits of tax-deferred and tax-free growth on your savings and investments as long as possible.
But, you know what happens when you assume…
Given your tax situation and your personal mix of retirement savings among the 3 tax buckets, it could make sense to spend tax-deferred dollars before your RMD age and before you’ve used up all your after-tax savings.
Of course, your situation is your situation and your mileage may vary…
But while accounting for other sources of income (Social Security, pension, etc.) it’s worthwhile to explore the impact (positive or negative) of utilizing tax-deferred assets sooner than later.
It’s generally a good idea to leave any Roth IRA balances in place as long as possible, as tax-free growth is a rare thing indeed.
For example, and as Mike suggested in his email to me, you could perhaps use your IRA dollars sooner which in turn allows you to defer your Social Security benefits to age 70 which locks in a higher benefit amount for you.
And it also locks in a higher Social Security benefit for a surviving spouse, is applicable.
Also “using” your IRA balances sooner doesn’t necessarily require you to spend the money.
You could also explore the potential benefits of a Roth conversion where we take some money out of your traditional IRA, pay the taxes, and then move the dollars to a Roth IRA to capture any future growth tax-free.
There are also qualified charitable distributions (QCDs) which you’re eligible for (under current law) at age 70 1/2.
And based on the most recent changes to the RMD beginning age, QCDs might allow you to use traditional IRA dollars to fulfill your charitable giving goals in a tax-free manner prior to your RMDs starting.
So should you spend your retirement savings “out of order” compared to the generally accepted approach?
It depends (of course).
This is an important question which illustrates the benefits of a coordinated approach to evaluating and planning your retirement income.
And once you have a plan in place, it’s not “set it and forget it.”
For example, with the new Secure Act 2.0 rules, the later RMD age could result in more taxes paid as this Yahoo Finance article outlines.
So you still need to regularly review and adjust your retirement income plan as appropriate based on taxes, income needs, what the investment markets are doing, and other lifestyle factors that weigh into your personal decision making.
This is one (of many) reasons why I ask my clients for a copy of their tax return each year… so we can look at the impact of these alternative approaches to using your accumulated retirement savings in the most tax-efficient manner possible while also giving us comfort and confidence that your savings will last for the rest of your years.
Questions about your retirement income plan?
Or the order in which it’s best to utilize your accumulated retirement assets?
Hit reply and let me know what’s on your mind.
Links & things
Medicare Advantage Open Enrollment
While you’ll probably start to see fewer Medicare and healthcare ads on TV these days, there’s still an open enrollment period happening for those of you enrolled in a Medicare Advantage plan. From January 1st to March 31st you can:
Switch to another Medicare Advantage Plan with or without drug coverage.
Drop your Medicare Advantage Plan and go back to Original Medicare.
You can also join a Medicare drug plan.
With the ever-changing landscape in healthcare and prescriptions, it’s smart to review this every year to make sure you have the best coverage and cost for your situation.
The Problem with Goals
I’ve written about “goals” many times in these emails. And they’re a key to much of the work I do with my clients.
Yet, goals can be problematic.
Many people’s goals are mimetic, or based on what we see others doing and working towards.
Our goals are also often limited by our beliefs of what’s possible.
This all this in mind, I found this article to be an interesting argument for:
Would love to know your thoughts on this, so hit reply and let me know.
Thank You!
I’m grateful to have you as a reader.
If you have any questions or an idea for a future newsletter, blog post, or YouTube video, I'd love your input.
Just hit reply - I read (and truly appreciate) every email you send.
Until next Wednesday,
Russ