Unfortunately, most retirement discussions revolve around two figures – the amount you need to save and your expected annual expenses throughout retirement. Those figures, however, are only part of the equation. Any successful retirement includes an effective retirement distribution strategy. You can reduce the risks of a life with no regular paychecks by designing an efficient retirement distribution strategy before you retire.
When planning for retirement distributions, you have three main goals:
- Guarantee your money will last the rest of your life (Duh!).
- Keep income taxes as low as possible – who wants their retirement savings to go toward taxes?
- Avoid Medicare Premium surcharges.
Retirement distribution planning is a continually moving target based on your situation, the economy, and recent tax laws. You can improve your chances of success and provide yourself with some much-needed flexibility with a few retirement planning moves.
Budget and Plan to retire your debt before you do
To know how much you need to save, you need to know how much you’ll spend. That requires a budget. Daily living, housing, hobby/vacation, taxes, and healthcare must be included. It’s a necessary evil; even though it’s a pain, it will eventually pay off.
Speaking of budgeting…debt is a retirement savings killer. Taking distributions from your retirement accounts to pay for debt is not one of your retirement dreams. Eliminating debt before retirement provides more flexibility and significantly reduces your fixed expenses, which obviously leaves more for you.
I’ve never seen a retirement advertisement showing a happy couple paying their mortgage. They’re on a sailboat, riding bikes, or walking the beach. Don’t let your retirement savings be a slave to debt in retirement. It’s not a good look.
Determine when should you (and your spouse) file for Social Security
Social Security filing is more critical than most people realize. Although you can take your benefit as early as age 62, it makes sense to wait in most cases. The difference between claiming your benefit at 62 and 67 (the full retirement age for those born after 1960) is about 7% annually. Waiting until age 70 adds another roughly 8% annually from age 66 to 70.
But that is only part of the Social Security puzzle. Are you married, single, divorced, healthy, etc.? If you’re retired but delay taking Social Security, that means more will have to come from other sources early in retirement but less later in retirement. That may be OK and, in fact, beneficial. It requires in-depth analysis and is not as simple as most people believe.
Create retirement distribution diversification
When you hear about diversification, it usually refers to investments, such as stocks and bonds. The appropriate investment allocation is essential, but we also recommend income diversification. Multiple income options, with different tax consequences, will expand the possibilities in retirement.
I lump them into the following retirement income categories:
Taxable as income: Contributions and growth are tax-deferred, but distributions will be taxed as ordinary income in retirement. You know ’em and love ’em as the Traditional IRA, 401(k), 403(b), pensions, deferred comp plans, qualified annuities, etc.
After-tax: This group would include everyone in the Roth Family: all the Roth IRAs, 401(k) ‘s, and 403(b) ‘s. Contributions are considered after tax. Growth is not taxed, and distributions are tax-free as long as you’re 59½ and made the first Roth contribution at least five years ago.
Mixed Bag: We have non-qualified annuities, brokerage investment accounts, and nondeductible IRAs.
Brokerage: The sale of investments is subject to long-term capital gains if held for over one year. For investments held less than a year, those gains, called short-term gains, are taxed at ordinary income tax rates. Don’t forget about interest and dividends. They’re taxed as well. The good news is that distributions are not taxed as income.
Non-qualified annuities: When you take partial withdrawals, the total amount is taxed at ordinary income tax rates until the gain is used up. Then after the gain has been distributed, the balance of withdrawals is a tax-free return of the cost basis.
Nondeductible IRAs: Contributions are after-tax, and growth is tax-deferred. Distributions are split; contributions are a tax-free return of your contributions, but growth is taxed as income. Each partial distribution will be a prorated split of tax-free and taxable.
However, there may be a way around this with the Back Door Roth IRA strategy. You can roll a nondeductible IRA into a Roth IRA and avoid taxes on the conversion in specific situations. Learn more in our post How to Grow More Tax Free Retirement Assets with Backdoor Roth Conversions.
The Holy Grail: I’m talking about HSA—tax-deductible contributions, tax-free growth, and tax-free distributions for qualified medical expenses. If you qualify for an HSA and can save it for retirement, an HSA is a fantastic tax-advantaged tool. We love it so much that we wrote a blog post about the 7 Ways an HSA Can Help You Now and In retirement.
Social Security: Your Social Security is subject to taxation based on income.
- 50% of your Social Security benefits if your income is $25,000 to $34,000 for an individual or $32,000 to $44,000 for a married couple filing jointly.
- 85% of your Social Security benefits if your income is more than $34,000 (individual) or $44,000 (couple).
Budgeting, paying off debt, and creating diverse income streams increases the chance that your a$$ is covered during retirement and that more of your money will stay in your pocket. You can switch income resources as needed or mix and match them to reduce your income taxes and avoid or reduce the Medicare Premium Surcharges.
Nothing is certain except death and taxes
No, we can’t help you entirely avoid taxes (or death), but we can set up a plan to minimize the tax bite. Think about what you can save if we get a plan in place. A reduction of taxes each and every year of a hopefully very long retirement. That could add to a big ol’ chunk of change—more for you and less for the government.
Taxes go up. Taxes go down. Rules change, and deductions come and go. You can expect many tax law changes before and during retirement. Creating a mix of taxable, non-taxable, and partially taxable income enables you to devise a withdrawal strategy to handle almost any change in your tax situation.
Manage the Medicare Premium Surcharges
Everyone has to pay for Medicare. That’s a fact of retirement. Did you know there are Medicare premium surcharges if your income passes certain thresholds? These surcharges are for Part B, medical insurance coverage, and Part D, prescription drug coverage.
The surcharge for a year is set using the Modified Adjusted Gross Income (MAGI) reported on the tax return filed two years before. For example, your 2021 tax return will be used to set premiums paid in 2023. Your returns filed two years prior are the most recent available to Social Security for setting the premiums.
MAGI is adjusted gross income plus tax-exempt interest and tax-exempt foreign income and includes Retirement plan distributions and Social Security. It also includes capital gains, interest, and dividends from non-retirement investment accounts.
Surcharges apply on a “cliff” basis. For example, a married couple with a MAGI of $194,000 owes no surcharge. But a MAGI of $194,001 results in Part B surcharges. It goes up from there…
Part D has surcharges as well.
You can visit Medicare.gov for more information on the charts above.
If your income has decreased, you can appeal the medicare premium surcharge. File Form SSA-44 with the Social Security Administration, along with documentation of the event that caused the decrease in income. So, the good news is it’s not a forever surcharge.
Retirement Distribution Flexibility
There are very few retirement distribution absolutes. No single distribution strategy can apply to everyone. Most people will use multiple strategies throughout retirement. That’s why there are no recommendations to do X when Y occurs.
What we do have is an annual process that implements the recommendations above, which will allow you to pivot and change strategies.
Annual Tax & Retirement Income Strategy Session
A great time to do this is during tax time. It’s easy to review the previous year and still early enough to manage the new year. If you file for an extension, we can make it later in the year!
We take into consideration your income needs for the year. Compare those needs to your tax and medicare premium situation and devise a retirement distribution strategy to create the lowest tax liability possible.
Another vital point to monitor is your withdrawal rate: The amount you take out divided by the total amount is your annual withdrawal rate.
For example, if you need $100,000 per year to cover all expenses and income taxes, and you receive $30,00 annually from Social Security. That means $70,000 must come from your retirement accounts. If your total retirement accounts value on 1/1/19 was $1,000,000, your withdrawal rate = 7%
Let’s talk about the 4% rule of thumb. The 4% rule states that you won’t run out of money if you withdraw 4% from a retirement fund in the first year, followed by inflation-adjusted withdrawals every year. Although rules of thumb aren’t guaranteed, the 4% rule is a sound theory tested and analyzed over the past 25 years.
Never-ending retirement distribution analysis
There are many moving parts regarding retirement, requiring constant analysis to fight the good fight. However, you will not be in control if you don’t plan ahead. You’ll be up a creek without a paddle, helplessly subject to the ever-changing currents of taxes and Medicare premium surcharges.
If you want to start planning your retirement distributions, you better start before it’s too late. Let us help you design a strategy to save your taxes and avoid or delay those Medicare premium surcharges. Contact us today to get started!