Saving for retirement is half the battle. Withdrawing from your retirement funds so they provide a steady income after you stop working presents a whole other set of challenges.
"As much as 70% of your hard-earned retirement funds can be eaten up by income, estate and state taxes," says individual retirement account guru Ed Slott, author of the retirement-planning books, "Fund Your Future: A Tax-Smart Savings Plan in Your 20s and 30s" and "The Retirement Savings Time Bomb ... and How to Defuse It."
To avoid costly traps, Slott and other experts urge consumers to know the rules, plan carefully and maximize opportunity whenever possible.
Retirement accounts are not created equal
In a Roth IRA, you invest with after-tax dollars, and your earnings grow tax-free. Financial advisers love them because you never have to tap into them, but if you do, you don't have to pay any taxes on withdrawals. An exception: Taxes are due only on earnings if you withdraw assets before you turn 59 1/2 or if the Roth is fewer than 5 years old.
But traditional IRAs, simplified employee pension plans (SEPs), SIMPLE IRAs, 401(k) plans, 457 plans and 403(b) plans are different animals. These generally involve a tax deduction upfront, but investors face a deadline. You have to start taking withdrawals, known as required minimum distributions, or RMDs, after you turn 70 1/2. And when you do, you'll owe ordinary income taxes -- as much as 39.6% for the top tax bracket.
Rules for RMDs are rigid
You have to take required minimum distributions annually by April 1 of the year after you turn 70 1/2 and by Dec. 31 in subsequent years. In other words, if you turn 70 1/2 in 2014, you have until April 1, 2015, to take your first RMD.
Don't miss those deadlines! Failure to make on-time RMDs triggers a whopping 50% excise tax.
That's true if you underpay, too. Let's say your RMD for the year is $20,000, but you only take a $5,000 distribution because of a miscalculation. The Internal Revenue Service will levy the 50% penalty -- in this case $7,500, or half of the $15,000 you failed to withdraw. So double-check your math, or seek guidance from a professional.
When you compute your required minimum distribution, be aware that it will change from year to year. That's because it's determined by your age, your life expectancy (the longer it is, the less you have to take out) and your account balance, which will be the fair market value of the assets in your accounts on Dec. 31 the year before you start taking distributions.
A professional can help you with the calculations -- or check out what you owe by referring to the "Uniform Life Table" in IRS Publication 590.
Spend accounts in the right order
If you need retirement savings to get by, and you're wondering whether to take them from an IRA, 401(k) or a Roth, don't be tempted by instant gratification. Sure, the Roth IRA withdrawal will be tax-free, but you may wind up paying more in lost opportunity.
Instead, if it makes sense to do so, withdraw from taxable retirement accounts first, and leave Roth IRAs alone for as long as possible.
Skeptical? Consider what happens if 72-year-old Joe Retiree takes $18,000 out of a traditional IRA, and he's in the 25% tax bracket: He'll owe $4,500 in taxes. If he withdraws the same amount from a Roth, he won't pay a dime. But Joe doesn't have to take a required minimum distribution from a Roth, so if he doesn't withdraw the $18,000 from the Roth and earns 5% annually for another 10 years, it would grow to $29,320. Moreover, those earnings also would be tax-free when withdrawn from the Roth.
Keep in mind that taking distributions in a tax-smart way depends on your particular situation. Before you withdraw money, be sure to run the numbers -- with a certified public accountant if necessary.
The mechanics of taking distributions
If you have several retirement accounts due to frequent job changes in your career and you're approaching 70 1/2, you now have the task of figuring out how to withdraw the money.
Will you have to tap all of your accounts? Probably not.
If you own a handful of traditional IRAs, you can withdraw from each of them. But the more efficient move is to add up the assets from all your accounts, and take one withdrawal from a single IRA.
Now for the fine print: You can pool your distributions for 403(b) plans, too, but you can't mix them up, say, by making withdrawals from an IRA to meet your RMD requirements for a 403(b) plan. Similar accounts have to be pooled together. Also, 401(k) plans cannot be pooled to compute a single RMD, says George Jones, a senior analyst for CCH/Wolters Kluwer. To streamline those, roll them into an IRA.
Also, rather than owning several IRAs, consider consolidating them into a single account to simplify paperwork, make it easier to compute future withdrawals and gain greater control over your asset allocation, says Slott.
"The last thing people need is three different IRAs, because it's complicated," he says, adding that financial institutions generally offer the same products, so, "You can have diversification from one account."
RMDs smaller for some married couples
If your significantly younger spouse will inherit your IRA, you may be able to reduce your required distributions, thereby trimming taxes and making your retirement funds last longer.
Recall that required minimum distributions are calculated using factors that include your life expectancy as determined by the IRS. But if you've named a spouse as the sole beneficiary of your IRA and he or she is at least 10 years younger than you, then your RMD is computed using a joint life expectancy table. That will reduce the amount you need to distribute in any given year.
For example, a retiree who turned 70 1/2 in the previous year and who would have to take his first required minimum distribution by April 1 of the current year would have a life expectancy of 26 1/2 years in the eyes of the IRS. So if his IRA were worth $200,000, his first RMD would be $7,547 ($200,000 divided by 26.5).
But let's say he designates his 56-year-old wife to be the sole beneficiary of that retirement account. In that case, their joint life expectancy would be 30.1 years. So the first RMD would be trimmed to $6,645. The IRS provides a table for this situation in its Publication 590.
Making a charitable contribution
If your dreams for a lifetime of savings include helping a charity, it may be well worth using your retirement funds to make a difference.
Currently, if you give assets from your traditional IRA to charity, you may be able to claim a charitable deduction, up to certain limits.
Alternatively, individuals 70 1/2 or older are allowed to make tax-free donations, known as qualified charitable distributions, of up to $100,000 directly from their IRAs to a charity. Such a distribution doesn't count as income, reducing any income tax liability to the donor.
The opportunity to make these tax-free distributions was extended through the 2013 tax year, thanks to the American Taxpayer Relief Act of 2012.
"It's one of those provisions most people think is a good idea," says Jones, who had predicted it would be extended. "I know that several charitable organizations put their weight behind it."
Be aware that you can't have your proverbial tax cake and eat it, too. Individuals who make tax-free charitable distributions from their IRAs won't be able to itemize them as a charitable deduction.
"You get one or the other," says Slott. "Whoever uses this strategy will pay less in taxes, so if you're charitably inclined, it's the best way to make donations."
'In kind' withdrawals qualify as RMDs
It's easier to take withdrawals in cash, but that doesn't mean you have to -- or should. So-called in-kind distributions are taken out in the form of stocks or bonds, and they may make more sense for certain individuals who want to keep assets for various reasons. You'll simply move the assets from your IRA into a taxable account. These in-kind withdrawals will be assigned a fair market value on the date they are moved.
An in-kind withdrawal may be easier and less expensive than triggering transaction fees by selling the securities in the IRA and buying them back in a brokerage account.
RMDs can be delayed for some workers
If you're still working at 70 1/2 and still contributing to a 401(k) or 403(b), you're entitled to an RMD reprieve.
As long as you don't own more than 5% of a company and your retirement plan lets you, you can delay the RMDs until April 1 after the year that you "separate from service," at which point you'll have to start taking withdrawals.
This is true as long as you work during any part of a year. So if you're 71 1/2 and thinking about retiring by the end of the calendar year, reconsider if you don't want to make a withdrawal. If you keep working after Jan. 1 -- even if it's just a day -- you'll push off the date for taking that first RMD by one more year.
Keep in mind that the delay only counts for the 401(k) plan of the company you're still working for. If you have other 401(k) plans from previous jobs, you'll need to take distributions from them if you're 70 1/2.
Consider a Roth conversion
Talk to tax pros and retirement advisers, and they'll often push clients to roll retirement accounts into Roth IRAs, where time and tax-free growth can work their magic.
The conversion will generally trigger a tax bill. But the upside is considerable: Once you make the move, all the funds grow tax-free and can remain untouched. With the possibility of higher taxes looming, it may make sense to pay up now.
For example, a 43-year-old gets a new job and decides to move $150,000 from his 401(k) into a Roth IRA. He's in the 33% tax bracket, so he'll owe roughly $49,500, which he'd be wise to pay with funds outside of the IRA. If he leaves the entire amount untouched in the Roth and it grows at a rate of 7% annually, it will be worth $1.14 million in 30 years.
What about someone who's close to retirement, or possibly even turned 70 1/2? If you need the retirement funds for yourself and don't plan to pass them on to heirs, then it may be smart to leave them where they are.
"But if you want to preserve that retirement asset for heirs," says Slott, "it's a great move because it removes the uncertainty of what future taxes will be. Converting to a Roth is a great thing to do for the next generation."