Retirement withdrawal strategies: Stay tax smart

Photo of a couple who are enjoying retirement because they have a plan for withdrawing their retirement savings.

The way you withdraw your retirement savings can have a big impact on how long your money will last.

Mary B. Knutson, 58, who recently retired early from Principal®, already has contemplated her options. Her husband still works while the couple divides time between Arizona and Iowa.

Mary knows that she won’t touch her 401(k) or pension until she’s 62—and maybe not even then.

She also has an annuity and other savings to rely on in her late 60s. When she reaches age 70½ she’ll want to consider more seriously how she contributes to charity, as those donations also can help satisfy the required minimum distributions (RMDs) from tax-deferred accounts.1

Meanwhile, she may teach yoga in retirement.

“I’ve been planning this for 35 years,” she says. “You don’t start when you’re 54. You start way before that."

Here are tips for creating a withdrawal strategy of your own:

Decide how much retirement income you need

You've spent your career saving for retirement—maybe, like Mary, mostly in your 401(k). But once you retire, how do you switch to spending?

First, decide how much retirement income you'll likely need:

  1. Calculate your annual retirement spending. Look at your spending history, and break down your annual estimate into a monthly figure.
  2. Calculate how much of that need is met by Social Security, pensions, annuities, and work income.
  3. To cover the remaining amount, categorize your savings into 2 buckets:
    • Accounts built with after-tax dollars, such as bank accounts and investments that are not tax-deferred. Options such as a Roth individual retirement account (IRA) or Roth 401(k) also allow tax-free distribution in retirement.2
    • Tax-deferred accounts, such as traditional IRAs, 401(k)s, and 403(b)s.

How taxes and RMDs affect retirement withdrawals

Generally, your first stop for withdrawals should be RMDs from tax-deferred accounts. That's because any RMD that hasn't been withdrawn for the year could be subject to a 50% tax penalty.3 This is where donating to charity, in other words a qualified charitable distribution (QCD), can both satisfy the RMD and avoid a taxable event.

Next, consider withdrawing from accounts that are taxable to you—regardless of whether you spend or reinvest those distributions. Examples include capital gains, dividends, and interest. (Keep in mind that these different types of distribution may be taxed at different rates.)

For most retirees, withdrawing more than the RMD from tax-deferred accounts generally should be the last choice. This is due to the way these accounts are taxed—every dollar withdrawn from tax-deferred accounts is taxed as ordinary income.

However, if you're in a year in which your overall income is lower than normal, or if you feel your future tax rate will go up, you may want to think differently. Consider drawing from tax-deferred money up until the point that it would push you into the next marginal tax bracket.

Who might inherit your savings?

You also may opt to draw from tax-deferred money for heirs likely to be in a high future tax bracket. It may benefit them to inherit taxable assets because those assets enjoy a “step-up in basis.” That means the capital gains tax on the assets are based on the value when inherited, not the original purchase price for the relative who bequeathed them. That can often result in a significant tax savings.  

Get help

Consult your tax advisor before making decisions. No single withdrawal strategy is right for everyone. But how you spend, plus the market conditions at the time, can have a big impact on how long your money lasts (also known as “sequence risk”). Ask questions until you’re comfortable and clear about your plan.

Next steps:

  • Looking for estimates? Start visualizing retirement with your own info by visiting our planning tools and calculators.
  • Have a retirement account from your employer serviced by Principal? Log in to principal.com to access personalized planning, sign up for our quarterly newsletter and more. First time logging in? Get started.
  • Interested in starting an individual retirement account (IRA) or consolidating other accounts into your existing one? Call 800-247-8000, ext. 2503 between 7 a.m. and 9 p.m. CT. Not familiar with IRAs? Here’s a refresher.

1 See publication 590; Qualified charitable distributions.

2Assuming you meet the certain qualified distribution requirements: made after holding the account for a five-year period and is made after either participant reaches 59 1/2, participant’s death, or participant becomes disabled.

3 Individuals with IRAs and those who are a 5% or more owners —with qualified retirement plans are required to receive a minimum distribution by April 1 after they reach age 70½, and each December 31 thereafter. For employees with qualified retirement plans who are not HCEs but are still actively employed, RMDs can be delayed until April 1 of the year following the year they terminate employment, and each December 31 thereafter. RMDs may also apply to some beneficiaries.

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.

Insurance products and plan administrative services provided through Principal Life Insurance Co. Securities offered through Principal Securities, Inc., 800-547-7754, member SIPC and/or independent broker-dealers. Principal Life, and Principal Securities are members of the Principal Financial Group®, Des Moines, Iowa 50392.