Distribution Strategies For Retirement
In the United States, we have been experiencing a period of benign inflation for quite some time.
But even at this low level, the cumulative effects are significant. Costs, and thus needs, are likely to double or quadruple across a long retirement. A long-term retirement necessitates maintaining a growth-oriented investment approach in order to keep up with or outpace inflation. But growth-oriented investments are volatile. This means that they also have less potential to earn, which is fine. But the pool of assets funding your long-term retirement is therefore smaller, as some assets are earmarked for shorter-term needs and not in a growth position.
Retiring does not allow you to escape the IRS. Any spendable need is after taxes. You will need to gross-up your requirements so you can allocate for taxes and spend what is left. You need retirement assets to fund your expenses over whatever base of other incomes you may have.
Social Security benefits and any pension income form your base.
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Instead, use a good estimate of your own number. Your desired lifestyle determines what you need. Other factors, as described above, also influence that need. From there, you can consider a retirement distribution strategy. There are two main types: A capital retention retirement strategy keeps your principal intact, while you live off of the earnings.
Or, in most cases, a portion of the earnings. That means your assets will have to fund an increasingly large portion of your retirement across time. So if your capital is going to remain intact across your lifetime, it will need to keep growing in order for you to be able to fund these future — larger — needs. Capital retention has some great benefits. Many people want to use a capital retention strategy in order to pass assets on to their heirs.
They get to live off of the money during retirement, but what they have accumulated goes on to their beneficiaries. A win-win for sure. Capital retention keeps the principal intact, which gives you more options if things go bad. Or even just not super well. If inflation increases your needs significantly, you still have that pool of money. If you have large unforeseen medical expenses , you have resources. Capital retention is a conservative approach that allows you a great deal of flexibility in retirement. But it also requires you to accumulate a lot of money.
The key is that you aim for this to happen after the longest you reasonably expect to live in retirement. This gives you a little cushion. Not much, but a little.
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Higher-than-expected inflation or unexpected medical expenses can throw plans off. Using conservative assumptions and allowing for contingencies is essential. A capital depletion strategy is the more common than the capital depletion method.
But remember—the impact of taxes is just as important to consider now as it was when saving for retirement. The good news is that in retirement there may be more options to increase after-tax income, especially when savings span multiple account types, such as traditional retirement accounts, Roth accounts, and taxable savings like brokerage or savings accounts. The not-so-good news is that choosing which accounts to draw from and when can be a complicated decision. So, how and when you choose to withdraw from various accounts— k s, Roth accounts, and other accounts—can impact your taxes in different ways.
Let's start with a key question that many retirees ask: How long will my money last in my retirement? But from which accounts should you be taking that money? Traditionally, many advisors have suggested withdrawing first from taxable accounts, then tax deferred accounts, and finally Roth accounts where withdrawals are tax free see illustration below.
For most people with multiple retirement saving accounts and relatively even retirement income year over year, a better approach might be proportional withdrawals. The effect is a more stable tax bill over retirement, and potentially lower lifetime taxes and higher lifetime after-tax income.
To get started, consider these 2 simple strategies that can help you get more out of your retirement savings, depending on your personal situation. To help get a clearer picture of how this could work, let's take a look at a hypothetical example: Joe is 62 and single. Now let's consider the proportional approach.
As you can see in the graph above, this strategy spreads out and dramatically reduces the tax impact, thereby extending the life of the portfolio from slightly more than 22 years to slightly more than 23 years. By spreading out taxable income more evenly over retirement, you may also be able to potentially reduce the taxes you pay on Social Security benefits and the premiums you pay on Medicare. Spreading traditional IRA withdrawals out over the course of retirement lifetime may make sense for many people.
First use up taxable accounts, then take the remaining withdrawals proportionally.
The purpose of this strategy is to take advantage of zero or low long-term capital gains rates, if available based on ordinary income tax brackets. One strategy for retirees to help reduce taxes is to take capital gains when they are in the lower tax brackets. Remember, the amount of ordinary income impacts long-term capital gain tax rates. Estimated total tax due: His estimated total tax due: Once the taxable account is exhausted, the proportional approach can then be applied.
Key takeaways
Additionally, this strategy allows investors to keep their assets in more tax-efficient accounts for a longer period of time by delaying withdrawing from their traditional and Roth accounts where the assets can grow tax-deferred or tax-exempt, respectively. Optimizing withdrawals in retirement is a complex process that requries a firm understanding of tax situations, financial goals, and how accounts are structured.
However, the 2 simple strategies highlighted here could potentially help reduce the amount of tax due in retirement. It's important to take the time to think about taxes and make a plan to manage withdrawals. Be sure to consult with a tax or financial advisor to determine the course of action that makes sense for you. This information is intended to be educational and is not tailored to the investment needs of any specific investor.
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Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money. Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice.
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Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
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