You've finally reached retirement, and you're ready to start living off all that money you worked so hard to save. Unfortunately, withdrawing money isn't quite as simple as just taking cash out of your investment accounts. You'll need to think about how you can make your money last, and how your withdrawals will affect your overall financial situation.
Since making withdrawals from your investment account may impact your financial life in unexpected ways, it's important to look at the big picture. Here are five key things you'll want to consider when you start taking money out of your retirement savings.
1. How will your withdrawals get taxed?
Depending upon the type of retirement account you have, your withdrawals may be treated as taxable income. If you have a Roth 401(k) or a Roth IRA, you don't have to worry about being taxed on the income -- as long as you follow specific rules for withdrawals, such as waiting at least five years after an IRA conversion, or leaving money invested for at least five years.
If you have a traditional IRA or 401(k), however, distributions will be treated just like income from a paycheck, and will be taxed accordingly at your regular tax rate. Because withdrawals are treated as ordinary income, be mindful of whether your withdrawals will push you into a higher tax bracket -- which means some of your income will be taxed at the higher rate -- or will cause you to hit the income limit for any deductions you may be taking.
Do not take money out of any IRA or 401(k) before you're 59 1/2, or you could be hit with substantial early-withdrawal tax penalties if you don't qualify for certain exceptions.
2. Will your withdrawals cause you to be taxed on your Social Security?
Tapping retirement accounts could have other tax consequences. If you make taxable withdrawals that cause you to exceed income limits you were previously below, your Social Security benefits could become taxable, or could be taxed at higher rates:
- If you file a joint tax return and your provisional income is between $32,000 and $44,000, you'll be taxed on up to 50% of Social Security benefits. If your combined income exceeds $44,000, you're taxed on up to 85% of your Social Security benefits.
- If you're a single tax filer, you'll be taxed on up to 50% of Social Security benefits if your income is between $25,000 and $34,000, and taxed on up to 85% of benefits if your income exceeds $34,000.
It's important to note that "income" means something specific for purposes of determining if you'll be taxed on Social Security benefits. Income is calculated by adding half of your Social Security benefits to your adjusted gross income plus certain nontaxable income, such as interest income. Tax-free distributions from Roth IRAs don't count.
You can use the calculator in this linked article to determine if you'll pay tax on Social Security benefits.
3. Will your Medicare premiums go up?
The Social Security Administration uses the income reported on your most recent federal tax return to determine what premiums you'll pay for Medicare Parts B and D. If your taxable income is suddenly higher because of taxable withdrawals from your 401(k) or IRA, premiums could rise.
For example, if your modified adjusted gross income exceeds $170,000 for a married couple filing jointly, or $85,000 for other tax filers, your premiums will be higher for both Part B and Part D.
The increase can be substantial. In 2017, for example, you'd pay $53.50 more per month for Part B and $13.30 more for Part D if your income was $85,000 to $107,000, or was $170,000 to $214,000 if filing a joint return.
Premiums continue to go up at different income levels, up to a maximum additional premium of $294.60 per month for Part B and $76.20 per month for part D if your income exceeds $214,000, or $428,000 for joint filers.
4. What are your required minimum distributions?
While you want to be cognizant of whether withdrawals increase your taxes, or affect Social Security or Medicare, you also need to make sure your withdrawals are large enough to meet Required Minimum Distribution (RMD) requirements.
RMDs are the minimum withdrawals you must make from 401(k)s, traditional IRAs, SEP IRAs, and Simple IRAs. If you have a Roth IRA, you don't need to make RMDs .
RMDs are required once you reach age 70 1/2 if you're retired. If you're not yet retired, RMDs can begin after retirement, unless you fall within an exception for business owners. You must take your first RMD no later than April 1 after the year you turn 70 1/2 and must take all subsequent RMDs by December 31 of each year.
The amount of your required minimum distribution is based on your account balance and a life expectancy table in Publication 590-B. You can learn in that article how to calculate your required minimum distributions.
Penalties are very substantial if you fail to take RMDs by the required deadline, as the amount you failed to withdraw is taxed at 50%. You must make sure you take RMDs when required to avoid this huge loss.
5. Are you reducing your retirement balance too quickly?
Last but not least, you must consider whether you're reducing your retirement balance more quickly than you should. If you do, you're in danger of running out of money.
The traditional rule-of-thumb was that you could withdraw up to 4% each year from retirement accounts without running out of money, but with longer life spans and lower interest rates, you have almost a 60% chance of running out of money if you do that. New research has suggested you may need to stick closer to a 2% withdrawal rate if you want to ensure you won't go broke.
If you're withdrawing too much, consider downsizing your home, moving to a lower cost-of-living area, or simply finding a way to live on a budget.
Don't go broke during retirement
Your golden years should be a time to enjoy yourself -- but you want to make sure you have the money you need now and in the future. This means fully understanding how withdrawals affect your finances.
Now you know the key factors to consider, and you can be smart about how you take money from your savings so your nest egg should hopefully last for life.