Retirement brings major changes in your life. One big change is that you'll go from contributing to your retirement accounts to withdrawing from them.
Taking money out of these accounts can seem scary after you've worked so hard to save it, and indeed there is a risk of running out of cash and having to struggle to live on Social Security alone.
But if you've saved diligently and are smart about how you make withdrawals, your money should hopefully last for as long as you need it. To maximize the chance of that happening, ask yourself these three key questions before tapping your retirement accounts.
1. Is your withdrawal rate safe?
Retirees shouldn't just withdraw savings without a plan. In fact, they should develop a strategy to take out money on a set schedule that ensures their accounts will not run dry throughout their lifetime.
There are a few different ways to establish a safe withdrawal rate, and one especially popular option is the 4% rule. This involves making a withdrawal equal to 4% of your account balance in your first year of retirement, then bumping up the amount each year to account for inflation.
If you follow the 4% rule and have $850,000 in your retirement account, you'd be able to take a $34,000 distribution in your first year of retirement. If you're considering taking out a lot more than that, you may want to reconsider. And if you have no withdrawal strategy at all, you won't have an easy way of knowing if you're taking too much out in any given year.
2. How will your withdrawals affect your taxes?
If you have a traditional 401(k) or IRA, the money you take out of your account will be taxed as ordinary income as long as you're at least 59 1/2.
But it's not just taxes on your retirement account distributions you have to worry about. Depending on how much you take out, the withdrawals could affect whether your Social Security benefits are taxed and at what rate. It's important to understand how taxes on retirement account distributions and Social Security retirement benefits work so you understand the implications of your choice to withdraw funds.
If you have Roth accounts, on the other hand, you can make withdrawals tax-free (and without affecting taxes on your Social Security benefits) as long as you follow a few basic rules.
3. What are your RMDs?
Lastly, there are the rules for required minimum distributions (RMDs), which apply to traditional IRAs and 401(k)s once you reach 72.
The CARES Act suspended RMDs for 2020, but you still need to be sure you're withdrawing enough to meet these requirements. Otherwise, you could face steep tax penalties equaling 50% of the missed withdrawal.
Don't make a withdrawal unless you can answer these three questions
When you've worked hard to save, you don't want to undermine your efforts by making the wrong choices about taking money out as a retiree.
By answering these three questions, you can understand all the financial consequences of withdrawing funds and reduce the chances you'll run your retirement accounts dry too soon. You'll protect your hard-earned dollars and ensure a comfortable retirement.