Retirement day is a financial rite of passage, a transition from accumulating wealth to spending it. The leading edge of the massive baby boom generation is reaching age 59½. That’s the age at which you may begin taking money from a traditional retirement account without incurring the dreaded 10% early withdrawal penalty. But distribution planning is complex, and just because you can take the money doesn’t mean you necessarily should.
Which money should you spend first during retirement? The retirement plan? Personal accounts? What kind of holdings should you sell, and in what order? The answers depend on your circumstances. Key variables include:
Still, many individuals—particularly if you won’t owe estate tax—fare better spending non-retirement accounts first. Potential benefits of tapping personal accounts first include the following:
Lower current taxes. Cash in personal accounts has already been taxed, and appreciated assets may qualify for taxation at long-term capital gain rates, generally at a maximum rate of 15% (20% for upper income taxpayers). Beginning in 2013, withdrawals from employer plans and traditional IRAs are taxable at ordinary rates as high as 39.6%.
Continued tax-deferred growth. Spending taxable accounts first allows your retirement account to keep growing free from current taxation.
More for heirs. Leaving an IRA to loved ones lets them continue the tax-deferred ride. With a “stretch” IRA, beneficiaries withdraw from the account over their life expectancies—especially attractive when their tax brackets are lower than the IRA owner’s. Note that non-spouse beneficiaries are no longer required to empty company plan accounts, generating current taxes. Rolling plan assets to an IRA could allow your heirs to maximize your retirement money.
Which taxable assets should you sell first? Let annual rebalancing be your guide. By selling from portfolio positions that have grown larger than your target allocations, you get cash to live on while keeping your investments well diversified.
Estate tax liquidity. If your estate lacks the cash to pay estate taxes, heirs might have to raid your retirement account, triggering income tax. If estate taxes are likely, it may be wise to keep some taxable assets in reserve to cover the bill.
Highly appreciated assets. Currently, when you leave taxable assets to heirs, their basis in the property is normally its value on the date of your death. This increase—or step-up—in basis to the current value effectively eliminates capital gains tax liability for investment appreciation during your lifetime. So it could pay to leave such assets to heirs and live off other taxable assets and your retirement account instead. However, highly appreciated assets also make good charitable gifts, because you can deduct their fair market value when they’re donated. It takes detailed analysis to determine the best approach.
Concentrated holdings. If you are retired or nearing retirement and much of your net worth is tied up in the stock of your company, trimming that exposure should be a priority. If the shares are in a retirement plan at work—and if you’ve participated in the plan for the past five years—you may benefit by taking the actual shares out of the plan when you leave the firm. You’ll pay income tax on the shares’ cost basis, but all of their prior appreciation will be taxed at lower, long-term capital gains rates. To benefit, however, the distribution must follow very specific rules. Don’t make a move until you have received professional advice.
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