Step 4 of 4: Get to Know Your Retirement Building Blocks
KEY TAKEAWAYS
Step 4 of the 4-step process to determine YOUR personal retirement income and withdrawal plan – getting to know YOUR retirement building blocks, including when and how to use them for maximum effect.
The three building blocks are pre-tax accounts, tax-free accounts that are funded with after-tax dollars, and after-tax accounts.
59 ½ is the typical age in which the IRS says you can begin taking distributions from tax-favored accounts like traditional 401(k) plans and Roth IRAs.
The current age at which RMDs kick in is 73; however, starting in 2033, the RMD age will be increased to 75.
This article is entry #5 in our Retirement Income Series and is step #4 of a 4-step planning process that we employ, called “Getting to Know YOUR Retirement Building Blocks and When and How to Use Them for Maximum Effect." As a refresher, our 4-step process to your Retirement Income Plan is as follows:
Begin with the end in mind: what's your ultimate nest egg goal?
Understand different withdrawal methods that tell you how much money you can take out.
Perform multi-year tax planning to minimize taxes in retirement.
Get to know YOUR retirement building blocks and when and how to use them for maximum effect.
If you still need to do so, we recommend reading our other Retirement Income Series articles that go over Step 1, Step 2, and Step 3. Briefly – as you define your goals, consider your withdrawal strategies, and evaluate how to minimize your taxes, you are ready to start using your building blocks. Each of these steps is an essential layer of the overall foundation. Once your foundation is built, you can confidently follow a retirement withdrawal plan that meets your goals and allows you to maximize the wealth you worked hard to save.
MEET YOUR BUILDING BLOCKS
Your building blocks are made up of pre-tax accounts, tax-free accounts that are funded with after-tax dollars, and after-tax accounts. Put another way, these building blocks are commonly known as:
401(k) plans, 403(b) plans, 457 plans, and traditional IRAs are your pre-tax accounts.
Roth IRAs and Roth 401(k) plans are your tax-free accounts that are funded with after-tax dollars.
Savings and brokerage accounts are your after-tax accounts.
Before diving into more specifics, you need a better understanding of how each building block is constructed. The figure below overviews how each account operates – everything from how a withdrawal is taxed, to the age you can start accessing funds, to the age the IRS says you are now forced to withdraw money, and last but not least, to the financial penalties that are applicable if you don't follow the rules.
When we analyze the table above, there are some areas to draw your attention to that are more nuanced and therefore need to be expanded upon. Let's start from the top down.
THE AGE YOU CAN BEGIN ACCESSING YOUR RETIREMENT FUNDS & TAXES
To incentivize retirement savings, the IRS provides tax breaks to those that save a portion of their paycheck into company sponsored retirement accounts or individual retirement accounts. The tradeoff for those tax incentives is the IRS restricts access to those same savings. In other words, 59 ½ is when the IRS permits withdraws from tax-favored accounts like traditional 401(k) plans and Roth IRAs.
If you follow their rules, you only pay income taxes for taking a withdrawal from traditional 401(k) plans, IRAs, and other pre-tax retirement vehicles (457, SEP, SIMPLE). What makes Roth accounts so popular is that they allow for withdrawals to come out tax-free – assuming certain requirements are met (more on that later). Whereas with brokerage accounts the realized profits (when you sell an investment security at a gain) are taxed at long-term capital gains rates of 15%-20%, if the investment was owned for more than a year. If owned for less than one year, then the gains are considered short-term and taxed as ordinary income. Similarly interest from savings and bonds are taxed as ordinary income.
Unfortunately, if you decide to break the rules and take a withdrawal before 59 ½, the IRS penalizes the taxable amount distributed at a rate of 10%. For example, if you are 52 and took out $100,000 from your Roth IRA, but only $30,000 of that withdrawal was taxable, then the IRS penalty applied to your withdrawal is $3,000 ($30,000 x 10%). If that same $100,000 came out of a traditional IRA, the penalty is $10,000 ($100,000 x 10%).
Aside from the penalty free withdrawal options discussed later in this article, a notable exception to the age 59 ½ restriction is that certain company-sponsored retirement plans allow for withdrawals starting at age 55. More specifically, when a retiree terminates employment with their most recent employer, that 401(k) plan may allow the former employee to take penalty-free withdrawals when they are 55 or older.
However, this rule does not apply to 401(k) plans that are tied to your previous jobs. In other words, you can only make penalty-free withdrawals from the 401(k) plan that you were most recently contributing to at the time you were terminated or retired. Let's review an example to help bring this point home - Bob Jones is the 401(k) owner and is 56. Say Bob worked for Florida Blue 20 years ago, but his most recent employer is Johnson and Johnson. Upon retiring, only Bob’s JNJ 401(k) plan is eligible for penalty-free withdrawals.
Another exception involves Roth IRAs. There are two components to the Roth IRA exception that you need to be mindful of, which are: 1) your original contributions can be withdrawn without incurring taxes or penalties at any time; 2) the 5-year waiting rule stipulates that you must wait at least five years after you first contributed to a Roth IRA account before you can withdraw the earnings tax-free. The reason your contributions are not taxed or penalized is because you already paid taxes on that money before it went into the Roth account.
MANDATORY WITHDRAWALS
Wait a minute... what the bleep? Does the IRS actually require you to take withdrawals from your retirement funds? Even when you don't need the money! The short answer is YES. That is for pre-tax accounts only. Roth IRAs are not currently subject to required minimum distributions (RMDs), and brokerages accounts are never subject to such requirements because those accounts do not receive the same preferential tax treatment as IRAs.
The current age at which RMDs kick in is 73; however, starting in 2033, the RMD age will be increased to 75. To complicate matters further, thanks to the passage of the SECURE Acts 1.0 and 2.0, the previous RMD ages were 70 ½ and 72 before the rollout of each respective law change.
Because the IRS likes to overcomplicate our lives and help people like me keep a job, I created the following table that organizes the year you were born to when your RMD age begins:
Due to the various nuances of RMDs, we will only cover the abovementioned fundamentals. To learn more in-depth details about RMDs, check out our other Retirement Income Series article – Managing your Required Minimum Distributions (RMDs) in Retirement.
PENALTY FOR SKIPPING YOUR MANDATORY DISTRIBUTIONS
What happens if you have not paid attention so far or you just flat out forgot to take your RMD one year? Well, consider yourself "lucky" because the penalty for skipping your RMD has decreased from 50% to 25%. Thanks again, SECURE Act! Sarcasm aside, this is something you will want to avoid. Even 25% is a steep price to pay for a simple mistake.
PENALTY-FREE WITHDRAWAL OPTIONS
As discussed earlier, withdrawing Roth contributions and the age 55 rule for 401(k) and 403(b) plans are exceptions to the IRS penalty. Unfortunately, some of the other penalty-free exceptions fall under the bad news is good news category. In other words, if you want to withdraw from your IRA or 401(k) without the IRS clipping off 10%, you can do so when a death, disability, or divorce occurs. Note that under the divorce scenario, a QDRO document is required for 401(k) and 403(b) plans (ERISA plans only).
Other exceptions include:
Both IRAs and 401(k) Plans
Un-reimbursed medical expenses in excess of 10% of your Adjusted Gross Income (AGI)
QBOAD – Qualified Birth or Adoption expense ($5,000 single, $10,000 married filing jointly)
IRAs Only
First-time home purchases allow the buyer to withdraw up to $10,000
College expenses
Health insurance premiums while unemployed
Lastly, a more complex withdrawal exception is the 72(t). This rule stipulates that you are permitted to make penalty-free withdrawals from an IRA or 401(k) as long as you take at least five substantially equal payments. Expanding on this further, you must withdraw your calculated amount for five years or until age 59 1/2, whichever comes later.
The dollar amount of your payments depends on your life expectancy and is calculated using one of the three IRS methods. Those three methods are 1) the required minimum distribution method, 2) the fixed amortization method, and 3) the fixed annuitization method. To learn more about each method in greater detail, read pages 2 and 3 of IRC Section 72(t). The bottom line is that 72(t) withdrawals are typically a last resort option.
SETTING UP YOUR RETIREMENT INCOME PLAN FOR SUCCESS
Armed with our 4-Step Process to YOUR Retirement Income Plan, you are ready to take it to the next level. Coming up next, we will go over the Mechanics of Making Withdrawals. Wouldn’t it be nice to just hit the EASY BUTTON and make it all magically work? Even though taking a withdrawal from your retirement accounts sounds simple enough, the truth is that there is more to it than meets the eye. With that in mind, our next article will teach you how to streamline accessing your nest egg and what pitfalls to watch out for.
IMPORTANT DISCLOSURE INFORMATION
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