Financial advisors make their bread and butter from retirement planning. Unless you’re wealthy (or young), chances are that most of your money is in your retirement savings and home equity. That makes your retirement accounts the main interest of most financial advisors, so it’s in their best interest to make it sound complicated. Unfortunately, they are right. There are a bunch of little tricks to good retirement planning. Fortunately, most of them are easy to straighten out, like the tax triangle.
Welcome to Retirement. Oh, while you’re here, we need to tax those 401(k) withdrawals.
All too many new retirees find themselves surprised that withdrawals from their 401k accounts are fully taxable. It’s an easy mistake to make. After all, when you contributed money to your 401k it was tax-free (technically, pre-tax, but same difference). And, while all of that money sat in your 401k earning interest and dividends, it was tax-free. So, why wouldn’t it keep being tax-free?
Unfortunately, that’s the deal you make with the IRS. A 401k plan is actually a tax-deferred account. As the name implies, the IRS allows you to defer, or wait, to pay the taxes. It is a huge advantage and the resulting growth in your 401k is one of the only reasons a 401k plan has a chance to pay for your retirement. But, the tax does come due eventually. In fact, the IRS forces you to pay taxes by requiring a minimum withdrawal from your tax-deferred retirement accounts every year, just to be sure that you don’t keep all that money in there until you die.
Every withdrawal from a 401k, or traditional IRA, is fully taxable. That means not only do you pay taxes on the money, but it adds to your adjusted gross income, which determines your eligibility for certain tax credits and deductions, as well as various services you might want to use as a retiree.
Building a Tax Triangle
To help alleviate this problem, financial experts suggest that you cultivate not just tax-deferred savings but tax-free retirement savings and fully taxable investments.
Here is how the tax triangle works.
One point of the tax triangle is your 401k plan, and traditional IRA plans. These are tax-deferred.
The second point of the tax triangle are tax-free retirement accounts like a Roth IRA. These are tax-free.
Is it the key to wealth?
And the third point of the tax triangle are fully taxable investments, just your regular old brokerage account. These are taxable.
By having all three kinds of investments in retirement you can calculate a withdrawal strategy that makes the most sense for you both tax-wise, and for preserving retirement assets so that last as long as you live.
Withdrawing Money In Retirement
Ideally, you would use the tax triangle and be able to live on an amount that gives you a taxable income low enough to minimize the taxability of any Social Security payments without draining any one of the triangle points. In reality, your 401k is likely to be much larger than your Roth IRA simply because of contribution limits. However, draining the triangles for minimum taxes during your early retirement years when you are likely to be more active, and thus using more money is a winning strategy. Eventually, you may have nothing left but your 401k, but hopefully by then, your withdrawals are not as large.
I’ll put together some graphics to go with this article. That will make it much easier to see.
Until then, if you are maxing out your 401k, open a Roth IRA and get some money in there. Your future, retired self will thank you.
By Brian Nelson – Brian is a former Certified Financial Planner and financial advisor. He writes for the Finance Gourmet and other financial publications. The material provided on this website is for informational use only and is not intended for financial or tax advice. ArcticLlama, LLC, FinanceGourmet.com, and Brian Nelson, assume no liability for any loss or damage resulting from one’s reliance on the material provided. Please also note that such material is not always updated regularly and that some of the information may therefore not be current. Consult with a tax professional when making decisions regarding your tax situation.