What is a “safe withdrawal rate”? A Google search will return a million results – and that’s no surprise. People debate practically everything in personal finance, but the debate around this question is particularly heated.
For over two decades, conventional wisdom has been that it’s safe for retirees to base portfolio withdrawals on the 4% rule. But not everyone agrees. Some feel that percentage should be higher, while others feel it out to be lower. The debate is ongoing.
Yes, it is an important question, however, it often feels like it’s the only question. It’s just one piece of the retirement puzzle. Managing taxes, is another important aspect of the retirement puzzle – especially for high-net-worth families. You must think long term when it comes to taxes. Yet, most of us tend to think about taxes on a year-by-year basis. When you’re making a retirement plan, you want to think about it differently. Instead of trying to minimize your tax bill in any given year, make decisions with an eye toward minimizing your total lifetime tax bill.
Let’s consider required minimum distributions (RMDs). The are a great example of why it’s useful to take a multi-year perspective. Under current rules, withdrawals from tax-deferred accounts must begin at age 72 – starting at 4% of your tax deferred savings. But if you have substantial savings, that can translate into a big dollar figure. And that percentage increases each year as you get older. This can be a challenge because every dollar that comes out of a tax-deferred account it taxable as ordinary income.
Here are four strategies that may help you combat the RMD dilemma:
Keep Working
One way to circumvent RMDs is to continue working, even part-time, at a company that offers a 401(k) plan. Assets in the 401(k) won’t be subject to RMDs as long as you’re still working there.
Early Withdrawals
Suppose you retire at age 65 and defer Social Security until 70. That means your tax rate will probably be quite low for the first five or seven years of retirement – before Social Security and RMDs start. In situations like that, high-income people can see their tax rate drop to lower levels. It may be worth taking withdrawals from your tax-deferred accounts during this time, even if you are not required to. Yes, you would be intentionally driving up your tax rate during that time frame, but it could be a smart move if it helps lower your tax rate later.
Even if you don’t expect to have an RMD problem, its worth considering taking distributions before you’re required to. That’s because the key principle here is to try to even out, as much as possible, your tax rate during retirement.
Roth Conversions
Roth conversions have many benefits. Among them is the potential to lower RMDs and the resulting impact on your taxable income.
Charitable Gifts
If you plan on making charitable contributions, you can avoid taking your RMD, or part of it, by sending it directly to a charity. This is called a qualified charitable contribution (QCD). You won’t receive a tax deduction for this kind of donation, but it will satisfy your required minimum distribution.
Now, I’ve covered a lot of ground – and if this sounds complicated, I don’t blame you. I recommend drafting a long-term plan and revisiting it each year with assistance from your financial advisor and tax accountant.