If you think saving for retirement is hard, you will get a rude shock once it is time to withdraw your retirement funds. Since you never stop paying taxes in retirement, you have to figure out how to withdraw money without being overtaxed. Besides being overtaxed, you also need to figure out the right amount to withdraw without depleting your savings. According to Fidelity, retirees should strive to withdraw 4-5% of their savings for the entire year. Since you will likely have saved in various accounts, you will learn which savings accounts to prioritize first. Here are the chronological steps for the order to tap into your retirement funds.
1. Set Up a Money Market Account
Even at retirement, you will still need to pay house bills. However, you may be reluctant to transfer money directly from your investments to your bank every time you need to pay bills. A major challenge of frequently withdrawing from investments is grappling with the possibility of market swings. In case market swings occur, you could wind up selling your shares just to pay for food. So, the first thing you may want to do is to set up a retirement money market account. Once you have the account, you can direct all your investments to it. A retirement money market account is similar to a savings account since the money is liquid and earns a low interest rate. The average interest rate for money market accounts is 0.08% APY. Despite the low interest rate, money market accounts are generally a low-risk place to store cash. A retirement money market account is held inside a retirement account. It could be within a rollover, traditional, or Roth IRA account, which means it is governed by a retirement plan agreement. Typically, money market accounts only allow you to withdraw money when you are 59 ½ years old. However, the beauty of this account is that the money is tax-free.
2. Begin Collecting Your Required Minimum Distribution (RMD) Distributions
This step is only applicable to those who have turned 72. If you are not yet 72, you can skip this step. When you withdraw your distributions, you can opt to receive them as a lump sum or in installments. Whichever way you want to receive your money, always remember to collect it before 31st December. If you fail to collect your distributions in time, you will be penalized. According to Smart Asset, the IRS will charge you a 50% tax for every dollar you did not take when you were supposed to. Once you have withdrawn your RMD money, you have to determine how soon you need to pay your bills. You can divert some of the money to your money market fund if you are constantly paying bills. However, if you do not need the funds, you can divert them to any taxable accounts like savings or brokerage accounts.
3. You Can Begin Funding Your Retirements With Dividends
Whichever savings account you invested your money in, you may have used your dividends to buy more shares. By doing so, you benefit from compounding. At this point, you may be on the verge of depleting your money market account savings. Fortunately, you can divert some of your dividends to your money market account. Since your goal should be minimizing being taxed, it wouldn’t be a good idea to reinvest the dividends into your taxable accounts. That means every time you withdrew money from taxable accounts; you would pay a certain tax amount.
4. Withdraw From Retirement Savings
If you are at this final stage, you have probably used a lot of money from your RMDs and money market account. Additionally, the money from the two sources could be insufficient to procure what you want. In that case, you can withdraw from taxable accounts, tax-deferred accounts like IRAs, and tax-free accounts like Roth 401 (k) s in that order. There are many reasons you should first withdraw your savings from taxable accounts. First, they are very flexible. Since you always need to pay bills, you need to be able to withdraw your funds without any restrictions. Unlike traditional IRAs and 401 (k) plans, you do not need to wait until you are 72 to begin withdrawing your savings. That means you can withdraw your savings anytime you feel like it.
Additionally, you will also not need to pay a levy each time you withdraw your savings. Instead, you will only pay the long-term capital gains rate after holding your investments for more than a year. According to Nerd Wallet, the long-term capital gains rate range from 0-20%, depending on your tax bracket. After spending most of your taxable account funds, you can proceed to tax-deferred accounts. When you withdraw from these accounts, you are subject to ordinary income tax rates. Before you withdraw from tax-deferred accounts, consider your current age. If you withdraw funds before you are 59½ years old, you will receive an additional 10% tax penalty. However, there are exceptions when withdrawing before the required age. For instance, you can use it to pay for medical insurance. Lastly, you can begin withdrawing from your tax-free accounts. You will be free from any tax or penalties upon withdrawal, but you must prove that you qualify for these exemptions. Some of the requirements that the account holder needs to be exempted include:
- Being at least 59½ years when the distribution occurred
- When you receive assets after the death of the account owner
- When you are living with a disability
Withdrawing your retirement funds is almost as challenging as saving for retirement. If you employ a poor strategy when withdrawing your savings, you may end up depleting your savings. By depleting your savings, we do not even mean excessive spending. Sometimes you end up paying certain penalties for withdrawing too early. Since you do not have a stable income, you cannot afford to make such a mistake. So, you must understand the terms of your savings in various accounts. If you are yet to retire, now would be the best time to familiarize yourself with how withdrawing from retirement savings works.
Written by Allen Lee
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