by: Cassandra Laymon, CFP®, MBA
Financial planning is a little more straightforward in the accumulation phase, which means the years that you are working and saving for retirement. Once you’ve determined your goals and how much you need to save to get there, you can set up an automatic plan to contribute to your retirement accounts (IRAs or 401(k) and just monitor your accounts from time to time.
When you get closer to retirement, or the spending phase of your plan, things can get trickier. There are a number of rules in place that you should be aware of to avoid unintended penalties when taking a distribution from your retirement accounts.
First, let me be clear that for the purpose of today’s discussion, we are talking about tax-deferred accounts: traditional IRAs or employer plans like a 401(k). Tax-deferred means that you saved that money before the taxes were taken out.
As you can imagine, the government is not going to let you keep all that money without paying taxes indefinitely. In the case of these accounts, you don’t pay taxes until you take the money out (this is referred to as a distribution).
Here’s an example:
For every paycheck you’ve received over your working career, you’ve put money into your 401(k), and your employer has also made contributions to that account.
When you retire, let’s say you take a $3,000/month distribution from this account. You will pay ordinary income tax rates on that money. The government treats it just like income from your job, so you will pay tax rates based on the tax bracket that you and your spouse fall into.
What happens at age 59 ½?
You may not realize that there is more to consider than just the impact of the income tax – which itself will likely be about 30% of your distribution. If you take money out of these accounts before age 59½, you will also pay a 10% penalty on the money you withdrew. This means on a distribution of $10,000, you will pay in the neighborhood of 40% to taxes. It hardly seems worth it, right? That’s why we highly encourage you to use retirement savings as a last resort when you have a short-term cash needs. This penalty also underscores the need for an emergency savings fund so you can avoid unnecessary penalties when an unexpected need arises. The combination of taxes and penalties on retirement account distributions can quickly deplete your savings.
What happens at 70½?
Let’s say you continue to work through your 60’s and beyond, and you have no need of those retirement funds you’ve been socking away for years. Can you just let that money continue to accumulate tax-deferred? No. As mentioned earlier, the government does want to start collecting their taxes on the money you’ve saved. When you turn 70½ you must start taking a Required Minimum Distribution. The amount of this distribution is calculated based on your age, and the account balance of your tax deferred accounts as of December 31st of the prior year. Your financial advisor can help you with this calculation. When you turn 70½ the required distribution is about 4% of your account balance if you are married (single tax payers may pay more or less depending on the age of their beneficiaries). That amount increases each year, with the government’s plan that your account will be exhausted by age 100.
What if you don’t need the money? It’s important to note that this distribution is required. That means even if you don’t need the money, you must take it out, and pay the taxes. What happens if you don’t take out the RMD? Just as there are penalties for taking your money too early, there are also penalties for not taking your required distributions starting at age 70½. The penalties are much higher on this end of the spectrum: 50%! That means if you were required to take $20,000 out of your account at 70 ½, but you failed to do so, you not only have to take that amount, you must pay a $10,000 penalty on top of it! It’s hard to believe, but it’s true!
It’s vitally important to keep these special planning milestones in mind when planning your withdrawals in retirement. At Beacon Wealth Consultants, Inc. we use an Implementation Plan that clearly spells out all of these important dates, including special Social Security and Medicare planning milestones so that you can clearly avoid penalties in your retirement planning. If you’re unclear about any of these planning dates, we’d be happy to help you complete your own Implementation Plan so you can gain clarity on your personal retirement planning milestones. Give us a call to get started!
Financial Planning & Investment Advisory services offered through Beacon Wealth Consultants, Inc.