Help a Reader: IRA Withdrawal Strategies

Here's a question I received from a reader via email:

What's the most tax-efficient method for withdrawing from a traditional IRA?  My situation: I will retire next year at age 65 - $2000/month pension, $1000/month Social Security, $250,000 in TSP (federal gov't equivalent to 401k). I'll roll the TSP into an IRA (Q2:  any reason not to move it all into my Fidelity account?).

I'll have to withdraw all the IRA funds in 6 years time,  With minimal appreciation, that will total $300,000, $50,000/year added to the joint income with my wife.  Looks like we'll be shoved into a higher tax category, and pay an extra penalty for our saving habit.

I haven't come across any discussions of how best to deal with the expanded income created by mandatory IRA withdrawals.  Suggestions?

I told him I'd open it up and let free Money Finance readers help him out. Have at it!

Comments

[Luke]

Why will he have to withdraw all of the IRA funds in 6-years?

[FMF]

Luke -- Don't know.

[CLD]

I think he might be confused. At age 70 1/2 he has to *start* taking distributions, and they're only a small %age (like 3-4%). Find out why he has to take distributions, then we can answer the question...

[broknowrchlatr]

Pull it out in a lump sum on Jan 1 each year. Then you can delay tax paying and minimize it. If the market grows 10% that year, exchanging it on Jan 1 will save you tax on $2500 of income. In the US, getting that additional money in a longer term investment earlier will save. Not sure about Canada

You also want to limit the number of withdrawals if there is a per transaction charge, which there probably is. In my IRA, I am invested in several funds with a flat transaction fee of $75. As such, making monthly withdrawals vs an annual withdrawal will cost a lot. I'll likely liquidate all investments in a fund at once (~ $25k apiece)

So, pull it all out at once each year into a savings account. Then reinvest anything you don't need to spend.

[Andy]

Required minimum distributions, which begin at 701/2, are based on a life expectancy factor (usually from the "uniform table," unless his wife is ten years younger, and the preceding 12/31 balance of the account. They certainly do not require the complete liquidation of the IRA. I think he may be confused over the old 5-year rule, which applied to non-spouse beneficiaries of a qualified plan and forced a total payout within 5 years.

[Dave]

What is the point of having all these complex withdrawal rules?

[EMF]

The $1000/month in Social Security benefits you think you'll be getting may turn out to be much less. If that $2000/month of pension money is based on a job for which you did not pay social security taxes, then the Windfall Elimination Provision applies (http://www.ssa.gov/retire2/wep.htm. Also, depending on how much you earn next year, you may have to give all or part of your SS benefits back. Your Normal Retirement Age is 66, not 65. (No, 65 is not the magic age at which you're required to quit working and start drawing Social Security. And neither is 66, for that matter.) So any earnings next year when you turn 65 in excess of $12,960 will cause you to have to give back some or all of your benefits. If you wait until age 66 to start SS, you won't have to give any back even if you work and the amount you get each month will be larger than if you start at 65.

I've never heard of a requirement to clear out an IRA in less than 6 years. Where did you hear this? When I worked for civil service over 20 years ago, there was a book available that detailed the various rules effecting civil service employees. Perhaps published by the Federal Times. Ask around at your work to see if someone knows about the book. I get the impression that you are not well informed about issues such as these that may end up costing you thousands of dollars. Use the internet to learn. http://www.ssa.gov for Social Security, http://www.irs.gov for IRS regulations, start with http://www.federaltimes.com to learn more about civil service rules. It would be worth your time to spend a couple of dozen hours to learn about these issues. Or perhaps you need a qualified financial planner (but not one who calls himself one but who is actually some type of salesman). In any case, double check for yourself any advice you get here, even mine. Everyone's situation is slightly different, and the few sentences you provided may not adequately describe yours.

I believe that you are not required to clear out your IRA in 5 years. Once you turn 70 1/2 you will have Required Minimum Distributions. But the RMD amount is generally less than what you'd pull out anyway if you follow the 4% rule-of-thumb, which would have you pulling out 1/25 of your retirement savings the 1st year and increasing your withdrawal above that amount in later years to keep up with inflation.

Given your pension of $24000 a year plus about $10000/year of distributions from your IRA, you have $34,000 of taxable income. As a married couple, when your taxable income plus 50% of your Social Security benefits exceeds $32000, you start paying taxes on $.50 of SS for each $1 of other income, and then at a higher level you pay taxes on $.85 of SS benefits for every $1 of other income, which can result in your paying taxes on up to 85% of your SS benefit. One effect is that your marginal tax rates can be effectively increased by a factor of 1.5 or 1.85, for example a tax rate of 25% gets turned into 37.5% or 46.25%.

You didn't mention any Roth IRAs. It's good to have part of your money in Roth IRAs instead of traditional. If you have a major expense one year, then pulling the money to cover it out of a traditional IRA may really pump up your taxes, whereas you could pull money from a Roth to cover it without increasing your taxes that year at all.

One thing you could do is delay taking your SS benefits up to the age of 70, and convert some of your IRA money to Roth. By doing the conversion in years you're not taking SS benefits, it doesn't increase the amount of SS that's taxed. After studying the issue, you may find a conversion amount that optimizes your taxes. Probably should have at least $50K in Roth IRA to cover a few major expenses, a new roof, a new car, whatever.

Delaying the start of SS benefits will result in larger payments when you do start. If you're in good health and you live long enough you come out ahead. If you're in poor health and don't expect to live long, then maybe that's not such a good strategy for you.

If you do conversions to Roth, be sure you have enough withholdings or estimated tax payments so that you don't have to pay under-witholding penalties when you file your taxes.

[Jason @ Redeeming Riches]

I agree, I think there is some confusion here with the rules. Those five years, I would've been seriously considering Roth IRA conversions if it made sense for his tax situation.