In my early days as a financial advisor, I remember meeting a retired couple, anxious and confused about their retirement savings. As we sat in my office one spring afternoon, they looked at me earnestly and asked, "Leibel, where should we start spending our money first in retirement?" This question has stuck with me through the years, and I've realized how complex the answer can be.
You see, when it comes to managing finances, especially for retirement, there are two kinds of people. Some folks see the big picture, while others excel in the nitty-gritty details. But in retirement, you really need to be a bit of both. It's like playing a chess game where you're thinking several moves ahead while also focusing on the intricate play-by-play.
Let's say you've got a 401K and an IRA. Your 401K is just sitting there, safely tucked away in cash or cash equivalents. But your IRA? It's a wild stallion, aggressively investing and growing at an exponential rate. So, which do you touch first? Well, it's not always about the specific account. It's more about what you're trying to achieve.
Let's circle back to that couple in my office. They had a substantial 401k, but it was mostly in cash. Their IRA, on the other hand, was considerably smaller but invested aggressively. In their case, the IRA was growing rapidly, while their 401K was essentially idle. So, we decided to spend from the 401K first, allowing the IRA to continue its growth trajectory.
RMDs Are The Real Enemy
The government has a say in all this, too. You see, Uncle Sam is pretty hands-off with your 401K and traditional IRA until you hit a certain age. Then, they want their cut, and you have to start taking required minimum distributions (RMDs). It's like a ticking tax time bomb.
Say you've been diligently saving, and now you're sitting on a significant retirement account balance. By the time you're in your eighties, the RMDs could be 20, 30, even 40% of your account balance. That could mean shelling out hundreds of thousands just in taxes. You might find yourself in a higher tax bracket in retirement than you ever were while working, with the largest beneficiary of your hard-earned savings being Congress, not your family.
So, what's the best way to avoid this? Keep a close eye on your retirement account balance and your potential RMDs. If you project your RMDs to be significantly higher than your annual income in retirement, you might need to spend down your retirement accounts or consider Roth conversions.
What Are RMDs?
Required Minimum Distributions, or RMDs, are essentially the tax bill coming due on the money you've saved in your retirement accounts. You see, when you were working, you got a tax break for contributing to these accounts. This allowed you to save more and pay less in taxes at the time. But the government wants its share eventually, and that's where RMDs come in.
Once you hit 73 or 75, depending on when you were born, Congress insists you start withdrawing a specified amount from these accounts each year. It's like they're saying, "Hey, we know you've been saving diligently, and maybe you feel comfortable with your Social Security and pension. But we want our share, and we're going to make sure you pay up."
And if you're thinking, "Well, I'll just leave it to my kids when I pass," think again. The government will require your beneficiaries to drain the account within ten years of inheriting it, often bumping them into a higher tax bracket.
So, how do they calculate your RMD? The IRS gives you a number based on your account balance as of December 31st. You multiply your balance by this number, and that's your RMD. If you don't take it out, you'll face a tax penalty, which could be as high as 25% with the new Secure 2.0 Act.
Generally, there's no reason not to take out your RMDs unless it would push you into an unusually high tax bracket. In the end, Congress wants you to start drawing down that money. For a clearer idea of what your RMD might look like, you ca