Now that you have come to the decision to retire, there are several more decisions to make. One is how to take advantage of tax-deferred plans and when to tap into them. Although we do not have any control over taxes, we can reduce the burden taxes have on our investments. All gains in 401(k)’s and traditional IRA’s are taxed at ordinary income when withdrawn and long-term capital gains and dividends face a lower tax rate. A key factor in many retirement plans is to make withdraws in a tax-efficient manner. This typically entails pulling money from taxable accounts first, where you’ll presumable pay the lower capital gains rate, then move on to tax-deferred accounts like 401(k)s and IRAs, and finally Roth IRAs. The balances in your tax-advantaged accounts will have more time to compound tax-free.
David Blanchett, head of Morningstar’s Retirement Research, suggests that “you should maintain your target stocks/bonds mix first and then allocate your assets as best you can for tax efficiency.” Also it is smart to keep in mind that in some years you can sell taxable investments at a loss to offset taxes on your qualified plan withdrawals. If you liquidate all your qualified plans early on, you will lose this option.
Although there is no perfect way to take withdraws during retirement the one thing that is certain is we don’t know what will happen to taxes down the road. Having your savings in a variety of taxable accounts allows you the freedom of managing different tax treatments.