Quick Important Retirement Examples: Considering the Taxability of Your Retirement Distributions
As part of this new blog series: Quick Important Retirement Examples, this blog looks to keeps things short and simple, and use a hypothetical scenario to illustrate important parts of retirement planning.
The menu of retirement savings vehicles is a large one. The retirement landscape has evolved over the years to include different types of accounts for numerous differentiated situations. You have 401(k)’s, 403(b)’s, ESOPs, IRAs, Taxable Accounts, etc. You have choices of pre-tax, Roth, and after-tax (different from Roth). While on one hand, it can be great that you have so many choices to choose from and customize your savings to the account type/s that best fits your financial picture. On the other hand, it can create confusion and uncertainty about choosing the right account/s for you, and understanding how they actually work in retirement.
A common question I receive as a financial planner is: “How much should I have saved for retirement?” Like many answers in finance, it depends. It depends on various factors such as your lifestyle’s needs, your age at retirement, your Social Security and pensions, your projected taxes, etc.
It also greatly depends on the “type” of savings you have and how much you have in each type.
Not all retirement accounts are created equal. And it’s important to understand how the different account types work in retirement, so there are no surprises or miscalculations. For example, a couple with $2,000,000 saved up in pre-tax 401(k)’s is in a vastly different financial situation than a couple that has $2,000,000 saved up in Roth accounts.
As mentioned in the beginning, there are a large number of retirement accounts. For simplicity purposes, we’re going to look at two of the more general and common types:
Pre-tax (or Traditional) accounts
Roth accounts
Nowadays, most retirement accounts (IRAs, 401(k)’s, 403(b)’s, etc.) offer both Pre-tax and Roth. And as mentioned in a previous blog, it’s important to understand how both work, so you can prepare accurately for your retirement.
Let’s look at an example of 2 couples to help illustrate the potential impact of different retirement account types when it comes to your nest egg and it’s longevity.
**The following examples are hypothetical and meant for illustrative purposes only.
Maggie & John
Maggie & John are both 62 and have just retired. They have $2,000,000 saved for retirement. They saved all this money into Roth IRAs and Roth 401(k)’s.
They want to be able to withdraw $100,000 at the beginning of each year for expenses. Increasing this by 2.0% each year for inflation. And they want this to last 30 years.
Since all their retirement savings are in Roth accounts, each distribution of theirs is entirely tax-free. They can take exactly $100,000 out and that’s how much they’ll receive.
Result: Assuming Maggie & John average an annual rate of return of 5.0% on their investments, this $2,000,000 would last them exactly 30 years. They feel comfortable with this analysis and are prepared to transition into retirement.
At a neighborhood gathering, John & Maggie are talking to their friends, Kate & Dan:
Kate & Dan
Kate & Dan are the neighbors of John & Maggie. They too have just turned 62 and they live a similar lifestyle to their friends. In conversation with John & Maggie, they learn that their friends have $2,000,000 saved up and feel prepared for retirement. Kate & Dan themselves also have $2,000,000 saved for retirement, and when hearing this from their friends, they feel they are prepared for retirement too. Only one (big) difference. All Kate & Dan’s retirement savings are in pre-tax 401(k)’s and Traditional IRAs. Because of this, all their distributions are going to be taxed as ordinary income. They are going to have to withhold from each distribution to pay taxes, and in turn, they’ll need to distribute more than the amount they actually need each time. Let’s look:
Kate & Dan, similar to John & Maggie, need $100,000 / year from their savings to fund their lifestyle in retirement. And they’ll increase this amount by 2.0% each year to keep up with inflation.
Since all Kate & Dan’s retirement savings are in pre-tax accounts, they’ll actually need to distribute more than $100,000 / year to net the desired $100,000. Assuming a default withholding rate of 20% for income taxes, Kate and Dan will actually need to withdraw $125,000 to meet their expenses. This will look like:
Income Needed: $100,000
Estimated Tax Withholding: 20%
Gross Amount Needed to Distribute: $100,000 / (1 - 0.20) = $125,000
Distribution Amount Needed for Year 1: $125,000
Each distribution will follow the same pattern of needing to take out extra for taxes.
Result: Assuming that same 5.0% average annual return on their investments, Kate & Dan’s 401(k) retirement savings would last them only 21 years, getting them to age 83.
As you can see, the type of account plays a huge role. That’s a difference of 9 years compared to their friends with the same amount of savings and expenses.
Now, this is not to say that pre-tax retirement savings are bad, nor to say they shouldn’t be included in a retirement nest egg. Most retirement nest eggs I review have a large portion dedicated to pre-tax accounts. The potential benefit to pre-tax retirement savings is the tax deduction you receive during the year you make the contribution. Those tax savings could be very beneficial to you during your accumulation years.
This example is more so intended to illustrate in a simple manner the importance of including the taxability of your accounts in your retirement calculations. And if you have pre-tax retirement accounts, you may want to view them in their “after-tax” value when planning your retirement. You want to avoid a situation where you plan out your retirement needs, feel confident that your savings can sustain your needs, then get met with a surprise when you have to take an additional 10%-20% out for each distribution.
Accumulation targets are good to have as they could provide motivation to save. But these targets should not be blanket targets. They should incorporate the types of accounts you save towards for your retirement. Each individual and household’s retirement picture is different and requires it’s own analysis to help ensure that it’s in good shape to meet your desired retirement.
As always, please feel free to reach out with any questions on this. You can contact me going through the Contact page or by scheduling an appointment.
Thank you,
Drew Schaffer, CFP®
Please note, the people, the assumed rate of returns, and the assumed taxes are all entirely hypothetical. They are used for illustrative purposes only.
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