How to withdraw pension funds: Learn 9 smart ways

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If you think saving for retirement is complicated, try to figure out how to withdraw retirement funds while minimizing taxes.

“As much as 70 percent of your hard-earned retirement funds can be eaten up by income, estate and state taxes,” says IRA guru Ed Slott, author of the retirement planning books “Fund Your Future: A Tax-Smart Savings Plan in Your 20s and The 30s” and “The Retirement Savings Time Bomb … and How to Defuse It.”

This is money that most people prefer to keep in their own pockets. But how exactly can this be achieved?

Here are nine smart withdrawal strategies to help you avoid costly tax traps and keep more of your retirement funds.

1. Follow the rules for RMDs

RMD stands for required minimum distribution, and once you reach age 73, you’ll need to start taking this minimum amount from many retirement accounts, such as a traditional IRA or 401(k) plans.

You must take RMDs annually by April 1 of the year after you turn 73 and by December 31 in subsequent years. In other words, if you turn 73 in 2023, you have until April 1, 2024 to take your first RMD.

With the passage of the SECURE Act 2.0 in late 2022, the age at which RMDs begin increased from 72 to 73 in 2023. If you’ve already started taking RMDs, you’ll need to take them in 2023 , but no one has to start taking RMDs in 2023. The age at which RMDs begin increases again to 75 on January 1, 2033.

The penalty for not following the rules is severe. Failure to make RMDs on time triggers a whopping 25 percent excise tax. If you miss an RMD from an IRA, correct the mistake quickly and file your taxes, the penalty can be reduced to 10 percent.

That’s true if you’re underpaying too. Let’s say your RMD for the year is $20,000, but you only take a $5,000 distribution because of a miscalculation. The IRS will charge a 25 percent penalty—in this case, $3,750, or a quarter of the $15,000 you failed to withdraw.

When calculating your RMD, be aware that it will change from year to year. That’s because it’s determined by your age, life expectancy (the longer it is, the less you have to withdraw) and account balance, which will be the fair market value of the assets in your account on December 31 of the year before you take a distribution.

Check the “Uniform Life Table” in IRS Publication 590-B to help figure out what to withdraw from your account.

2. Withdraw from accounts in the correct order

If you need retirement savings to get by and you’re wondering whether to take them from an IRA, 401(k) or a Roth account, don’t be tempted by instant gratification. Sure, a Roth IRA withdrawal will be tax-free, but you could end up paying more in lost opportunities.

Instead, withdraw from taxable retirement accounts first and leave Roth IRAs alone for as long as possible.

Skeptical? Consider what happens if a 73-year-old takes $18,000 out of a traditional IRA while in the 24 percent tax bracket: They owe $4,320 in taxes. If they withdraw the same amount from a Roth, they don’t pay a dime. But if that person doesn’t need to take an RMD from a Roth IRA, and instead earns 7 percent annually in the account for another 10 years, that would grow to $35,409. These earnings would also be tax-free when withdrawn from the Roth, whether by the person holding the account or their beneficiary.

3. Know how to take distributions

If you have multiple retirement accounts due to frequent job changes and you’re nearing retirement, you now have the task of figuring out how to withdraw the money.

Do you need to tap all your accounts? Probably not.

If you own a handful of traditional IRAs, you can withdraw from each of them. But the more effective step may be to add the assets from all your accounts and take a withdrawal from a single IRA.

Consolidating IRAs into a single account can simplify paperwork, make it easier to calculate future payouts and give you more control over your asset allocation, Slott says.

However, you cannot make withdrawals from an IRA to meet your RMD requirements for a 403(b), 401(k) or other plan.

It’s important to note that 401(k) plans cannot be aggregated to calculate a single RMD, says George Jones, managing editor of Wolters Kluwer Tax & Accounting. To streamline them, roll them into an IRA.

4. RMDs smaller for some married couples

If you have a significantly younger spouse who is expected to inherit your IRA, you may be able to reduce your required distributions, thereby trimming taxes and making your retirement funds last longer.

Remember that RMDs are calculated using factors that include your life expectancy as determined by the IRS. However, if you named a spouse as the sole beneficiary of your IRA and he or she is at least 10 years younger than you, your RMD is calculated using a common life expectancy table. It will reduce the amount you have to distribute in a given year.

For example, a single retiree who turns 73 in the current year and must take their first RMD by April 1 of the following year will have a life expectancy of 26.5 more years in the eyes of the IRS. So if that person’s IRA was worth $200,000, their first RMD would be $7,547.17 ($200,000 divided by 26.5).

But let’s say that person designates their 56-year-old married partner to be the sole beneficiary of this retirement account. In that case, their combined life expectancy would be 31.7 years. So the first RMD would be trimmed to $6,309.15. The IRS provides a table for this situation in its Publication 590-B.

5. Make a charitable contribution

Do you have a worthy cause you want to donate to? If your dreams for a lifetime of savings include helping a charity, it may be worth using your retirement funds to make a difference.

This law allows people 70 1/2 or older to make tax-free donations, known as qualified charitable distributions, of up to $100,000 annually directly from their IRAs to a charity as part of their required minimum distribution. Such a distribution does not count as income, reducing any income tax liability of the donor. And if you file a joint return, your spouse can also make a contribution of up to $100,000 each year.

But be aware that individuals who make tax-free charitable distributions from their IRAs will not be able to itemize them as a charitable deduction.

“You get one or the other,” says Slott. “Whoever uses this strategy will pay less in taxes, so if you’re a charity, it’s the best way to make donations.”

6. “In-kind” withdrawals qualify as RMDs

Don’t want to sell your assets? It’s easier to take withdrawals in cash, but that doesn’t mean you have to – or should. So-called in-kind distributions are taken in the form of stocks or bonds, and they can make more sense for people who want to keep assets for various reasons. You simply move the assets from your IRA to a taxable account. These in-kind payments will be assigned a fair market value on the date they are moved.

A cash withdrawal can be easier and cheaper than incurring fees by selling the securities in the IRA and buying them back in a brokerage account.

7. RMDs may be delayed for some workers

Postpone your pension? If you’re still working at age 73 and continue to contribute to a 401(k) or 403(b), you’re eligible for an RMD deferral—as long as you don’t own more than 5 percent of a business and your retirement plan lets you. If these conditions apply, you can defer the RMDs until April 1st after the year in which you are “separated from service,” after which you must begin taking withdrawals.

This applies as long as you work for any part of a year. So if you’re 73 ½ and thinking about retiring before the end of the calendar year, reconsider whether you want to withdraw. If you continue to work after January 1—even if it’s just one day—you’ll delay the date you take the first RMD by another year.

Remember, the delay only counts toward the 401(k) plan of the company you still work for. If you have other 401(k) plans from previous jobs, you must take distributions from them if you are age 73 or older.

8. Consider a Roth conversion

Tax professionals and retirement advisors often push clients to roll retirement accounts into Roth IRAs, where time and tax-free growth can work their magic. But it’s not a silver bullet, and the move may not make sense for some workers.

The conversion of a traditional 401(k) or traditional IRA to a Roth IRA will generally trigger a tax bill. But once you move, all the funds grow tax-free and can remain untouched.

For example, let’s say a 43-year-old gets a new job and decides to move $150,000 from their 401(k) to a Roth IRA. If that person is in the 35 percent federal tax bracket, they owe $52,500, which would be wise to pay with funds outside of the IRA. If the entire amount in the Roth remains untouched and it grows at an annual rate of 7 percent, it would be worth $1.14 million in 30 years.

What about someone who is close to retirement or taking RMDs? If you need the pension funds for yourself and do not plan to pass them on to heirs, it may be smart to leave them where they are.

“But if you want to preserve that retirement asset for heirs,” says Slott, “it’s a good move because it removes the uncertainty of what future taxes will be. Converting to a Roth is a great thing to do for the next generation. “

9. Make a Roth Conversion During “Semi-Retirement”

If your career is winding down and you find yourself earning less income, it may be necessary to take distributions from your pension scheme. If you are at least 59 ½ years old, you will be able to take distributions from pension plans without being hit with a 10 percent early withdrawal penalty.

It may also be an opportune time to convert a portion of your traditional IRA to a Roth IRA—especially if your marginal rate is lower than you expect it to be when you turn 73, when you must take minimum distributions. This strategy can also help you delay taking Social Security until a later age when the benefits will be greater.

Discuss it with your tax accountant to see if it makes sense in your situation.

Bottom line

With a few clever moves and knowledge of how to take pension distributions, you can minimize the government’s bite. But it’s a complex situation, and finding a financial advisor who will work in your best interest to help you navigate everything can easily pay for itself many times over. How to find a top-notch advisor.

Editorial Disclaimer: All investors are advised to conduct their own independent investigation of investment strategies before making any investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price increases.

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