Taking Money Out of Tax-Deferred Retirement Accounts

Many people are not prepared for the shift from employee to retiree. They don't always realize that Uncle Sam has strict rules on when you can (and must) begin withdrawing funds from tax-deferred retirement accounts. (These kinds of accounts include 403(b) plans and traditional IRAs.)

Here's a rundown of the basic rules, which changed significantly in recent years with the SECURE Act and SECURE 2.0 Act.

Keep in mind that you will pay taxes on whatever you saved in tax-deferred accounts when you take it out. That additional income could then put you into a higher tax bracket. This is why Roth IRAs can be helpful, as you pay no tax on whatever you withdraw after age 59 1/2.

Remember, even though it's permissible for you to spend retirement funds starting at 59 1/2, you don't have to do so. One of the best strategies is to postpone retirement for as long as you can manage to avoid tapping into your nest egg. Get yourself a spreadsheet and project out the following:

• your expenses,
• taxes,
• inflation,
• income,
• Social Security,
• growth of investment assets, and
• your drawdown on retirement savings.

Run these numbers all the way out to age 100.

One of the least recognized but more potent strategies is to be flexible on your spending needs. The wider the range of acceptable spending levels, the more power you have to adjust outflow to support your investment strategy. Work with competent financial and tax advisors to help you think through different scenarios and how they would affect your projections.

Investing correctly is one thing; executing your plan for taking money out in retirement is another. A comprehensive approach to sorting out your options is best and should include consideration of worst-case scenarios. A qualified estate planning attorney can help.

When You Reach Age 73

One of the most critical and frequently overlooked issues in retirement planning comes after most people have retired. When you reach age 73, you must begin taking money out of your retirement plan each year. (Note that this age can vary depending on your birth year, known as the required minimum distribution date.)

Individuals are responsible for knowing how much to withdraw as part of these required minimum distributions (RMDs).

By law, you must now take your first RMD by April of the year after you turn 73. (If you were age 70 1/2 before the end of 2019, you had to begin distributions at 70 1/2.) How you structure these distributions can have a profound effect on your own retirement and even more on what you leave your heirs.

To get the most out of your retirement plan, consider the steps listed below. Otherwise, you and your heirs could end up owing many thousands of dollars in unnecessary taxes.

Calculate Your Required Minimum Distributions

Congress created rules governing RMDs to allow retirement assets to build up tax-free during the plan owner's working years. You do not pay tax on earned income you put into a tax-deferred retirement plan. You also don't owe tax on investment income or gains on the account itself.

However, the funds you withdraw upon retirement count as taxable income in the year you take the distribution. If your children withdraw funds from a tax-deferred account they inherited from you, they will owe tax on these funds at their income tax rates.

The idea behind retirement plans is to encourage taxpayers to save for retirement. So, lawmakers imposed a penalty for early withdrawal (before age 59 1/2).

The withdrawal penalties are in the form of excise taxes. Withdrawals you make before you reach age 59 1/2 are subject to a 10 percent excise tax (with limited exceptions). In other words, you pay the government 10 percent of the amount withdrawn plus the taxes that would normally be due upon withdrawal.

Lawmakers also set up a penalty for failure to withdraw once the owner reaches retirement age – after age 73. These penalties apply to tax-advantaged retirement plans. This includes Individual Retirement Accounts (IRAs), SIMPLE IRAs, SEP IRA plans, and pensions, among others.

Again, you must begin taking distributions by April 1 in the year after you reach age 73. If not, you'll pay a 25 percent excise tax on the amount you should have withdrawn but did not. (If you correct this mistake within two years, you may be able to reduce your penalty to 10 percent.)

Use the following chart to calculate your RMD for a given year. Find your age (as of December 31 of the prior year) and the corresponding distribution period. Then, divide that figure into your prior year-end retirement account balance.

For example, say you have $100,000 in a retirement account as of December 31, 2024. If you are 74 as of that date, you'd have to withdraw $3,921 from the account by the end of 2025. (Dividing $100,000 by your distribution period of 25.5 years = $3,921.)

Minimum Lifetime Distribution Chart

Designate a Beneficiary

It used to be that the first rule of retirement plans was always to designate a beneficiary. While it's still important to designate a person or institution to inherit your retirement accounts, the choice of beneficiary is not nearly as critical a decision as it once was.

For one, your choice of beneficiary generally won't have an impact on your required minimum distributions. (However, the rules may differ if you named a spouse who is more than 10 years younger than you as beneficiary. Retirement account holders in this situation should consult the IRS "Joint Life and Last Survivor Expectancy" table.)

Second, you can change your beneficiary down the road. In fact, the executor of your estate can change your beneficiary after your death. The date for determining designated beneficiaries is September 30 of the year following the year of your death.

All this means that your designation of a beneficiary (or failure to name one) will rarely result in the kinds of tax-planning disasters that were common before. In most cases, your heirs will be able to take steps that will ensure deferral of taxes on retirement accounts over their lifetimes. This is why it's important that your heirs consult with a qualified elder law or tax attorney. They will want to ensure they're making the best decisions regarding beneficiaries from a tax-planning standpoint.

Consider Designating a Trust as the Plan Beneficiary

For tax planning and other purposes, many couples set up "A and B" trusts (also called credit shelter trusts). These serve to take advantage of the unified credit of the first spouse to pass away. When retirement plans comprise a large portion of an estate, it often makes sense to have them payable to the trust rather than to the surviving spouse.

The trust must be properly drafted, however. Otherwise, the surviving spouse will have to withdraw all the retirement plan funds within five years. Executing a trust correctly is complicated; work with an experienced elder law attorney.

Find an estate planning or elder law attorney near you.