The Nuances of Distribution Planning for Pre-Retirees

The Nuances of Distribution Planning for Pre-Retirees

June 03, 2024

Retirement savings accounts, such as 401(k)s, traditional IRAs, and Roth IRAs, are widely recognized as crucial components of retirement planning. However, the journey to a financially independent retirement continues beyond merely investing in these accounts. It's equally essential to strategize how to withdraw these funds efficiently, considering factors like taxes, required minimum distributions (RMDs), and longevity. This is where distribution planning, a vital aspect of retirement preparation, comes into play.

In this article, we delve into distribution planning and some of the critical components that must be considered as they will impact the longevity of your retirement savings.

What is Distribution Planning?

Distribution planning refers to spending down retirement savings to optimize financial independence during retirement. It involves a detailed assessment of your retirement accounts, factoring in tax considerations, your expected lifespan, potential healthcare and other costs, your desired lifestyle post-retirement, and estate planning goals. This comprehensive approach gives you the control to shape your financial independence in retirement.

Distribution planning is a complex process that aims to develop a strategy to ensure you appropriately deplete your retirement savings while maintaining a comfortable lifestyle. It's a delicate balancing act that requires thought, comprehensive planning, and careful management. Given its intricacies, working with financial and tax professionals is highly recommended.

Retirement savings strategies, taxes, and RMDs

One of the more critical aspects of retirement savings accounts is the tax treatment of contributions and distributions. Understanding how taxes will impact you once you begin taking distributions from these accounts in retirement is essential for effective planning.

401(k), 403(b), 457 plan, IRA, SIMPLE IRA

These pre-tax retirement savings accounts allow contributions to be made with pre-tax money, but withdrawals are subject to taxation. Once distributions begin, both contributions and accumulation are taxed as ordinary income. Understanding these tax implications is crucial for effective distribution planning. Withdrawals before age 59 1/2 on some retirement accounts may result in a 10% IRS penalty tax in addition to current income tax.

Roth IRA

Contributions to a Roth IRA are made with after-tax dollars, and the contributions and accumulation are tax-free when withdrawn after age 59 ½. If the account has been open for at least five years, the contributions can be withdrawn before age 59 1/2 without penalty.

Annuities

Annuity contributions are generally made by transferring a pre-tax retirement savings account or from contributions into an annuity within a retirement savings strategy. When distributions begin, both contributions and accumulation are taxable. It's important to note that annuities may come with a surrender period, impacting when distributions can begin penalty-free.

Developing an effective distribution strategy may involve integrating multiple account types, taxable, tax-deferred, and tax-free accounts, to mitigate or even eliminate taxes upon distribution. It may also include accounts outside retirement savings, such as brokerage accounts, bonds, and other investment strategies. Understanding the tax implications of each account type is vital, as it can help you decide when and how much to withdraw from each.

Distribution plan examples

Tax first, no tax last

Take distributions from taxable and tax-deferred accounts until assets deplete. Then, take distributions from tax-free accounts last. This method lowers taxable income as one ages.

Market-driven distribution

If a down market occurs during retirement, distributions can switch to accounts less affected by market performance—for example, fixed or fixed-indexed annuities. Occasionally, a distribution plan may be altered depending on the retirement portfolio's allocation and market risk.

Required Minimum Distributions (RMDs)

Another vital aspect of distribution planning is the required minimum distributions (RMDs). Starting at age 73, owners of traditional IRAs, 401(k)s, and other pre-tax retirement accounts must begin taking RMDs—minimum amounts that must be withdrawn annually. Failing to follow these requirements can result in hefty penalty taxes.

In contrast, Roth IRAs do not have RMDs during the owner's lifetime, making them an attractive strategy for those who may only need to tap into their retirement savings later or wish to leave assets to their heirs.

Social Security

Although Social Security retirement benefits are not an investment strategy, they are taxable retirement income. For this reason, distribution planning includes Social Security as one component of life income.

Addressing Life Expectancy and Healthcare Costs

When crafting a distribution plan for your retirement savings, it's essential to address two significant unknowns:

  • How long you will live
  • What your healthcare costs can be

Although difficult to predict accurately, creating a distribution plan with a reasonable estimate of these figures can provide a more realistic assessment of how long your retirement savings funds may last.

Healthcare can be a substantial expense in retirement, and costs often rise as you age. Therefore, planning for healthcare and estimating unexpected health costs can deter you from depleting your retirement savings too quickly.

Factoring in Your Desired Post-Retirement Lifestyle

Your post-retirement lifestyle goals also play a crucial role in shaping your distribution planning. If your vision of retirement includes extensive travel or engaging in potentially expensive hobbies, you may need to make larger withdrawals that could impact the longevity of your retirement savings.

Work with a financial professional

Given the complexity and importance of distribution planning for retirement savings, it can be beneficial to work with a financial professional. Distribution planning aims to help ensure you have enough to sustain your desired lifestyle throughout your golden years, even as you navigate the uncertainties of taxes, healthcare costs, and longevity. A comprehensive distribution plan, ideally formed with a financial professional's help, can be your roadmap to a more independent retirement.





Sources
https://www.annuity.org/selling-payments/withdrawing/
https://www.nerdwallet.com/article/investing/roth-ira-withdrawal-rules#:~:text=Contributions%20to%20a%20Roth%20IRA,before%20withdrawing%20earnings%20tax%2Dfree.&text=Arielle%20O'Shea%20leads%20the%20investing%20and%20taxes%20team%20at%20NerdWallet
Important Disclosures
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking tax, legal or investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
This article was prepared by Fresh Finance.
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