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Look Before You Leap Into a Taxing Withdrawal Strategy

Before you decide to turn on your Social Security, pension or some other income stream in retirement, consider the big picture. You have some control over the taxes you’ll pay in the future if you plan it right now.

Life is unpredictable enough before retirement, but once your regular paycheck goes away for good, it can feel downright dicey.

So you can’t really blame people for wanting to be sure the income streams that will replace that paycheck are all turned on and ready to go on their very first day off the job. They diligently do the paperwork to claim their Social Security benefits, their employer pension and anything else they have coming that will pay them consistently. Having all those boxes checked as soon as possible gives them the feeling that everything will be OK.

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Unfortunately for many, it’s likely the opposite. Turning on those income streams too early could increase their lifetime tax bite and decrease their portfolio’s longevity.

Instead, I tell pre-retirees to pause and look at all their sources of income, and to think about their withdrawal strategy from a tax standpoint as well.

Take control of your tax fate

Remember, once your paycheck goes away, you’re working with a clean slate when it comes to income taxes. You have control over your financial fate. And it might make more sense to delay those Social Security and pension payments – letting that money grow – while you draw from other holdings. You could pull from company stock options, for example, or get rid of some tax-inefficient assets. Or you could start pulling money from your tax-deferred accounts, which will help you later, when you turn 70½ and the IRS insists on collecting its share of your tax-deferred savings through required minimum distributions (RMDs).

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Tax-deferred retirement plans have the great benefit of allowing you to leverage money for growth that otherwise would go to the government up front. But it’s important to understand the path you’re on when you invest in a plan like a 401(k) or 403(b). You could be deferring yourself into quite a mess, creating tax ramifications down the road.

RMD amounts are based on age and account value. And if that annual distribution is high enough, it could throw you into a higher tax bracket, which can raise the amount of taxes you’ll pay on your Social Security benefit (up to 85% of your benefit can be taxable) and even affect your Medicare premiums. It makes sense to lower the amount of money in your qualified retirement accounts (those funded with pretax money) before that happens.

You have 10 critical years to execute your plan

I call the years from age 60 to 70 the “golden decade,” because that’s when you have the most control over your tax situation. You can do the advanced planning needed to limit the IRS’ impact on your retirement plans.

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But once you turn on certain income streams, it can be difficult to turn them off. If you take Social Security and change your mind, you have only 12 months to withdraw your claim. Of course, you can turn off (suspend) benefits any time after full retirement age, taking them out of your income stream and earning delayed retirement credits to age 70. Pension decisions, meanwhile, are typically irrevocable.

So, before you make those decisions, why not do a trial run to see what withdrawal strategies would work best for you? Maybe a Roth conversion is the way to go. Or a plan that makes the most of the low taxes on capital gains.

You might want to ask your tax preparer what it would cost to run a sample return to see what would happen if you didn’t have Social Security or a pension but used other assets for income instead. What would that look like? Or you could buy tax software and play around with the numbers yourself. Your accountant and financial adviser should be able to help, as well.

Of course, all of this is very nuanced. There isn’t a one-size-fits-all answer, and you should seek professional advice before making any final decisions.

It’s up to you to know the tax consequences of your investments and to be sure you get the breaks you deserve. But an astute adviser can help steer you the right way, with a withdrawal strategy that could make all the difference to your long-term financial future.

Kim Franke-Folstad contributed to this article.

About the Author

Eric Peterson, Registered Financial Consultant

Founder, CEO, Peterson Financial Group

Eric Peterson is a Registered Financial Consultant (RFC) and founder of the Peterson Financial Group. He is the author of "Preparing for the Back Nine of Life: A Boomer's Guide to Getting Retirement Ready."

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