Retirees should reconsider strategies on IRA, 401(k) withdrawals

A government rule on retirement savings may be tricking retirees into looking at their financial situations all wrong.

The rule says retirees can’t leave money in their IRA or 401(k) accounts forever. At age 70½, they must begin making minimum withdrawals, even if they prefer to leave the accounts untouched.

You are forced to take money out whether you want to or not.

And in reality, you should want to take out as much as possible. That’s why I liken the rule to a head fake because it causes retirees to look at the situation from the wrong perspective. 

They get fixated on that minimum amount they must withdraw, so that’s how much they end up withdrawing, leaving the bulk of their savings right there in the 401(k) or IRA.

That’s a mistake, especially for people who hope to leave a healthy inheritance to heirs.

If you keep taking out the minimum amount each year, it will just about guarantee you have a large amount in there at your death. Under the current tax law, if you die and your IRA or 401(k) is left to your heirs, they are taxed on it at a high rate. With state taxes added in, it could be 40 to 45 percent.

The percentage could end up being even higher, depending on when you retire and whether tax laws change. 

If Congress and the president raise taxes, the government’s share of your retirement savings would go up and the amount left to heirs would go down. 

That’s where it would be good for the middle class to take a lesson from wealthy retirees, who are less likely to fall for that head fake. They understand that they need to withdraw greater chunks from their IRA and 401(k) accounts, placing the money in tax-friendlier accounts.

While people in the middle class take out the minimum-required amount, the rich do the exact opposite.

Retirees have a few strategies they can take advantage of to make sure taxes don’t deplete their legacy to their children. You have to put these strategies into place early, though. The longer you wait, the less effective they are and the less your savings will be.

• Explore tax-free options. Move the money into a tax-free vehicle, such as a Roth IRA or a specially designed life-insurance plan that would allow the dollars to flow tax free to heirs. One additional advantage with the life-insurance option is that, historically, when laws are changed related to life insurance the old policies are grandfathered in and not affected. It’s a top estate-planning trick for the rich. The challenge is the middle class doesn’t know it exists.

• Stretch-out inherited IRA withdrawals. Under tax law, when your heirs inherit an IRA, they don’t have to take money as a lump sum. They can have it paid out over their lifetime, which could keep them in a lower tax bracket. They pay taxes only on what they take out. There is a gamble involved with this plan. You are gambling that the law that allows heirs to do this will still be in effect when you die. Many people think this law is one of the easiest ones to change because the government could just claim this is a tax loophole and say it is simply closing the loophole.

Ultimately, it will pay off to sit down ahead of time to review options with a financial advisor who understands the intricacies of retirement planning. 

You don’t want to be taken in by that head fake. You want to make sure you and your family get as much benefit as possible from all those years you were saving your hard-earned money.                       

Dave Lopez is founder of ILG Financial, LLC (www.ILGFinancial.com). Lopez, who was a mathematics and computer science major, applies his analytical mind to specialize in retirement planning. Lopez is an investment-advisor representative of AlphaStar Capital Management, LLC, a registered investment advisor. 

Ideally, your tax refund shouldn’t be at a level that makes you want to do a touchdown dance. Large refunds mean the government is getting an interest-free loan from you during the year. Sure, it’s nice to get a lump sum of cash to do something with, especially something fun. Wouldn’t it be better, though, if you had use of that cash during the year by having fewer taxes withheld and taking home a bigger paycheck? But, what would you do if you had a bigger paycheck?

Maybe you have the discipline and systems in place to set cash aside from each check instead of spending it. Many people don’t, and look at it as a forced saving strategy. Hey, if that works best for you, great. Personal-finance strategies are as much about what makes financial sense as they are about what actually works for you with your behavioral tendencies. It then becomes a question of what to do with that refund. Consider carving out a portion for something fun and use the rest for something that puts you in a better financial position. Here are some possibilities.

Beef up your emergency fund 

Generally, your emergency fund should cover three to six months of living expenses, or higher if you have job insecurity, dependents, or are retired. These cash reserves can cover living expenses should you lose your job, face a health issue, or need to wait out a bad market decline in retirement. The fund also can cover unforeseen expenses such as car repairs, home repairs (i.e., furnace, water heater), medical emergencies, and children-related expenses.

Knock down debt

If you have credit-card balances, use some of the refund money to knock down the balance and save yourself some interest and stress. Some ideas on how to tackle this topic and prioritize by shoring up your emergency fund include getting a handle on everything you owe, looking for a lower interest rate, and developing a spending plan to free up more cash flow. 

Put it toward retirement 

Retirement can seem so far away (sometimes even if it’s next year), but saving as much as you can, as early as possible, can mean less out of your pocket later due to the power of compounding. Let the money do some of the work for you. If $100 earns a hypothetical average annual return of 8 percent, you would then have $108 earning 8 percent, which then becomes $116.64 earning 8 percent, and so on. The more time you have for that magic to work, the greater your earnings might be and the less cash out of pocket you would need to accumulate a retirement nest egg.

Save for college

If you have determined that you can afford to save for your children’s college education without jeopardizing your retirement security, consider using some of your refund to add to your college savings accounts. A 529 college savings plan is an effective vehicle to use for this purpose. New York state allows a married couple an income-tax deduction of up to $10,000 for contributing to the New York 529 plan and the funds can come out tax-free if used for qualified education expenses in the year incurred.

Improve your home

If there are some home improvements you have been hoping to pursue, your refund could help keep you from having to borrow the money for them. As with everything else, balance this wish-list item with your other goals to make sure everything is properly prioritized. We have seen clients overextend themselves in this area, leaving something else at risk (retirement, for example).

Your refund might feel like found money, but rather than spending it all on something frivolous, now is your chance to do something practical with at least some of it so that you might produce longer-lasting results.        

Cynthia (Cindi) Turoski, CPA, CFP, is a managing member of Bonadio Wealth Advisors, LLC, and has more than 25 years of tax and financial experience. Prior to joining Bonadio in 2008, Turoski was managing member of DR Financial Services, which merged with Bonadio to form Bonadio Wealth Advisors.