Should You Wait Until Age 70 1/2 to Start 401k Withdrawals?: Timing Your 401k Withdrawals

[dropcap]O[/dropcap]Our initial plan regarding 401k withdrawal was to wait until age 70 ½ at which time the government forces you to begin distributions (Required Minimum Distributions or RMD) or else pay a penalty (the amount not withdrawn is taxed at 50%). Our assumption was that it was in our financial interest to wait until that time because that would maximize our 401k investments.

However, we were introduced to an alternate view at a Fidelity seminar. The presenter showed an example where it may work out better if you start taking 401k distributions earlier than 70 ½. Here are some of the conditions under which it may be better to start taking distributions sooner rather than waiting until you are forced to.

  • If your marginal tax rate now is less than what it will be at age 70 ½
    • Consider whether you think it’s more likely for taxes to rise over time or decrease.
    • Consider whether you think inflation will rise over time. If you think it will, then your dollars have more spending power today than in the future.
    • Also consider that your income will increase when you factor in that 85% of Social Security benefits may be taxed along with the amount of your RMD. Together they may push you into a higher tax bracket.
  • You can withdraw from your 401k beginning at age 59 ½. You can choose to make a withdrawal in any given year. If you make a withdrawal you are not required to continue to make annual withdrawals until 70 ½. Whether you choose to make a withdrawal in any given year is entirely up to your discretion.

Here is an example to illustrate the point.

Assumptions Re: 401k Withdrawals

  • You estimate a 4% investment growth rate (which is consistent with a conservative investment strategy) for your 401k
  • Your AGI (Adjusted Gross Income) is $55,000 before taking any RMDs.
  • Your marginal tax rate is 15% (based on 2014 tax rates).
  • You are married and file jointly.
  • No additional contributions are made to the 401k account.
  • I used Fidelity’s RMD calcuator
  • The example uses 2 scenarios
  • Scenario 1
    • You have waited until age 70 1/2 before making any withdrawals from your 401k
    • Your 401k balance is $400,000 at the time that you start taking your RMDs
  • Scenario 2
    • You have withdrawn $100,000 prior to reaching age 70 1/2
    • You have paid 15% tax on that $100,000 or $15,000
    • Your 401k balance is $300,000 at the time that you resume making withdrawals, e.g. age 70 1/2
  • Example includes 20 years of distributions.
  • There are many “moving parts” involved in this example. For example, in scenario 2, at some point prior to starting to withdraw $100,000, the 401k balance has to be greater than $300,000. In scenario 1, at some prior point (between ages 59 1/2 and 70 1/2), the 401k balance had to be less than $400,000, i.e. a smaller balance had to grow by 4% into a starting balance of $400,000.
  • Tax table used is the current IRS (2014) tax table. Only Federal taxes are used in the analysis.

Image 2 401k distribution post

 

 

 

 

Results

In scenario 1, where you wait until age 70 ½ to begin RMDs, the amount of your RMD pushes you into a higher tax bracket at age 78. In scenario 2, where you have withdrawn $100,000 before age 70 ½, you do not reach a higher tax bracket until age 88!

  • The amount of tax paid under scenario 1 is $216,643 while under scenario 2 it is $209,198 plus $15,000 for the early withdrawal of $100,000.
  • Scenario 2 offers a tax savings of $7,445 over the 20 year time horizon.

 

 

RMD scenario 1RMD scenario 2

Conclusions

  • Depending on individual circumstances, it may be advantageous over the long term to begin 401k withdrawals earlier than age 70 ½.
  • There are many variables, assumptions and unknowns to consider. No one knows how inflation, taxes, rates of return and individual situations will change over time.
  • Our decision to begin taking some early withdrawals were guided by the following assumptions.
    • Our tax rate at age 70 1/2 will be higher, perhaps considerably higher, than it is today.
    • We prefer to actively manage our financial affairs whenever possible rather than wait for mandatory requirements to kick in.
    • Trying to delay the point in time where we are pushed into a higher tax bracket.
  • The calculations presented are intended to illustrate a point, not to prove it.
  • Your 401k withdrawal strategy is yours to make. I always recommend that you consult with a financial planning professional to obtain guidance.

 

Note: the information contained in this article is not offered as advice or guidance. It’s purpose is illustrative – not instructive or prescriptive. As always, consider seeking professional advice when it comes to your financial decisions.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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1 Response

  1. Albert Jeans says:

    This is certainly worth keeping in mind. Seems like it wouldn’t hurt to at least withdraw an amount to bring you up to the top of your current tax bracket if the tax rate seems relatively low (like 15%).

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