When Should I Start Drawing on my IRA, 401(k), or 403(b) Plan?

I just finished this article for the web site. I probably won't post it until tomorrow, when the other two pages that link to it will be ready. But YOU can read it :-).

This question is, in my experience, the hands down winner as the most popular question asked of a financial planner. And it's no wonder, because what it really translates into is, "When can I get at all that money I put away for all those years?" And the answer to that question, "When CAN I..." is really any old time. But the answer to "When SHOULD I ..." is usually age 70 1/2. And here's why...

First of all, let me simplify the terminology a bit by calling all of these plans by their generic name, "qualified plans." They earn that name because they "qualify" under IRS regulations for pretax contributions and tax deferred growth. In other words, the contributions to these plans are made in pretax dollars, either because you can deduct the amount contributed (in the case of an IRA) or your employer is allowed to exclude the amount contributed from your taxable income reported on the form W-2 they give you. Either way, what you have sitting in the account after that contribution is pretax money. Then, as the money grows in your qualified account, you don't have to pay taxes on the capital gains, dividends or interest that cause the account to grow. So what you are left with at the end of your life is a hopefully large qualified account that is filled with pretax dollars.

The downside of the above is that when you remove money from the qualified plan in our example, it will all be considered income to you, and you will pay taxes on the full amount received. And if you make a withdrawal before age 59 1/2 (except for a few special exceptions), you will pay an additional 10% penalty for a "premature" distribution. It is usually the avoidance of this 10% penalty that people have in mind when they ask the "When CAN I..." question. But is important to note that avoiding the 10% penalty does not free you from having to pay income taxes on the full amount withdrawn.

So here's how the chronology works out in real life. At some point in their 50s, people see age 59 1/2 appear on the horizon and think, "Hey, I'll be able to get at that IRA money pretty soon." And I start with my reality therapy. When the time actually comes near, we look at their assets and set apart the total of "qualified" (pre-tax) money from the total of their non-qualified money (everything else). Let's say for simplicity that I am talking to a friend, age 60, who has $100,000 in qualified money and $100,000 in non-qualified, personal money. Naturally, they are anxious to finally be able to "get at" this money that has seemed so untouchable all these years. And they decide they have a need for $30,000. I will usually show them that if they just spend the $30,000 out of their individual account, they will have $170,000 left over. But if they take it out of their IRA, they will be looking at an income tax bill of up to $10,000 on the extra income created by the withdrawal. This means that you will either have to write a $10,000 tax check from the individual account or take the extra $10,000 taxes out of the IRA. But of course that now makes the withdrawal $40,000 less a $10,000 tax withholding. Leaving aside the fact that the taxes on $40,000 would be a few thousand dollars higher, using the IRA for this need reduces your net worth to $160,000 instead of $170,000.

There is another factor at work here as well. If you take the needed funds out of the IRA, you are reducing the balance of the money that is growing without tax in order to preserve the amount that's generating taxable interest and dividends.

So when you really come to understand what is going on in this situation tax wise, the logical question becomes, "Well when do I HAVE TO start taking out of my qualified plan?" And the answer to THAT question is at age 70 1/2. The IRS, you see, knows that once people figure out the above, they will rarely choose to expose themselves to unnecessaary taxes, so the IRS enforces a MINIMUM annual distribution based on your life expectancy.

Many years ago, I showed this comparison to a man who had about $85,000 in an IRA Rollover and $20,000 or so in personal funds. He had a company pension plus social security, so he decided to see how long he could stretch that $20,000 and try to grow the $85,000. He was a pretty frugal guy, so he only ended up dipping into the $20,000 for a "new" (actually "used") vehicle. By the time THAT vehicle needed to be replaced, he was nearing the 70 1/2 minimum withdrawal threshhold. His personal funds were exhausted, but his $85,000 IRA had grown to over $150,000! And by the time he started to draw on that, his part time employment was starting to wind down, so his taxes on those distributions were at the lowest tax rate.

For years I have joked with clients that I would like to have a drive up money window where they could come and just "be with" their money. They could let it run through their hands, maybe throw it up in the air and let it float down on them. And then, when visiting hours were over, they could go on their way. Because even though there is a powerful desire to be able to "get at" your money, most people, especially here in New England, where a good "Yankee" wouldn't dream of "dipping into the principal," don't really want to spend it. They just want to know they can. And that's the way it is with qualified money. You just have to get used to thinking of it as a little more distant, but that distance also has its benefits. Not only tax benefits, but it provides you with a little discipline as well.

Think of it as money in your left pocket and money in your right pocket. If you dip into the left pocket, a dollar is a dollar. But dip into the right pocket and the dollar you spend costs you $1.33. Unless of course, you really do NEED it. The assumption would be that if you really do NEED it, then by definition you are probably in a low tax year, perhaps out of work for a while, or sick. In that case, the taxability of the payments is not as big of a deal. Otherwise, it's the last place you should go for money.


Anonymous said…
I was laid off Feb. 2008, provided with a 6-mth. severance (which will be exhausted at the end of Aug, 08 due to paying my bills totalling $3810/mth. I have been receiving unemployment checks of $2036/mth. since May 08, which will stop mid Dec. I will start using those checks to pay bills starting with Sept. 08 (as my severance will have been used up by then), which will take me safely to Dec. '08. I have been looking for a job since being laid off - nothing yet. I purchased a single immediate annuity with my 401K (during the Bear Stearns flop) & have been receiving a mthly. distribution since May '08 of $1228 (actually $1404 minus taxes), which I have continued to deposit in my savings until my severance & unemployment checks are exhausted. I do not plan on drawing from my social security until I reach my full retiremnet age of 66 (23 mths. away). As my Annuity is my only income to date, which I have not been using, would it be wise to start drawing enough money monthly starting Jan. 09 from my IRA account to make up the difference for my mthly. bills until June 2010, when I can draw from my social security?

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