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How to set up your withdrawals

Coordinating withdrawals among multiple accounts can be tricky. For most people, these steps give you a tax-efficient way to use your money.

1. Set up a money market account

You'll still have bills to pay in retirement, but you probably don't want to move money directly from your investments to your bank account every time you need to pay one.

For one thing, frequent transactions mean market swings could have a bigger impact on you—if you're forced to sell shares whenever you need cash, even if the value of your investments has dropped.

Instead, think about opening an account in a money market fund. You can move a year's worth of withdrawals to your money market account at one time, to lessen the impact of market swings.

You can also direct any other income streams (like Social Security) into your money market fund. Then transfer one month's worth of expenses at a time to your bank account, and pay your bills from there.

2. If you're Required Minimum Distribution (RMD) age*, take your distributions.

*The age at which you must begin taking RMDs differs depending when you were born:

  • If you were age 70½ before January 1, 2020 (i.e., you were born before July 1, 1949), you were required to begin taking RMDs for each year beginning with the year you turned age 70½.
  • If you were not age 70½ before January 1, 2020 (i.e., you were born after June 30, 1949), you must begin taking RMDs for each year beginning with the year you reach age 72.

If you haven't reached RMD age, you can skip this step. But if you have, you're now required to withdraw a certain amount from many types of retirement accounts so that you can start paying the taxes you've been deferring all these years.

Consider moving your yearly RMD amount into your money market fund—unless you don't need it to cover your expenses. If that's the case, you can move the money into any taxable account.

Just don't leave it in your retirement account. There are steep IRS penalties (50% of the shortfall) if you don't take your RMDs.

3. Direct dividends and capital gains to your money market

As you were building your savings, you probably used your earnings to buy more shares of your investments—that's how you benefit from compounding.

But now that you're spending money from your accounts, consider having your earnings sent to your money market fund rather than reinvested, at least in your taxable accounts.

Here's why: You'll incur taxes on these gains when they're paid out. If you reinvest them and then turn around and withdraw them in a few months, you'll likely have to pay taxes on them again.

4. Withdraw money from your accounts in this order

If your taxable distributions and RMDs (if any) aren't enough to cover your spending, withdraw additional money from your savings in a way that will allow you to pay the majority of your taxes while you're in a lower tax bracket.

That's sometimes easier said than done, but for many people, the order below will make the most sense.

  1. Withdraw from your taxable accounts first. This will allow your accounts with tax benefits to keep growing as long as possible. Remember that as you sell assets in these accounts, offsetting your capital gains with losses will help keep your taxes down.
  2. When you've spent all the money in your taxable accounts, begin withdrawing from your tax-deferred accounts, like traditional 401(k)s and IRAs.
  3. Finally, withdraw from your tax-free accounts like Roth 401(k)s and Roth IRAs. If you don't use all your Roth money, you can include it in your estate plan, since Roth accounts keep many of their tax advantages even after being passed down.

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Money market fund

A mutual fund that invests in very-short-term securities. Because they tend to have stable share prices and a relatively low rate of return, money market funds are often used for the cash portion of a portfolio or for holding money you'll need soon.

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Required minimum distributions (RMDs)

Annual withdrawals required by the IRS from certain retirement accounts, beginning at age 72 (age 70½ if you attained age 70½ before 2020). RMDs are intended to ensure that the assets in these types of accounts are eventually subject to taxation.

Please note: The CARES Act provides a temporary waiver of RMDs. If you've reached RMD age, you do not have to take your RMD for 2020 if you don't want to.

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Taxable accounts

Accounts that don't receive special tax treatment, so all interest, dividends, and capital gains are subject to taxation in the year they're received.

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Roth conversion

The movement of money from a traditional IRA or 401(k) to a Roth IRA, essentially changing tax-deferred assets into tax-free assets. When you convert assets, you'll pay income taxes on the amount you convert. After the conversion, withdrawals from the Roth IRA will be tax-free as long as you meet the requirements.

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Roth IRA

A type of IRA that allows you to make after-tax contributions (so you don't get an immediate tax deduction) and then withdraw money in retirement tax-free as long as you meet the requirements.

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The investment returns you accumulate on the savings in your account.

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When earnings on invested money generate their own earnings. For example, if you invested $5,000 and earned 6% a year, in the first year you'd earn $300 ($5,000 x 0.06), in the second year you'd earn $318 ($5,300 x 0.06), in the third year you'd earn $337.08 ($5,618 x 0.06), and so on. Over longer periods of time, compounding becomes very powerful. In this example, you'd earn over $1,600 in the 30th year.

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You won't pay any income taxes on the amount your account earns until you take the money out. (Note that with Roth accounts, assuming you meet all requirements, the earnings become tax-free at that time.)

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Tax-free withdrawals

Money you can take out of your account without owing any federal income tax, even if some of it has never been taxed.