How to Turn an IRA into Retirement Income
By Carl Lachman, MBA, CFP®
Turn on the Water: An Important Rule for Cabins and IRAs
Some winters we visit our relatives’ log cabin in the woods. It is a 20-hour drive from Fullerton, California. There is no heat and it is totally shut down, as cold inside as it is outside. Outside temperatures at the cabin during the winter are often below zero, and we have experienced -27 degrees Fahrenheit. So, it usually takes all day to warm up the cabin to about 50 degrees by 10 p.m., when we want to go to sleep.
Once the cabin is warm enough and any ice in the cabin pipes has melted, we can turn on the water. The main valve is out the driveway by the dirt road, buried 8 feet deep. The depth keeps the water main from freezing. To turn the valve, one needs a 10-foot-long, thick, rebar-like “key” that can extend down the access pipe and turn the valve. The access pipe is usually buried under several feet of snow.
To turn on the water in an ice-cold cabin in the winter, one must complete a number of steps. If you make a mistake, no water. Go back and try again.
Turning on income from an IRA once you retire is easier in some ways, but if you make a mistake, the results are higher taxes and, in the worst case, no more income. If you make a mistake, you might not get to go back and try again.
What’s in the IRA?
Your individual retirement account (IRA) has savings and investments, which have never been taxed. IRAs are called tax-deferred accounts since you can avoid capital gain taxes and income taxes on the money in them.
You have contributed to the IRA each year, deducting the contributions on your taxes, or maybe you have rolled over the money from a 401(k) into an IRA, which is often a smart move. In retirement, IRAs have more options for investments than 401(k) plans.
Once you are 59½ years old, you can start taking money out of your IRA without paying the 10% penalty. There are just a few rules to follow when you take money out of your IRA. Mainly, you need to pay taxes on the money when it comes out of the IRA, and you must follow the IRS rules on mandatory distributions when you are older.
Other Sources of Retirement Income
Before you start using the money in your IRA, consider the other sources of income you have. Do you have a lot of money saved at the bank or in a trust account? What is your Social Security benefit each year, and how much does your spouse receive? Do you have a pension or rental income?
Before you start taking money from an IRA, you might want to use these other sources. The IRA is unique in its tax advantages, so you might not want to use the money in your IRA until the IRS forces you to start using it when you are 70½ years old. Keep that tax deferment going.
Is there enough money for retirement?
When you considered retiring, you probably met with a financial advisor to review an analysis and determine if you had enough saved to stop working. If it was a fee-only advisor, you got the straight scoop with probably a straightforward retirement projection. If it was an average financial “advisor,” you were probably told that you needed to buy an annuity to “secure” your retirement income. (If you want more information about why annuities are usually a bad idea, see this article: Why Ken Fisher Hates Annuities.)
A good and thorough retirement projection considers all sources of income you can use in retirement and gives you a map on using them to pay the bills when you have stopped working. Our firm runs projections regularly for our clients. The projections take into account IRAs, savings, pensions, Social Security, inflation, investment returns, taxes, etc.
The projections are thorough, but they’re not perfect. Can anyone tell you what is going to happen over the next 20 years? The retirement projections are a very good start and provide valuable direction to our clients, but we revisit them and update them even after our clients have retired.
A good retirement projection will tell you if you have enough assets and income to retire in the way you have planned. It might be obvious, but you really should start asking this question many years before you plan to retire. Better to find out in your 40s or early 50s if you are saving enough to retire when you want.
Even It Out
Once you have done the analysis and are sure you have enough to retire, you need to start taking money from the various sources. A general rule of thumb in retirement is that you want to “even out” your income from year to year. You want to avoid big swings in your taxable income, which would cause you to be subject to a high tax bracket. Rather, try to get money from the various sources in retirement and stay in a consistently lower tax bracket each year.
Regarding your IRA, this means you want to usually “sip” from it, rather than taking an occasional “gulp.” If you don’t plan ahead and need a bunch of money one year from your IRA, you will probably jump into a higher bracket and have to pay more in taxes. But, with good planning, it is usually possible to take some from your IRA every year and “even out” your income to stay in a lower bracket. The money you pay to a good fee-only advisor will help you save money in taxes, among other benefits.
Required Minimum Distributions (RMDs)
When you reach 70½ years old, the IRS forces you to start taking required minimum distributions (RMDs) from your IRA each year. There is a calculation that must be done using an IRS chart and your age to determine the amount. It’s not hard, but it has to be done.
When money is distributed (taken out) of an IRA, it triggers the taxation of that distribution as income. You have benefited from the tax deferment for years, but now the money must be taxed when it comes out of the IRA. We help our clients with their RMDs each year, making sure they fulfill these IRS requirements.
But, just because the IRS forces you to take money out of the IRA each year, doesn’t mean you have to spend it. You can just move it to a taxable brokerage account and re-invest it. If your advisor worked on a thorough retirement projection for you, this was one of the topics that were discussed. A good projection doesn’t just consider how much you can spend each year, but also the tax implications.
Monthly Withdrawals from you IRA
During your working life, you received income in the form of paychecks each month. You paid bills each month. You had that pattern for maybe 40–50 years. In retirement, it is probably easiest to keep the same pattern. Work with your advisor to figure out what you need each month for your expenses and then determine how much should be from your IRA.
It isn’t hard to set up monthly transfers from your IRA to your bank checking account that you use to pay bills. It can be an automatic transfer, and the amount can be changed, usually with just a phone call. But it is probably best that each time you take money from your IRA, you withhold some for federal and state taxes. In this way, you won’t have a big tax bill in April or be subject to IRS penalties.
Seek A Fee-Only Financial Advisor for Help
If you don’t think you can do these steps by yourself or your financial advisor hasn’t done them for you, maybe you need a new advisor. These are foundational things every good financial advisor does for their clients. They aren’t necessarily hard—like the steps needed to turn on the water in an ice-cold cabin—but they do need to be done in a certain order. Getting the steps right the first time will help you avoid paying too much in taxes and avoid running out of money in your IRA.
Schedule a 15-minute discovery call with a fee-only financial advisor to discuss your personal situation.