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Retirement Planning > Social Security

Why 401(k) Withdrawal Rules Are All Wrong

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We routinely rail against rules of thumb, as demand for customization from boomer retirees renders them increasingly obsolete — and dangerous.

Two areas of financial planning in particular bring this to bear — the coordination of Social Security with the overall retirement portfolio, and the subsequent tax-efficient distribution of accumulated assets.

Conventional wisdom dictates that retirees withdraw assets from their taxable accounts first, their tax-deferred accounts (401ks) second and their tax-exempt accounts third.

The sequence is so ingrained it’s almost repeated as rote, and that’s a problem. Here’s why:

A large percentage of the taxable account is its basis, or a return of principal, and therefore not taxed. Consider a retiree who has yet to reach age 70½ and therefore has no required minimum distributions. He might be in a 10% or 15% tax bracket with his taxable accounts. But once RMDs begin, he’ll jump to 25%.

In early retirement years, he should withdraw funds from tax-deferred accounts to take full advantage of the 15% tax bracket. But it begs the question — why not withdraw from a taxable account since the majority of assets are tax-free anyway? Because he blows the opportunity to take from the tax-deferred account at a 15% (or lower rate). It’s better to pay 15% before 70½ than to take these withdrawals after 70½ and pay the higher 25%.  

The correct sequence would therefore be to take tax-deferred income first up to the top of the 15% bracket and then taxable income second. After the taxable account is exhausted, he can take tax-deferred income first at the 15% bracket and then withdraw any additional needed funds from his tax-exempt account. 

It’s a tough sell. While most Americans have consistently saved for a longer period of time with Social Security than any other retirement asset, they’ve had no involvement in its operation.

Over time, they most likely even stopped noticing its deduction from their paychecks. Not so with their 401(k) — something they’ve had more of a direct hand in guiding, whether it be allocation amounts or portability issues associated with job changes. They therefore have more of an attachment, rightly or wrongly.

But what’s more secure; retirement assets subject to market volatility or guaranteed payments from the government?

Illustrating this point is critical to the long-term viability of the portfolio. For this reason, advisors should help clients focus on the bigger picture. For instance, for a retiree with a full retirement age of 66, real Social Security benefits are 76% higher if they delay payment until age 70. 

Our research further shows that maximizing a client’s Social Security benefits can extend the life of the portfolio by up to 10 years. The proper sequence of withdrawal can extend its life by up to six years.

The rules of thumb don’t work. It was folly to rely on them to begin with.