Conventional wisdom tells us to maximize our contributions to a 401(k) account and to grow the balance as much as possible for retirement.
However, we may not have considered the decumulation side of retirement income. If one waits till reaching the age of 70 ½, when the 401(k) balance is larger, he/she may face a large annual tax bill waiting, as the law requires withdrawals of a certain minimum amount from the balance. The withdrawals are treated as ordinary income and as a result may end up in a higher marginal income tax bracket.
There are two age-related rules governing the withdrawals from one’s 401(k) plan and the traditional Investment Retirement Account (IRA). The first one is the rule of 59 ½, which stipulates that, generally, for participants under the age of 59 ½, they must pay a 10% additional tax on the distribution from the account. After reaching the age of 59 ½, participants can receive distributions without having to pay the 10% additional tax.
The second age-related rule is the rule of required minimum distributions (RMDs). Individuals are required to begin lifetime RMDs from their IRAs no later than April 1 of the year after they reach the age of 70 ½. This is in contrast with RMDs from employer-sponsored plans, which, in most cases, may be postponed until after the employee retires or reaches age 70 ½, whichever happens last. One may have to pay a 50% excise tax on the amount not distributed as required.
Thus, there is an 11-year window during which withdrawals from such retirement savings accounts can be made, but are not required. Against that background, an optimal strategy may be to smooth out one’s retirement income from all sources in such a way that the marginal income tax rate is at the lowest possible level. In the event that one wants to delay receiving social security benefits until age 70 (in order to max out the social security benefits), tapping into a 401(k) or IRA to provide interim stopgap income could be considered.
In 2014, the U.S. Treasury and the IRS amended the RMD regulations in such a way that the part of the account balance that is subject to the RMD can be allowed to purchase a qualifying longevity annuity contract (QLAC) , as documented on page 10 of our paper “Rethinking Longevity Risk: A Framework to Address the Tail End.” Thus, by purchasing a QLAC which begins to pay the amount contracted no later than at age 85, one can defer the tax burden on one’s retirement assets for up to 15 years and have a guaranteed lifetime income starting at or before age 85.