In retirement the loss of a regular paycheck means you may need to turn to your investments for income. As a diligent saver, you likely have accumulated assets in various types of accounts like a 401(k), Roth IRA, Rollover IRA, taxable brokerage, bank savings, HSA and an annuity, just to name a few. At retirement, you may face what can seem like an overwhelming task – determining how to withdraw tax-efficiently from your different accounts to extend the portfolio’s longevity. The impact of taxes is just as important to consider now as it was when you were saving for retirement. Unfortunately, conventional wisdom regarding which order to draw down your accounts in retirement is fundamentally flawed. When followed blindly, it could potentially deduct years from the life of your portfolio.
The conventional view suggests spending from your taxable accounts first (non-retirement investment accounts, bank savings, etc.), next withdraw from your tax-deferred accounts (Traditional IRAs, 401(k)s, etc.), finally withdraw from your tax-free accounts (Roth IRAs, Roth 401(k)s, etc.) The theory is that you can prolong your portfolio by deferring tax bills as long as possible. While this makes some general sense, the flaws are apparent when considering a couple examples.
- In the scenario of spending down taxable and tax-deferred accounts and leaving just a Roth IRA could put you in a situation of negative taxable income, meaning deductions would exceed taxable income. If Social Security was your only income source, it wouldn't be taxed. The standard deduction would still apply and likely be wasted. Any strategy that doesn't take advantage of valuable deductions is inefficient.
- It’s also possible to be “too good” at tax deferral. Following the conventional view of spending down your taxable accounts can trap you in a high tax bracket after Social Security and RMDs begin.
It’s usually best to spend from tax-deferred accounts when current tax rates are expected to be lower than future tax rates and, conversely, from tax-free accounts when current tax rates are expected to be higher than future tax rates. Each account type has a list of its own advantages and disadvantages. Choosing which accounts to draw from and when can be a complicated decision and is different for each person. Considerations include the following:
Tax rates play an important and significant role in decisions regarding portfolio spend order. This includes not only income taxes, but rates on dividends, capital gains, estate taxes, as well as taxation of Social Security and Medicare. Unfortunately, tax rates are one factor you cannot control. You can decide to minimize taxes based on current and expected future tax rates, but keep in mind there are no guarantees as to what the future tax environment will be.
The time horizon over which you anticipate spending from a portfolio is also critical. As in the case of most retirees, your time horizon may be your life expectancy. If leaving a legacy is one of your financial goals, your time horizon may be even longer. The longer the anticipated time horizon, the greater the potential impact of tax-minimization strategies on your portfolio’s overall durability.
Before determining spending order, make sure you are making the most of each account type. Asset placement refers to the principle of placing asset classes in the optimal account. Different types of investments get different tax treatments. For example, stocks in taxable accounts receive favorable tax treatment of qualified dividends and long-term capital gains. Bonds are generally most efficient in tax-deferred accounts. However, decisions regarding your portfolio’s overall asset allocation needs to come first, based on your goals, time horizon and risk tolerance.
You will have the most tax-diversification opportunities if your portfolio is balanced among taxable, tax-deferred and tax-free accounts. Therefore, it is important to consider and take advantage of all funding possibilities when saving for retirement.
It will be critical to consider all income sources and how payouts could be structured. Pensions, deferred comp, annuities, stock options, part-time work, RMDs, and Social Security are all potential sources. It will be important to map out a multi-year cash-flow plan to determine when and how much you will need to tap into retirement savings.
We’ve written before about the importance of a sustainable retirement withdrawal strategy and contemplating your income replacement number. Obviously, there is no “one-size-fits-all” strategy. Select a spending plan that offers balance between goals, asset allocation and time horizon.
The decision regarding which accounts to spend first often has estate planning implications as well. It may be more beneficial to spend down tax-deferred accounts during your lifetime if you are in a lower income tax bracket than your heirs. Taxable accounts, especially those with highly appreciated assets, enjoy what is known as a step-up in basis when they are passed to a beneficiary. Essentially that means your beneficiary potentially can sell an inherited asset soon after it is received and owe little or no income tax on it whatsoever.
Through proper planning, various account types can work harmoniously together to maximize tax-efficiency and potentially add years to the longevity of your retirement savings or increase the value of your inheritance. Any strategy that doesn’t properly integrate them should be viewed as inefficient and incomplete. Work with an advisor to get the sequencing right so you can spend less time thinking about funding your retirement and more time spending your retirement doing what you love.
Kate Slocum is a Lead Advisor at Exchange Capital Management, a fee-only, fiduciary financial planning firm. The opinions expressed in this article are her own.