In retirement, the loss of a regular paycheck means you may need to turn to your investments for income, but it isn't as simple as turning into the drive through window at your local bank. At retirement, you'll face a potentially overwhelming task - determining how to efficiently withdraw from your different accounts to reduce the impact of taxes, therefore extending your portfolio’s longevity. With assets scattered in 401(k)s, IRAs, and other dark corners of your portfolio, building a pre-determined method to guide withdrawals will help minimize your tax burden, allowing your assets to last as long as possible once your bi-weekly paycheck disappears. The impact of taxes is just as important to consider now as it was when you started 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.), followed by withdrawing from your tax-deferred accounts (Traditional IRAs, 401(k)s, etc.), and finally withdrawing 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 of examples.
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 specific 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 need to come first, based on your goals, risk tolerance, and time horizon.
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 making the jump from years of diligent saving and transitioning into spending that money you've stashed away. Like with most elements of financial planning, there is no “one-size-fits-all” strategy. Map out your spending as best as you can. Create a spending plan that offers a balance between your 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.
While navigating the complexities of retirement accounts may seem overwhelming, you don't have to do it alone. Touch base with a financial advisor, they'll have a comprehensive understanding of the mechanics of various accounts, the current tax landscape, and strategies to help maximize efficiency in withdrawals. You'll spend less time worrying about funding your retirement, giving you more time to enjoy the rest and relaxation you've worked so hard to secure.