The guiding principle of “keeping more of what you earn” by minimizing unnecessary taxes becomes more complicated for those retirees who depend upon portfolio withdrawals to support living expenses. They face the dual challenges of investing and withdrawing their assets tax-efficiently.
Most retirees have accounts that are taxable, tax-deferred (traditional retirement), and tax-free (Roth retirement). If these accounts were taxed the same, an investor should be indifferent to the order in which they would be drawn down, because any order would produce the same results. However, because these accounts are subject to different tax rates and rules, a sensible withdrawal sequence can help reduce taxes and lengthen the portfolio’s life.
The guideline most often recommended is: First, withdraw from accounts where required minimum distributions (RMDs) are mandated. Second, spend cash flows (interest, dividends, and capital gains) from taxable accounts. Third, tap tax-deferred accounts. Finally, withdraw from tax-free (Roth) accounts. The rationale behind this approach is to allow tax-advantaged accounts to grow for as long as possible. Simulations conducted by academic and financial institutions generally support the notion that “all things being equal”, this spending order will usually produce a lower current tax bill, allow for more tax-deferred growth, and enable investors to achieve greater portfolio longevity.
However, in life, all things are rarely equal and retirees should avoid using this “one size fits all” approach before examining their specific situation. Each investor has unique personal and financial circumstances including: the type, size and cost basis of each investment account, estate planning goals, and current versus future tax rate expectations. All of these have important tax implications and therefore impact the preferred account withdrawal sequence.
Let’s consider when an alternative approach may be warranted.
— Capitalize on a temporary drop in income tax bracket. This often occurs during early retirement before required minimum distributions begin. This can provide an opportunity for the retiree to withdraw sufficient funds from tax-deferred accounts to fill up the lowest tax brackets, which under normal circumstances would be unavailable to the investor.
— Reduce the future tax impact of a large IRA or employer retirement plan. Those fortunate enough to have accumulated large tax-deferred balances may find these accounts lose some of their luster when they begin taking withdrawals under IRS distribution rules. They are fully taxable at ordinary income tax rates.
— Avoid paying capital gains taxes in taxable accounts. Investors who have amassed sizeable taxable accounts with low cost basis (large built-in gains) and do not need to tap them may choose to hold them and pass them on to beneficiaries. Doing so allows beneficiaries to receive them in a tax-efficient manner under current estate tax laws.
— Exploit differences between current and future tax rates. Accurately predicting future tax rates is a long shot at best. However, if an investor expects that her (or her heir’s) tax rate will be higher in future years than it is now, spending from tax-deferred accounts before tax-free Roth accounts may make more sense.
For most retirees generating a sustainable income while preserving the portfolio for themselves and their heirs is one of their highest financial priorities. Achieving this goal is challenging enough and is further complicated when the impact of taxes is introduced. However, employing a flexible, “tax-smart” strategy for drawing down the portfolio can go a long way toward helping retirees reach that important goal.
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