Getting money out of your portfolio is important, but just as important is knowing from which account to pull the funds, as most retirees are going to have some mix of taxable, tax-deferred (IRA, 401(k), etc.), and tax-free (Roth IRA) accounts at retirement.
The order in which you pull funds from these accounts matters. And, somewhat surprisingly to many, it matters quite a lot.
In a 2012 study published in the Journal of Financial Planning, the authors analyzed the most efficient order in which to withdraw funds and then quantified these benefits. They looked at 12 different combinations for ordering withdrawals. I’ll spare you all the details and highlight just two methods: 1) the “Common Rule” method, which is the default rule of thumb for most and 2) the best withdrawal order strategy identified, which the authors called the “Informed TDD” strategy.
The Common Withdrawal Rule
The common way most retirees pull money from their investment accounts is to take taxable funds first, as most distributions are taxed at the more favorable capital gains tax rates. Next people make tax-deferred withdrawals from their traditional IRA, which are taxed at your marginal income tax rate.
Lastly, tax-free withdrawals from a Roth IRA are taken to preserve the tax-free growth of these accounts.
On the surface, this seems like a good idea, and it actually is a decent way of doing things. The 2012 study ranked this “Common Rule” method right in the middle—sixth out of the 12 permutations tested. But, as we are about to see, there is a better way to do this.
The Informed Withdrawal Strategy
The best performing strategy in the study the authors identified as the “Informed TDD” strategy. This involves taking IRA distributions (from your tax-deferred accounts) up to the level of your taxable deductions (hence the TDD notation). This allows you to get some income out of your IRA without paying taxes on it. Next, your taxable funds are used, followed by tax-free (Roth) distributions to keep your tax rate low. Only if additional funds are still needed is the traditional IRA account tapped again. (For related reading, see: Strategies for Withdrawing Retirement Income.)
The research shows that doing this "informed" strategy leads to both higher ending wealth and lower taxes than by simply following the common rule. Let’s look at an example and we will see just how big of a difference this change makes.
Example: Common Rule vs. Informed Strategy
Assuming a $2 million portfolio with 70% in a traditional IRA, 20% in ataxable account and 10% in a Roth IRA, and an initial $50,000 withdrawal rate. After 30 years, the authors calculate the portfolio value to be roughly $1.1 million, with over $800,000 in taxes paid using the Common Rule method.
Not bad (you didn’t run out of money!), but you can do better...
Just by changing your withdrawal strategy, and taking IRA distributions up to the level of your taxable deductions, the research estimates that you can add $400,000 of additional wealth and pay $225,000 less in taxes over a 30-year retirement period.
As it goes with most things related to investments, what seems like a simple change can have dramatic effects—especially when compounded over a standard 20 to 30-year retirement horizon. We’ve written before that making these incremental enhancements, planning for them and making them in advance, is the magic trick behind successful wealth management.