One of the most important financial decisions a retiree can make is determining which assets should be withdrawn to fund everyday life. An optimal distribution strategy minimizes the overall tax impact and saves you money over time.
There are three general types of accounts that retirees have and each has different tax implications:
- Taxable accounts: This includes checking accounts, savings accounts and regular brokerage accounts. Interest and dividends from these accounts are taxed at ordinary income rates (10% to 37% in 2018), and capital gains rates (0% to 23.8% in 2018) are incurred when the are investments are sold.
- Tax-free accounts (Roth IRAs): These accounts are funded with after-tax money and grow tax-free indefinitely. No taxes are incurred when distributions are made.
- Tax-deferred accounts (traditional IRA, 401(k), 403(b), and 457 accounts): These accounts give you a tax deduction when they were funded, and are fully taxed when a distribution is made.
Optimal Order of Asset Distribution
The optimal order to distribute assets in retirement depends on your expected tax rates in the future. Assuming your tax rates will be the same or lower in the future, here's the optimal distribution order:
- Any income you receive and your required minimum distributions (RMDs). The first retirement money you should spend is from current income sources—like pensions and Social Security—and RMDs. If you are older than 70.5, you’ll have to take RMDs on your tax-deferred accounts based on the IRS formulas and you’ll have to pay taxes on these distributions at ordinary income rates. Your Roth IRAs don’t have RMDs. (For related reading, see: Avoiding Mistakes in Required Minimum Distributions (RMDs).)
- Taxable accounts. The first money distributed after your RMDs should be from your taxable accounts. Ideally, you would choose to sell specific taxable securities held for 12 months or longer with a high basis relative to its current price to minimize taxes. Using the taxable investments before your tax-free and tax-deferred funds allows you to maximize the tax benefits of tax-deferred and tax-free funds.
- Tax-deferred accounts. The long-term financial benefit of tax-free assets (Roth IRA) is more valuable than the benefit of tax-deferred assets, so preserve the Roth benefit by distributing from the tax-deferred accounts before your Roth IRAs.
- Tax-free accounts. You can maximize the value of tax-free assets by spending these assets last. Depending on how much income you earn in retirement, you might want to consider converting some of your tax-deferred assets into tax-free assets through a Roth conversion. The Roth conversion allows you to pay taxes on a tax-deferred distribution and put that money in a Roth account where all future growth and income would avoid taxation. This is particularly effective in years of low income or in conjunction with a charitable giving program. You can potentially do a partial Roth conversion on amounts that bring you up to the 10% or 12% bracket. (For related reading, see: Should You Convert Your IRA?)
Include Your Estate in Your Asset Distribution
You should also consider inheritance plans in your distribution strategy. For example, someone in their 80s or 90s may not want to sell low-basis stock in their taxable estate, since their heirs would get a step-up in basis when they inherit that stock and owe little or no taxes when they sell (if expecting higher future income tax rates).
Your Tax Bracket Impacts Your Distribution Strategy
If you are expecting your income to push you into a higher bracket later in retirement or you believe Congress would increase overall tax rates, the optimal distribution strategy changes.
Under this situation, you’ll likely want to distribute from your tax-deferred accounts before your taxable assets, given that distributing from tax-deferred accounts later would result in a much higher tax bill. After distributing the tax-deferred assets, you should distribute from the taxable accounts and then your tax-free accounts. (For related reading, see: Strategies for Withdrawing Retirement Income.)
Rebalancing and Portfolio Risk
It’s important to consider your overall portfolio objectives and risk while distributing assets in retirement. For example, avoiding selling a large low-basis taxable position can delay paying taxes, but it could also significantly increase the overall risk of the portfolio. As well, if you were optimizing which securities go into which accounts in pre-retirement by buying your stocks in taxable accounts and bonds in tax-free accounts since capital gains on stocks are lower than ordinary income rates, you’d start to have an overall portfolio increasingly weighted to bonds as you sold your taxable assets first in retirement. Regular rebalancing can help avoid any mismatch between your risk tolerance and overall portfolio risk.
Don’t forget tax basics in the taxable account. In conjunction with optimizing your retirement distribution order, you should continue to employ tax-minimization best practices in your taxable accounts: harvesting positions with losses to offset gains, and avoiding high-turnover investments to ultimately avoid capital gain distributions and short-term capital gains.
How you withdraw from your retirement accounts impacts how much money you have in retirement. Therefore, it's important to strategically approach your method of distribution to effectively use your retirement investments.
(For more from this author, see: 7 Ways the New Tax Law May Impact You.)