The whole point of saving your money is to be able to use it in the future. You’ve spent decades saving for retirement, so you want to use the money in the most effective way possible. When you take money out of your portfolio, we try to optimize in two different directions:
- Using your distributions to help rebalance your portfolio, and
- Optimizing your long-term spending power.
As you can guess, the second objective is much more important, but we can often do both at the same time, luckily.
Just like any cash flow, we want to use your spending to move your portfolio closer to your asset allocation. All things being equal, we want to sell from the asset classes that are overweight to get your portfolio back in balance. If you’re taking regular distributions, this can actually go a long way toward keeping your portfolio where it is supposed to be.
Just like any rebalancing trades, we’re thinking about the rebalancing frictions (though we don’t need to worry as much about the wash sale rule since we are selling and not buying). We want to:
- Keep your trading costs low and not make any more trades than absolutely necessary,
- Pay attention to the tax costs from trading (we’ll be talking about this more), and
- Avoid taking any short-term capital gains if we can.
Those factors are on our mind, but our primary focus is maximizing your long-term wealth, which boils down to optimizing your taxes. Notice I didn’t say minimizing your taxes. If we do this right, you could actually be paying more taxes, you’ll just have more money for paying those taxes. Maximizing your long-term wealth means maximizing your portfolio’s potential for growth through retirement.
We approach this mainly by thinking about the order in which we draw from your different investment accounts. While there are a lot of exceptions, the “normal” distribution order is:
- Required Minimum Distributions (RMDs)
- Taxable accounts
- Tax-deferred accounts
- Tax-exempt accounts
Those last two are tax-advantaged accounts, so you want to leave money in them as long as possible. Whenever we can, we use your RMDs first, then we spend from your brokerage account, followed by your traditional IRA and 401(k), and then your Roth IRA and Roth 401(k).
Your required minimum distributions are, well, required. Once you hit 70½ you need to start pulling money out of your tax-deferred accounts – the IRS wants to get their hands on that money again. If you don’t withdraw the required minimum amount, you’ll suffer a significant financial penalty. Since we are required to take that money out (and pay taxes on it), we start by using that for your spending needs. If you spend less than your RMDs, that’s ok. We can just reinvest that money in your brokerage account. If you spend more than your RMDs, no problem. We take the extra money from whatever account is next on the list.
Your brokerage account has the highest tax burden. Not only are you paying capital gains taxes on profit you make from your investments going up, but you are also taxed on the distributions you receive when you own a security. Since these accounts are taxed on an ongoing basis, taxes are a significant drain on its growth potential.
Once you work your way through your taxable accounts, we want to start pulling from your tax-deferred accounts (though you’ve likely been pulling from these for your RMDs). These are accounts like your traditional IRA or 401(k) that are not taxed until you withdraw money from them. They have had a lot of time to grow tax-free, but there will be a heavy bite when you take money out.
The last set of accounts – tax-exempt accounts – are exempt from taxes, just like their name says. You paid taxes on them when you put the money in, so they get tax-free growth and withdrawal. Being able to take money out without paying anything in taxes makes the tax-free growth even more valuable, so we want to give these accounts maximum growing time.
While this is the “normal” distribution order, it always depends on your broader situation. We deviate from the prescribed order in specific situations, such as:
- If you have holdings in your taxable portfolio with very low cost basis and you are going to leave an estate, you may choose not to sell the holdings with low cost basis so your heirs can get the step up in cost basis when you pass away, eliminating the need to pay taxes on those capital gains.
- If you are looking to manage your taxable income number – either up or down – you may decide to spend from different accounts.
As you can see, deciding how to take money out of your portfolio is not always straightforward. There are a lot of moving pieces – RMDs, rebalancing, trading fees, taxes, and your broader financial situation – and we are here to help you think about how they fit together. After saving for retirement for so long, you want to make sure you get the most out of those savings so you can enjoy the best retirement possible.