Taking retirement income from your investment portfolio in retirement is like walking through a minefield. If you don’t take the right path, you’re going to take a large tax hit. Most people don’t think about it, but your distribution strategy in retirement – how you actually take money out of your portfolio – and the resulting taxes can have a significant impact on how long your money lasts and how much you’ll be able to spend throughout retirement. Like asset location, withdrawal sequencing is an area where it’s easy to lose your way, but you can avoid major pitfalls by sticking to a couple guidelines.
Standard Withdrawal Sequence
Taxes are the driving factor in withdrawal sequencing. In order to maximize after-tax spending, you need to maximize the benefits of your tax-advantaged accounts.
Investment accounts fall into three main tax categories:
- Taxable accounts – Your standard brokerage accounts. Funded with after-tax money. Taxes are paid on capital gains and any income that comes from the account.
- Tax-deferred accounts – Accounts like your 401(k), 403(b), and traditional IRA. Funded with pre-tax money. Money is taxed upon withdrawal, generally at ordinary income tax rates.
- Tax-exempt accounts – Accounts like your Roth 401(k) and Roth IRA. Funded with after-tax money. but you don’t owe any taxes when you take the money out.
Just like anything with taxes, withdrawal sequencing has a number of exceptions and wrinkles to consider, but this is a good starting place.
If all of your investment accounts are of the same type – for instance, all of your savings are in a 401(k) and traditional IRA – then you really don’t have much to worry about as your distributions will all be taxed the same way. However, most retirees have more complicated situations. They have investment accounts across multiple different tax categories, and that means that they have the opportunity to take advantage of differences in how their accounts are treated.
So what is the best withdrawal sequence?
Well, just like anything in finance, there are always exceptions, but the standard withdrawal sequence that people typically work from is:
- Any income you receive (Social Security, annuities, etc…), and your RMDs
- Taxable accounts
- Tax-deferred accounts
- Tax-exempt accounts
This gives your tax-advantaged accounts more time to grow before you start taking money out, and helps you achieve a higher level of potential after-tax income.
Issues to Consider in Withdrawal Sequencing
Now for two of the big exceptions that we mentioned earlier: estate considerations and Roth conversions.
If you’re planning on leaving money to others after you pass, you might consider leaving your taxable accounts alone (assuming that this is an option for you). If you have taxable investment accounts in your estate, their basis gets reset to the account value when you pass, meaning that all of the unrealized capital gains taxes that you owe in the portfolio go away, and the recipient(s) of the assets essentially start fresh. This is known as a “step up” in cost basis. This can be a pretty big deal, depending on how long you have owned everything in your account.
You may also want to consider Roth conversions as well. Roth conversions allow you to move money from a traditional IRA (which is a tax deferred account), pay the taxes on it, and move it into a Roth IRA (which is a tax exempt account). You could pay a lower tax rate on the amount you’re converting, and then have that money grow tax free in the future. This can be especially useful in a year where you will have an unusually low income amount. This can be a very powerful strategy when combined with your charitable giving strategy, especially if you are considering funding a donor advised fund.
A lot goes into optimizing retirement distribution order, but the basics are reasonably straightforward. As a first approximation, you want as much tax-advantaged growth as possible. This will allow you to spend more in retirement and leave more behind after you pass.
To find out more about investing in retirement, read our eBook 8 Tips to Becoming a Retirement Income Investor.