How Tax-Efficient Withdrawals Can Enhance Retirement Income

Dr. William Reichenstein, emeritus professor of finance at Baylor University and head of research for Social Security Solutions and Retiree, Inc., joins The Long View this week to talk retirement withdrawals, tax planning, and how to make the most of retirement income. Here are a few excerpts from Dr. Reichenstein's conversation with Morningstar's Christine Benz and Jeff Ptak:

How Do Taxes Play a Part in Your Retirement Investing?

Benz: Do you think people often focus too much on withdrawal rates and how their investments are positioned and perhaps not enough on how taxes fit in? Reichenstein: Yeah. Well, yeah. So, obviously, what you want to do is you want to maximize – you've got financial resources in retirement, whether that's Social Security or your financial portfolio, but you're wondering, how much of that can you spend during your retirement while spending requires after-tax dollars. And as it turns out, there's a major difference in the amount though. Well, we'll get to a simple example. Even if you live in a tax-free state, you can have a marginal tax rate for moderate income individuals of 46.25% on a wide range of income. And that's – to the degree you can avoid that and pay instead of – when I say tax deferred account, think of a 401(k) or a traditional IRA. If you take money out of that instead of paying 46.25% marginal tax rate, let's pay, say, 22% or less, that will give you a whole lot more of your financial resources that you get to spend instead of the government.

Social Security and Sequencing Withdrawals

Ptak: It's a good segue to the next question that we had which is on a key theme of yours which is that de-accumulation and the sequencing of withdrawals from various accounts with different tax characteristics should go hand-in-hand with Social Security filing. Can you discuss that in general terms? Reichenstein: Okay. Yes. And I'll right now talk about a moderate income, moderate wealth client, which we'll call $2 million or less of financial assets. Here's what typically is a good strategy for somebody like that. And we'll talk a little bit later about higher income individuals and strategy for them, if you wish for myself and my wife. But for this moderate wealth couple, we encourage to delay Social Security benefits until 70. In those years before Social Security begins, you're going to have a marginal tax rate as the same as your tax bracket. Well, the conventional wisdom is, let's take money out of your taxable account first, and then out of your tax deferred account, the 401(k)s, those next. And if you have any Roth, and a lot of people don't, take that out last. Well, here's the trouble with that strategy. Well, if you're taking money out of your taxable account, you're going to be – that's usually tax-free withdrawals of principal largely. And so, you might be in a 0% tax bracket. Your adjusted gross income isn't even equal to your standard deduction. If not, you're in a low tax bracket. Don't waste the opportunity to take some of those tax deferred accounts and fill up those low tax brackets. The best way to do that, in that case, is a Roth conversion. Here's what happens. So, in those early years, let's say, you're filling up the 0%, 10%, 12%, and 22% tax bracket. Now, let's go to a few years later, you've started Social Security. And by the way, by then, you're probably in 2026 or later. So, we have those higher tax rates that are already scheduled to come back. That's the current law. And so, what happens is, you might be taking your money out of a tax deferred account, say, up to the top of the 15% bracket. Well, think about if you had to take out additional money, call on another $1,000, it would cause another $850 of Social Security benefits to be taxed. So, your taxable income goes up by $1,850. 25% of $1,850 is $462.50. Again, your marginal tax rate is 46.25%. Every dollar of income causes taxable income to go up by $1.85, because another $0.85 of Social Security is taxed. And 25% of $1.85 is $0.465. So, what happened is that you're saying, hey, in those early years, we made Roth conversions to fill, say, the 10%, the 12%, and the 22% tax bracket. Those were also the marginal tax rates. And what did we do? We avoided this 46.25% marginal tax rate on additional income during most of your retirement years. Well, you can do a whole lot better and add a lot of value by taking those tax deferred account dollars, making the Roth conversions now at much lower tax rates than those marginal tax rates. And why are the marginal tax rates higher later? Well, first of all, we're going from today's tax brackets to the higher ones. But more important, when Social Security begins, you're going to have a wide range of that income for these moderate wealth clients, say, 2 million and less, where they're going to pay a marginal tax rate of 185% of their tax bracket. We want to avoid that. How do you do it? Get those Roth account balances in those early years, and we use those as ammunition. You can withdraw those later, you're avoiding what – taking tax deferred account – so, you take $1,000 out of the Roth, and hey, that saves you what, from half and to take out a lot of money from the tax deferred account that would have been taxed at 46.25%. And of course, Roth withdrawals are tax-free. So, that's a good way to try to manage your retirement accounts there.

Should You Save Roth for Last?

Benz: You've talked about accelerating withdrawals from tax deferred accounts and how that can make sense in many situations. So, I guess, the question is, how did we end up with this conventional wisdom that it makes sense to start with taxable accounts, move on to tax deferred accounts, and then save Roth for last? Where did that conventional wisdom come from? Reichenstein: Well, it's – yeah, here's what happens. That's the conventional wisdom, and it's in a lot of your financial software out there is the default. But here's what happens. Let's say – let's just take year. Somebody who newly retired, and let's say, they haven't started – so, it doesn't matter – they're going to take money out of their taxable account. And remember, withdrawals from the taxable account are usually tax-free withdrawals of principal. They may be in a 0% tax bracket, or at least a low tax bracket this year. When I say a 0%, their adjusted gross income may not even be their standard deduction. And then, what happens after the taxable account is exhausted after, say, three or four years? Now, they've got most of their money in tax deferred accounts. And in the rest of the retirement, they're going to be in a lot higher tax bracket, because they've taken out all these pre-tax withdrawals from tax deferred accounts. Hey, instead of that, what's happening, you know, the marginal tax rate on a bunch of that's 46.25%. Instead, let's make the Roth conversions now. We want to fill up those low tax brackets, say the 0%, the 10%, the 12%, and perhaps the 22% with Roth conversions. That gives you that Roth account balance, it's that ammunition that later in retirement – so, let's say, 2026 and on, you take out enough from the tax deferred account to fill the 15% tax bracket. Think about if you had to take out more money, what would happen? You're already at the top of the 15% tax bracket to be taxed at the 25%. But each dollar of tax deferred account withdrawal causes another $0.85 in Social Security to be taxed. So, your marginal tax rate is 185% of the 25% tax brackets, so it's 46.25%. You're going, hey, that strategy, it sounds good, let's save taxes early. But no, you know, in your early years, you're in a 0% tax bracket unless you make those Roth conversions to fill those low tax brackets. In the middle years, and all those years, you're in a much higher tax bracket. By the way, for somebody who does have Roth balances, if you take those out last, what are you doing? And again, your adjusted gross income is going to be zero in those years. You want to fill in the lower tax brackets and avoid those really high tax brackets in those middle years when you're taking out of tax deferred accounts. And for most retirees, that's most of their retirement years, and most of their retirement balances are in those. So, the idea – almost never does the conventional wisdom come anywhere close to being an optimal strategy. Just think about – I mean, early years, you're in a 0% or maybe a 10% tax bracket. In the middle years, you're going to be in this 25% with a marginal tax rate of 46.25%. That doesn't make sense. Just go fill those lower tax brackets with, in this case, whether it's conventional tax deferred account withdrawals or Roth conversions. We recommend the Roth conversions.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.