Get a Tax-Smart Plan for In-Retirement Withdrawals

This article originally ran in February 2010. In case you missed it, we're running it again as part of Tax Relief Week.

Question: I'm preparing for retirement and trying to figure out where I should go for money to meet my income needs. I understand that it's important to start by withdrawing from some accounts and save other accounts for later. What's the right sequence?

Answer: There isn't a cookie-cutter answer to withdrawal sequencing because an investor's strategy will be determined by age and tax rate when taking the withdrawal. But a key focus when developing your withdrawal strategy should be preserving the tax-saving benefits of your tax-sheltered investments for as long as you possibly can.

As long as a retiree has both taxable and tax-advantaged assets like IRAs and company retirement plans, it's usually best to hold on to the accounts with the most generous tax treatment while spending down less tax-efficient assets. The following sequence will make sense for many retirees.

1. If you're over age 70 1/2, your withdrawals should come from those accounts that carry required minimum distributions, or RMDs, such as traditional IRAs and company retirement plans. (You'll pay penalties if you don't take these distributions on time.)

2. If you're not required to take RMDs or you've taken your RMDs and still need cash, turn to your taxable assets. Start by selling assets with the highest cost basis first and then move on to those assets where your cost basis is lower (and your tax hit is higher). Relative to tax-deferred or tax-free assets, these assets have the highest costs associated with them while you own them, so it makes sense to deplete those first.

3. Finally, tap company retirement plan accounts and IRAs.

The Logistics
The sequence in which you tap your accounts will help you determine how to position each pool of money. The money that you'll draw upon first--to fund living expenses in the first years of retirement--should be invested in highly liquid securities like certificates of deposit, money markets, and short-term bonds. The reason is pretty common-sensical: Doing so helps ensure that you're taking money from your most-stable pool of assets first, and therefore you won't have to withdraw from your higher-risk/higher-return accounts (for example, those that hold stocks or more-risky bonds) when your account is at a low ebb. That strategy also gives your stock assets, which have the potential for the highest long-term returns, more time to grow.

To put in place a system for tapping your retirement accounts, start with an estimate of your annual spending needs for the next three to five years

And your most recent statements for all of your retirement accounts. Then go through the following steps.

Step 1
Every retiree should have two to five years' worth of living expenses set aside in highly liquid (that is, checking, savings, money market, CD) investments at all times.

Once you've arrived at the amount of cash that you need to have on hand, determine if your RMDs will cover your income needs for the next two to five years (if you're older than 70 1/2). If you're not 70 1/2 and/or your RMDs won't cover your income needs, see if your taxable account will cover your income needs during the next two to five years.

If your taxable account doesn't cover two to five years' worth of living expenses, carve out any additional amount of living expenses from your IRA or company-retirement-plan assets using the sequence outlined above.

Step 2
Once you've set aside your cash position, put in place a plan to periodically refill your cash stake so that it always will cover two to five years' worth of living expenses.

Step 3
Next, determine a sequence of withdrawals for your longer-term assets, based on the guidelines provided above. The accounts you tap sooner should be in relatively more-liquid investments than those you tap later in retirement. Your longest-term, riskiest assets should go in your IRA or 401(k).

Also Keep in Mind
The preceding has focused primarily on retirees who are older than age 59 1/2, the age at which you can begin tapping retirement accounts without penalty. However, if you're between 55 and 59 1/2 and you left your employer after you turned age 55, you can tap your 401(k) without penalty. (You will pay taxes, however, as with all 401(k) distributions.)

And while taxable assets usually go in the "sell early" bin, that's not true if you have highly appreciated assets and plan to leave money to your heirs. If, for example, you own stock that has appreciated significantly since you bought it (and you have no way of offsetting that gain with a loss elsewhere in your portfolio) you may be better off leaving that position intact and passing it to your heirs. The reason is that your heirs will receive what's called a "step up" in their cost basis, meaning that they'll be taxed only on any appreciation in the security after you pass away. If you have a lot of highly appreciated securities in your portfolio (lucky you!), an accountant can help you sort through your options.

A version of this article appeared Jan. 25, 2011.  

Excerpted with permission of the publisher John Wiley & Sons, Inc. from 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances. Copyright (c) MMX by Morningstar Inc.

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