Get a Tax-Smart Plan for In-Retirement Withdrawals

Note: This article is part of Morningstar's February 2016 Tax Relief Week special report. A version of this article appeared Jan. 28, 2016.

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. In fact, it will often be a good idea to pull money from multiple account types during each year of retirement--tax-deferred (traditional IRA and 401(k)), Roth, and taxable accounts. 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. Tax diversification is also a worthwhile goal, as discussed in this article. The following sequence will make sense for many retirees.

1) If you're over age 70 1/2, your first stop for withdrawals are 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. However, taxable assets could also be valuable to tap in your later retirement years because you'll pay taxes on withdrawals at your capital gains rate, which is lower than your ordinary income tax rate.

3) Finally, tap company retirement-plan accounts and IRAs. Save Roth IRA assets for last.

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 one to two years and your most recent statements for all of your retirement accounts. Then, go through the following steps.

Step 1 Every retiree should have at least six months' to two years' worth of living expenses set aside in highly liquid (that is, checking, savings, money market, certificate of deposit) 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 those 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 one to two years.

If your taxable account doesn't cover one to two 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 one to two years' worth of living expenses. This article details the bucket approach to managing your income during retirement, and this one discusses bucket maintenance. This article shows a sample bucket portfolio using conventional mutual funds, while this one features a bucketed exchange-traded fund portfolio. This article shows how the bucket strategy would have worked on a year-by-year basis using the mutual fund bucket portfolio and a pure total-return strategy. This stress test, meanwhile, examines the performance of a simplified income-centric strategy, while this one examines a hybrid income/total-return approach.

Step 3 Next, determine a sequence of withdrawals for your longer-term assets, based on the aforementioned guidelines. Your longest-term, riskiest assets should generally go in your Roth IRA because you'll tap them last in the sequence. This article discusses the interplay between the bucket strategy and various account types.

Also Keep in Mind Sequence-of-withdrawal guidelines are just that--guidelines. There may be good reasons to use a different sequence than what's outlined above. For example, if you find yourself in a year in which you have a lot of taxable deductions, it may make sense to tap tax-deferred accounts (and pay ordinary income tax at a lower rate) rather than withdrawing from a taxable account. Alternatively, if you find yourself in a high tax year, you may want to tap Roth accounts and avoid taxes on distributions. This article discusses some situations in which it makes sense to flout traditional withdrawal-sequencing guidelines.

Also, bear in mind that 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.

Mark your calendars for the 2016 Morningstar Individual Investment Conference, taking place on April 2 at 9:00 a.m. CST. At this live-streamed event, we'll cover strategies to help you strengthen your investment plan, regardless of age or investing expertise. Register for free today.