A Tax-Efficient Hierarchy of Retirement Spending

This video has been corrected to reflect that heirs must take RMDs from inherited Roth IRAs.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many retirees are rightly concerned with how much to draw from their portfolios, but how to draw from their portfolios is also important. I recently sat down with Colleen Jaconetti, a senior investment strategist at Vanguard, to discuss some research on that topic.

Colleen, thank you so much for being here.

Colleen Jaconetti: Thank you for having me.

Benz: You put together with some co-authors a great research paper that brings together a lot of Vanguard's research on retirement planning, and I want to focus on one aspect of that paper. There were a lot of different pieces to it. But I want to focus specifically on this idea of tax-efficient withdrawals sequencing.

So the basic idea is that people typically might bring different types of accounts into retirement. They might have the traditional tax-deferred IRAs and 401(k)s; they might have Roth IRAs or 401(k)s; and they might have taxable assets. Those are sort of the three key categories. So, in the paper you talked about tax-efficiently drawing down those portfolios, deciding where to go first for money in retirement and deciding which accounts to save for last. So, let's discuss the general sequence that you think retirees can think about when deciding which accounts to pull from.

Jaconetti: Great. So, for retirees who are really looking to maximize the amount of spending during their lifetime, they should really start with required minimum distributions. So, for people who are over 70 1/2 years old, who have assets in tax-deferred accounts, they should spend their required minimum distributions first.

Benz: So, let's talk about the thinking behind prioritizing those. If you don't take the money out, you pay a big penalty. Is that why they have to go first in the queue?

Jaconetti: Yes. And it's required by law, and the penalty is 50% of the withdrawal amount. So, if your withdrawal was $50,000, the penalty for not taking that out would be $25,000. So that is definitely why we would put them first as far as spending would go.

Benz: OK. Then what's next in the queue?

Jaconetti: So, next would be the cash flows on assets held in taxable accounts. So any interest, dividends, or capital gains distributions on assets held in taxable accounts is next. And really that's because those assets are taxed to investors whether they are spent or reinvesting. So, if someone reinvests them but then has to sell them in the next three, six, or nine months to meet their expenses, they could actually incur a short-term capital gains which are taxed at ordinary income-tax rates.

Benz: So, a question there though, Colleen is, if I have been schooled in the topic of asset location, I typically don't have a lot of income-producers within my taxable account, right? I've been told to kind of keep those out and focus mainly on capital gains generating securities. Is that correct?

Jaconetti: Definitely. So, for asset-location purposes that tries to minimize the annual taxes on the portfolio, so we would absolutely try to, say, put the most tax-efficient assets out there. So, if you have limited amount of those, that's great because then that tax issue would pay as well.

Benz: OK. So, any income and interest distributions on my taxable accounts, those would go next in the queue after RMDs. What would come next beyond those organically occurring income distributions?

Jaconetti: Right. So then we'd say, start looking at your taxable portfolio in a manner to minimize the amount of taxes. So maybe sell assets at a loss, assets at no gain or loss, and then finally, assets at gains. So, the goal here is really to minimize the taxes because every dollar someone pays in taxes is less they have to spend.

Benz: OK. So, let's just quickly outline the tax treatment of investments held within taxable accounts. What sort of taxes will you pay on those withdrawals?

Jaconetti: So, for interest, so interest on equities, you would hopefully pay qualified dividend interest tax, so that's as much as 20%. On capital gains, you would pay capital gains taxes, so that's the amount of appreciation you have, you would pay 15% to 20% depending on your tax rate. And then on bond income, if it's taxable bond income, you pay ordinary income tax rates which are higher than the QDI rate or the capital gains tax rate.

Benz: OK. So, I have municipal bonds though, I get a little better tax treatment within my taxable account?

Jaconetti: Exactly. So, if someone is in a high margin on tax bracket holding municipal bonds in their taxable account would be preferred over taxable bonds because their income is tax free.

Benz: OK. So, I have cycled through my RMDs, my taxable accounts, what would be next in the distribution queue?

Jaconetti: Right. So, now we are looking at your tax-advantaged accounts. So your tax-deferred accounts, so like you said, the 401(k) or traditional IRA, or your tax-free accounts, the Roth accounts. So, the decision of which one of those to spend from really comes down to your expectation of your current tax rate versus your future tax rate. And the goal here is to really spend from your tax-deferred accounts when your tax rate will be the lowest. So, if you're starting retirement, you still have part-time income or something like that, you may want to spend it from your tax-free accounts then if your income is higher with this part-time income, knowing that that will go away eventually and then later spend from your tax-deferred accounts when tax rates are the lowest.

Conversely, if someone is in the, who thinks their tax rate now is lower and especially given at 70 1/2 they will be starting RMDs, if they think the tax rate is lower today, they might want to start spending from their tax-deferred account today, reduce future RMDs, and then in the future, spend from their tax-free accounts.

Benz: I've talked to your colleague Maria Bruno about this. She calls it retirement sweet spot--that those pre-RMD, postretirement years can actually give a retiree quite a bit of latitude to make decisions maybe expedite withdrawals from those tax-deferred accounts to try to reduce RMDs.

Jaconetti: Absolutely. So, it just really helps to manage the annual tax bill. So, if you can reduce your RMDs through three, five, or seven years prior to 70 1/2, in that way, you could actually have lower taxes now and then later on you will pay lower taxes on those RMDs as well.

Benz: So Roth accounts in your distribution queue generally would be the last thing that a retiree would tap unless for whatever reason they are in a higher-income tax bracket than they expect to be later on. So, let's talk about the logic there. Let's talk about the tax treatment of Roth assets.

Jaconetti: Right. So, Roth assets would be generally tax-free if you're over the age requirements, right? So, withdrawals from there would be tax-free because you pay taxes on those contributions before you made them. They are also a great asset to pass on for estate-planning purposes. So, your heirs will get those assets tax-free as well.

Benz: OK. So those are the general rules of thumb. People who have followed this issue might be up to speed on them. But let's talk about some exceptions, when it might make sense to kind of flout these rules of thumb and maybe pull spending from one of these accounts that you say to actually put later in the queue.

Jaconetti: Right. So, one exception could be, if your goal is not to maximize spending during your lifetime, maybe it's to maximize the amount of money you give to your heirs. And if you are in a lower tax bracket than your heirs, you may actually want to take out from your tax-deferred account earlier. So, for tax-deferred accounts, when you pass them on to your heirs, they pay income tax because you didn't pay income tax one them. They are also included in your estate. So, if you could actually remove those assets from the estate, you would avoid estate tax and then paying at your income tax rate rather than your heir's income tax rate which could be higher.

Benz: OK. Taxable assets, is there ever a reason that they shouldn't be sort of toward the front of the queue? Any reason why if I have certain types of assets in a taxable account that I may actually want to hold off on those?

Jaconetti: Well, if you have a taxable asset or say, maybe an individual stock with a very large embedded gain, right, and if you're in poor health, that could be one time where you actually wanted to maybe not spend from that asset because you would get a step-up upon your death.

Benz: So, your heirs would get that step-up in cost basis when you pass away.

Jaconetti: Exactly.

Benz: OK. Colleen, a lot to take in here, but thank you so much for being here to share this hierarchy of retirement spending.

Jaconetti: Happy to. Enjoyed it. Thank you.