Get a Tax-Smart Plan for In-Retirement Withdrawals

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. That underscores the argument for accumulating assets for retirement in those three account types, too.

But an overarching principle to bear in mind 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 older than age 73, 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 a stiff penalty, equivalent to half of the amount you should have taken but didn’t, 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. If your taxable assets are generating investment income, you may as well spend that money, because the taxes are the same whether you reinvest the income distributions or spend them. If you need additional spending, 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, taxable assets have the highest costs associated with them while you own them. However, the decision about when to sell taxable assets isn’t always clear-cut. For one thing, taxable assets could also be valuable to tap in higher-tax retirement years because you’ll pay taxes on withdrawals at your capital gains rate, which is lower than your ordinary income tax rate—and 0% for taxpayers in the lowest tax bracket. In addition, if your taxable assets are sizable and you leave them to your heirs, they’ll avoid capital gains tax altogether.

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

The Logistics of Withdrawal Sequencing

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 portfolio withdrawals (cash flow needs not being supplied by Social Security, a pension, or some other nonportfolio source) set aside in highly liquid investments at all times. That means checking, savings, money market, certificate of deposit, and so on. Yields will ebb and flow, but the main goal of this money is to provide for your cash flow needs (through selling these liquid securities) if stocks and/or bonds encounter turbulence.

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 73). If you’re not 73 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. The bucket approach to retirement portfolio management includes a cash component to provide for ongoing cash needs and segments the rest of the portfolio by anticipated spending horizon, too. I’ve provided some model Bucket portfolios for retirees’ varying risk capacities, account types, and different investment platforms (Fidelity, Vanguard, and so on) Unfortunately, the buckets can’t be set and forgotten about: The key to making a Bucket portfolio work is to maintain the buckets on an ongoing basis.

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. Bucketing gets a bit more complicated when you’re juggling multiple account types, as most retirees inevitably are.

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. In other words, don’t be dogmatic about spending your assets in the traditional sequence if doing so could lead to a higher tax bill or doesn’t make sense for some other reason.

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 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 necessarily true if you have highly appreciated assets. If, for example, you own stock or a mutual fund 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 or donating it directly to charity or to a donor-advised fund. If your heirs inherit appreciated assets from you, they 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 die. Meanwhile, appreciated assets that you donate to charity—either during your lifetime or after your death—won’t trigger a tax bill for you or for the charity. If you have a lot of highly appreciated securities in your portfolio, an accountant can help you sort through your options and understand proposed changes that could affect the tax treatment of appreciated assets in the future.