Which Account Should You Tap First in Retirement?

On this episode of The Long View, Roger Young, a thought leadership director at T. Rowe Price, discusses how to sequence withdrawals in retirement, 401(k) and IRAs, how to deal with required minimum distributions, and nonfinancial planning for retirement.

Here are a few excerpts from Young’s conversation with Morningstar’s Christine Benz and Amy Arnott:

Amy Arnott: You’ve also written about the topic of how to sequence withdrawals in retirement, whether you should tap into your taxable accounts first or tax-deferred or Roth assets. Can you share some guidance on how people should approach that issue?

Roger Young: It’s not easy, I will tell you that. I’ve done a good amount of work on it. And in addition to the work I’ve done, I’ll call out our new colleagues at T. Rowe Price. Last year, we acquired a company called Retiree, Inc., and that company has developed software to help people with the withdrawal strategy, as well as the Social Security-claiming decision, so looking at those in combination. One of the things that I really like about their approach—and I advocated us talking to them—is they recognize how the tactics you choose can optimally change over the course of retirement. You might do different sequences or strategies at different phases.

As an example, early in retirement, your income that is locked in place might be somewhat low. So, you might want to fill up low tax brackets with income from a tax-deferred account like a traditional IRA or 401(k). You might even do Roth conversions, moving money from an IRA to a Roth IRA. Then the approach might change. When you start getting Social Security, now you have a certain level of income, you have to worry about the taxes on Social Security, which are a whole other weird topic. And then later, required minimum distributions take effect. And that dramatically affects what your income looks like in retirement.

There are lots of techniques that can be used in these different phases. One technique is holding on to appreciated investments late in your life so that your beneficiaries get the step up in basis. In that case, they wouldn’t be paying capital gains taxes on the appreciation during your lifetime. On the flip side, you might have a strategy that involves selling taxable investments when your income is fairly low, and you don’t face capital gains taxes because your income is lower. So, there are a lot of techniques, and there are a tremendous number of combinations of those techniques and the phases of retirement. And there are also things like differences in ages between spouses and potential changes in the tax law. There are so many combinations, it’s very hard to convey broad guidance—everyone should use this particular approach—and that’s why we think software to help crunch those numbers can be so beneficial. But we have outlined some of those key strategies to consider, and we think that people will benefit if they work with us and use that software to develop a customized plan.

Should Retirees Take Their Money Out of a 401(k) and Roll It Into an IRA?

Christine Benz: One logistical question that comes up right when people retire is whether they should take their money out of the 401(k) context, out of the company retirement plan context, and roll it into an IRA. Can you talk about when it might make sense to stay back in the 401(k) and whether the rollover is usually advisable?

Young: There are a number of different factors to consider in that decision. I wouldn’t say that it’s a slam dunk one way or the other. My colleague Judith Ward and I worked with some of our colleagues in the Retirement Plan Services group and wrote an article specifically about this decision. I think we took a fairly evenhanded approach, especially since we’re coming from two parts of the businesses with different interests there.

Broadly speaking, an IRA gives you more investment choices. It typically also gives you more control over how you take distributions. There are bound to be some rules and limitations with a 401(k), and it could be that you have to take things out at certain frequencies limit the on-demand, or require things like pro rata distributions by type of account or by investment. So, you have a lot more freedom typically with an IRA. On the flip side, with a 401(k) at a large organization, your investment fees might be lower. There might be some other reasons to keep money there. So, it depends on your situation. It depends on the specifics of your workplace plan. And your personal preferences play a role, too.

I found some people like the simple approach of staying in a plan that’s worked for them. Our research and surveys over the years have shown that people find they get a lot of their financial education and guidance from their plan sponsor or the company that manages their 401(k). So, there are reasons people might like that. On the other hand, other people just can’t wait to cut every possible tie with their former employer. So, very, very different views. The good news is either approach can work out OK. And it’s not necessarily a one-time decision. If you don’t do a rollover right away, you can change your mind later. So, I’d say there are a lot of facets to that question.

Required Minimum Distributions

Arnott: We often hear complaints from retirees who have been able to build up a lot of retirement assets about required minimum distributions. They hate the tax impact; they feel like they don’t need the money necessarily to support their living expenses. Is there anything they can do about them?

Young: Well, one good thing is that the government has helped do something about RMDs with the Secure Act, delaying them now to age 73 instead of 70.5. So, there’s some recognition that people are living longer and stretching out those distributions and delaying them is a good thing for people.

Three more specific ideas come to mind that people can do. One I mentioned earlier is you might want to draw down some of those assets that are subject to RMDs early in retirement. Conventional wisdom would tell people to take money out of their taxable account first, and then tax-deferred, and then Roth. Well, you might want to switch that up a bit and take some of that tax-deferred money out first, and that will reduce your future RMDs. If you’re charitably inclined, the second idea is to use qualified charitable distributions. QCDs can support causes you like and also satisfy your RMD up to IRS limits. And third, you can use up to $200,000 of your retirement account money to buy a qualified longevity annuity contract—another acronym here, QLAC—and that may or may not be available to you at this point, but it’s allowable under the law. With a QLAC, that money is not subject to RMDs until you start actually getting the annuity payments out of it. You have to start those payments by age 85, but that’s significantly later than the age of 73 when RMDs start. So, you delay the RMDs, you don’t completely get rid of them, but it could help you manage your income over time a little bit better if you do a QLAC, and that obviously helps you to also prevent or protect against the possibility of a really long life that strains your finances as you get very old.