How to Spend From Your Portfolio Tax-Efficiently in Retirement

Spending from a portfolio in retirement can get complicated quickly. In addition to structuring investments to support cash flows and calibrating a safe spending rate, retirees also have to consider the tax implications of their spending decisions. In this excerpt from my new book, How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement, I asked author and tax and Social Security specialist Mike Piper to discuss tax-efficient withdrawal sequencing as well as considerations when converting tax-deferred accounts to Roth.

Christine Benz: Let’s talk about the tax implications of pulling money out in retirement. In many households the early retirement years are low tax years. Can you talk about why that is?

Mike Piper: It’s that the work income has gone away, Social Security hasn’t started yet, and RMDs haven’t started yet. The only automatic income that you’re likely to have coming in, unless you have a defined benefit pension, is often just going to be whatever interest or dividends you have from your taxable holdings. Aside from any amounts that you take out of tax-deferred accounts, your income is generally pretty low in those years.

Christine: Okay, so if I’m just embarking on retirement and I need spending money, how do I figure out which accounts to tap first? What makes the most sense from a tax perspective?

Mike: In tax planning, you almost always have to say, “it depends.” But not in this case. The first dollars to spend in retirement every year are your checking account dollars: everything in the checking account, as well as everything that automatically comes into the checking account. That might be interest from your taxable holdings, dividends from taxable holdings, earned income (if you still have any), required minimum distributions, Social Security, pension income, all of those things.

We want to spend those dollars first because spending them doesn’t create any additional tax cost. And because they’re taxable account dollars, they’re not very tax efficient to invest.

When we’re spending from checking account dollars, that doesn’t create taxable income. That’s the whole idea. So sometimes that does leave you with a low taxable income for the year. The best way to take advantage of that is by doing Roth conversions.

Christine: Okay, so put checking account dollars at the top of the queue. Assuming I need additional funds for living expenses, where should I turn next?

Mike: After the checking account, the next dollars to access are taxable dollars where you have an unrealized loss on an investment. There’s no tax cost to sell the position.

After that, it gets tricky because we’ve got three choices. We could spend from tax-deferred accounts, spend from Roth, or spend taxable dollars where there’s going to be a taxable gain.

The question of Roth versus tax-deferred depends on current tax rate versus future tax rate. That seems straightforward, but there are several “gotcha” provisions that could cause your tax rate to be different than your tax bracket.

The other thing to remember is that the future tax rate might not be what you’re expecting it to be, for a few reasons. The first one is that if we’re talking about a married couple, there will often be some years where only one of them is still alive. That’s important because it means that the surviving spouse only has half as much space in each tax bracket and half the standard deduction that a married couple filing jointly has, but they’ll generally have more than half as much income, because the portfolio is still there, doing what it does, and so on. That usually means they are going to have a higher tax rate during those years.

Another point about that future tax rate is that when we’re doing this “pay tax now versus pay tax later” assessment, it could be somebody else’s tax rate. It could be your heirs’ tax rate if they inherit traditional IRA assets from you. That tax rate is usually going to be high, because any beneficiary other than your spouse is generally going to have to distribute the account over ten years. So they’ll owe taxes on whatever tax-deferred balance there is over just ten years, plus on whatever earnings they have. Statistically speaking, this inheritance is likely to occur during their peak earning years. So it’s often going to be a pretty high tax rate.

Christine: So figuring out whether to spend traditional tax-deferred assets or Roth assets isn’t simple because of all of these additional considerations. What about the third option, spending taxable assets where you have a gain and will owe taxes when you sell?

Mike: When deciding whether it makes sense to sell assets from a taxable account to satisfy spending needs, the main things to consider are the amount of capital gain you will realize by doing so, as well as whether the gain will be long term or short term. If it’s short term, you probably don’t want to sell those assets. Leave them alone until it would be a long-term capital gain.

Assuming you do stand to realize a long-term gain, how big is the gain relative to the current value of the asset? If it’s only gone up a few percent since you bought it, that’s a pretty modest gain. You can sell it and the tax cost isn’t going to be that much. It’s almost like checking account dollars. You’ll lose a little bit to taxes, but it’s not a big deal.

If a position has gone way up, the decision is harder to make. Such assets can be valuable for heirs or charity to inherit, because they can completely avoid tax on appreciated taxable assets.

So the question is, is there a good chance that you would give away these assets later? If so, then you probably shouldn’t sell them. You should probably go ahead and spend retirement account dollars instead.

Christine: Earlier you mentioned that the early retirement years are often low tax years, and that seems like it should be a good time to convert traditional IRA balances to Roth because you might owe less in taxes. How should people decide whether to convert and how much to convert?

Mike: There are a few things going on with Roth conversions.

The first one gets all the discussion because it’s easy to understand and it’s the only one that’s always going to apply. When you convert, you are paying tax now, at whatever current tax rate would occur on your conversion, instead of paying tax later. That can be good, or it can be bad. It depends on the current tax rate and the future tax rate, and that’s more complicated than it might seem. It’s definitely a case-by-case thing, because it depends largely on how many of those “gotcha” provisions apply to you. If you have kids who are in college, for instance, a conversion might not be advisable. That’s because the American Opportunity Tax Credit phases out if your income is over certain levels, and it phases out over a relatively short window. Before doing conversions, ask how many things like this apply to you, and what is that actual tax rate going to be? You have to remember all of those various caveats and complicating factors. A conversion can be good or bad.

The second thing that happens when you do a Roth conversion is that you have to pay taxes. If you have taxable account dollars to use to pay the tax on the conversion, that’s a good thing by definition. That’s money that would have grown at a slower rate because you have to pay tax on interest and so on.

The third thing that happens when you do a Roth conversion relates to required minimum distributions. If you’re in a household that is not going to have to spend your entire RMD every year, then you can reinvest some of that money outside of a retirement account.

And by virtue of being in a taxable account going forward, that money would incur a tax cost every year for the rest of your life, potentially. How impactful that is depends on your life expectancy: what kind of health you’re in and how old you are right now. A good thing that happens if you’re doing a Roth conversion is you’re shrinking the RMD. You basically have money staying in a Roth account rather than in a taxable account where it’ll incur tax drag.

The fourth thing applies to fewer people. You’re shrinking the total number of dollars when you do a conversion and pay the taxes due, and that is relevant from an estate tax point of view. Of course, federal estate tax applies to a very small percentage of people these days. But there are a number of states that have estate taxes, and they often have much lower thresholds. So given the choice between $100,000 in a traditional IRA or $80,000 in a Roth IRA, $80,000 is less than $100,000, which means a smaller gross estate. The estate taxes don’t care whether it’s Roth or traditional.

Excerpted with permission of the publisher Harriman House Ltd. from How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement by Christine Benz. Copyright (c) MMXXIV Morningstar, Inc.