Once an investor decides how much to take from a portfolio, next is determining from which account type to withdraw from first.
Most retirees have taxable accounts, tax-deferred (traditional employer plans and IRAs) accounts, and tax-free (Roth employer plans and IRAs) accounts. It is important to establish the proper sequence of withdrawals to improve the portfolio’s tax efficiency and longevity. The primary determinant of spending order is taxes. Absent taxes, and assuming the accounts earn the same rate of return, an investor would be indifferent as to the sequence of withdrawals because any order would produce the same results.
The General Guidelines
The general guideline is to first withdraw from accounts where required minimum distributions (RMDs) are mandated, next from taxable accounts, then tax-deferred accounts, and finally tax-free accounts. This spending order will most likely produce a lower current tax bill, allow for more tax-deferred growth, and enable investors to achieve higher account balances and greater portfolio longevity. The rationale is to allow tax-advantaged accounts to grow for as long as possible. However, a retiree may want to deviate from the sequence for several reasons, including their unique personal and financial circumstances, estate planning goals and current versus future tax rate expectations. First, let’s discuss the most common spending order.
RMDs (if applicable) are required by law and should be taken first from traditional IRAs for retirees over 701/2 years old or from traditional employer plans (e.g. 401k, 403b) at age 701/2 or retirement date, whichever is later.
After RMDs are satisfied, it is generally advantageous to spend taxable assets. Withdrawals from taxable accounts are taxed at favorable dividend and capital gains rates and only on the capital appreciation, not the entire withdrawal amount. This compares favorably to withdrawals from tax-deferred accounts, where the investor pays a higher tax rate on a greater amount of income. Taking withdrawals sooner than necessary from tax-deferred accounts accelerates income taxes and reduces tax-deferred growth. This can negatively impact the portfolio value and longevity.
Once the taxable portfolio has been depleted, look to tax-advantaged accounts where the decision to spend from tax-deferred or tax-free investments depends primarily on current versus future tax rate assumptions. If you expect future tax rates will be higher than current rates, it generally makes sense to spend from tax-deferred accounts first. Conversely, if you anticipate your future tax rate will be lower than your current one, you should spend from tax-free accounts first.
But hold your horses
While these guidelines may hold for many investors, others may choose to deviate from this sequence. An investor may want to accelerate distributions from tax-deferred accounts in years when they are in a lower tax bracket or when large deductions are expected. This enables them to lock in lower tax rates while simultaneously reducing future RMDs and the resulting taxes.
The decision about which account to spend first often has estate planning implications also. An older investor who owns highly appreciated stock with built-in capital gains may consider spending from tax-deferred accounts first, allowing them to pass on their taxable accounts to heirs who receive a step-up in basis and can avoid paying capital gains taxes.
There are other situations that warrant deviating from the “normal” order of withdrawals. Be aware that the analysis can get complicated. Do your homework first and then discuss it with a professional before making a decision.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.