Society of Certified Senior Advisors: What Is Really the Best Way to Draw Down Retirement Funds?

Taxes may be your biggest expense in retirement. A surprising twist on the usual withdrawal strategy may help you save thousands of dollars.

Nobody wants to give more of their retirement fund to Uncle Sam than they need to. But while taxes are a given, how much you will pay is not. Every dollar of taxes saved is another dollar that you can spend or keep in your nest egg to grow until you need it.

Hidden Benefit of a Taxable Brokerage Account

If you have invested funds in a taxable brokerage account that lose money, you can sell them at a loss to reduce your taxes. This strategy, called tax-loss harvesting, allows you to reduce capital gains and apply up to $3,000 against ordinary income in the year of the loss.

Roth Conversions

Because gains in tax-deferred accounts will eventually be taxed at higher ordinary income rates instead of lower capital gains rates, it may make sense to take advantage of Roth conversions. A conversion takes money (or assets) in an existing IRA or 401(k), and places it in a Roth IRA. You are required to pay ordinary income tax on converted funds or assets in the year the conversion occurs, but then they can grow tax-free in the Roth and be tax-free upon withdrawal.

You do not have to have earned income in order to convert from an IRA to a Roth. Another benefit is that a lower account balance in your traditional IRA will reduce RMDs once you turn 72 since there is no withdrawal requirement for Roth funds. Converting funds may be particularly attractive to individuals with large balances in IRA accounts. Also, Roth IRAs pass untaxed to heirs, while new rules require that traditional IRAs must be distributed to non-spouse heirs over a period of no more than 10 years, potentially incurring taxes when heirs are in a high tax bracket.

However, putting money in a Roth requires you to pay ordinary income taxes up front, which reduces the amount that can compound and grow. This analysis is best done with a financial advisor’s help. To get a very rough idea if a conversion would benefit you, look at Schwab’s online Roth conversion calculator.

No one can predict how tax laws may change over the course of retirement. However, it’s important to work with a tax professional to plan as you go along and strategize as rates change. The rise of 401(k) plans (vs. pensions) has left many baby boomers with an oversize tax-deferred account, and smaller taxable and Roth savings.

These three types of accounts receive different tax treatment, offering investors different options to reduce taxes. Traditional IRA and 401(k) withdrawals are taxed as ordinary income, taxable brokerage account withdrawals after sale of most investments incur capital gains, and Roth IRAs get special treatment. Since you paid tax on Roth deposits when you funded the account, you can make withdrawals tax free once you turn 59 1/2 and the account has been open at least five years. There are no required minimum distributions on a Roth like there are for a traditional IRA, when you must take out a prescribed percentage beginning at age 72.

The Right Investments in the Right Accounts

First, let’s look at what assets are appropriate for the different accounts.

Stocks in a taxable account will be taxed at a lower rate than those in an IRA. Stock appreciation and qualified dividends (which does not include dividends from REITs) in a taxable account are taxed at lower capital gains rates, rather than as ordinary income.
Charitable donations can be made “in-kind” from a taxable account to a nonprofit. This means you can gift stocks directly, receiving tax benefits twice: once for the entire amount of the charitable gift, and again for the capital appreciation the asset has accrued. This is not true of stock held in an IRA. However, you can donate up to $100,000 from an IRA directly to a qualified charity after age 72 and lower your required minimum distribution, and taxes, which are not paid on the donation.
Currently, stocks in a taxable account receive a step-up in basis upon the death of the investor. In effect, the capital appreciation disappears without being taxed. Stock held in an IRA does not get a stepped-up basis, and the account is taxed at ordinary income rates.
Buying bonds for your IRA will likely lower future required minimum distributions because they tend to grow slower than stocks. (However, municipal bonds belong in your taxable account since they are already tax free.)
Bonds held in an IRA enjoy tax-deferred interest, which makes it a better place to hold bonds; the interest is taxed at ordinary income rates regardless of whether it is in an IRA or taxable account.

Withdrawing Funds

Unfortunately, there is no one-size-fits-all plan for taking out money in retirement. Everyone has a different risk appetite, and no two retirees have the same percentage of funds in their retirement accounts. People retire at different ages, and can spend vastly different amounts of time in the retirement phase of life. Add on to that Social Security or pension income (or perhaps an annuity or insurance instrument) and the potential for changes in tax law, and it can seem impossible to plan properly.

However, it is possible to make some general recommendations knowing that you will need to reassess every year or so depending on how your investments are doing and what is happening on Capital Hill. Traditional theory has retirees withdrawing first from their taxable account, then their tax-deferred IRA, and last from the tax-free Roth. The thought is that this will allow tax-deferred assets to grow longer, and tax-free accounts can keep on increasing the longest of all. Makes sense, right?

However, it’s possible that withdrawing funds from all three accounts proportionally every year may lower your tax bill. If your RMD is less than what you will withdraw, this strategy can beat the conventional wisdom. Using a traditional strategy results in a tax bump over the years when only the tax-deferred account, which is taxed at ordinary income rates, is drawn down. Let’s look at a hypothetical retiree to compare the two strategies.

Joe is 62 and single, with $200,000 in taxable accounts, $250,000 in a 401(k) and IRA, and $50,000 in a Roth IRA. He had a good job, and gets $25,000 every year from Social Security. He wants to get $60,000 after taxes in retirement. We will assume a 5% annual return on investments.

With a traditional withdrawal approach, Joe will take money from one account at a time, starting with his taxable account and ending with the Roth. His savings will last a little more than 22 years, and his total tax bill will be $70,000.

But what if he takes out proportional withdrawals instead? He will access all three accounts every year, and withdraw funds in proportionally equal amounts. His tax burden becomes spread out equally over his retirement, resulting in a total tax bill of $43,000. That $27,000 savings stretches his retirement funds an extra year.

For more details on this strategy, go to Fidelity Investments.

Capital Gains

If you have capital gains in a taxable account, it can be beneficial to take them in years when your income is low. For many, this can be the time frame between retirement and the start of required minimum distributions. For instance, a married couple with up to $80,000 of income will owe nothing on long-term capital gains, although ordinary income tax on that amount is 12%. However, be aware that the long-term capital gains count as income for the year in which they are taken.

Making withdrawals from retirement accounts may be as much an art as it is a science. So many variables change over the years as different investments fare better than others, tax laws change for better or for worse, and the financial needs of individuals change. A tax advisor or other investment professional can help guide retirees through these obstacles to ensure the best use of their precious nest egg.