For each and every client who is retired or approaching retirement, a single key question will undoubtedly arise: how does the client determine the order in which to draw from the hard earned savings that he has accumulated during working years?
Proper sequencing of withdrawals from taxable accounts, tax-deferred accounts (IRAs and 401(k)s) and Roth accounts can make or break a client’s retirement income plan, making this one of the most important counseling points for any financial advisor. While every client’s circumstances will be unique, fortunately there are several key guiding principles that can be followed to ensure that each client withdraws funds in a manner that will maximize retirement income potential.
Withdrawal Strategies: Guiding Principles
Clients who have been well advised will typically find themselves holding a variety of savings vehicles as they approach retirement: tax-deferred and Roth accounts designed to take advantage of government sponsored tax-preferred growth and taxable accounts that may be geared toward ensuring liquidity or pursuing more aggressive earnings strategies. In all of these cases, upon retirement, the client will be forced to choose which sources to deplete first.
Absent extenuating circumstances or turbulent market behavior, the client should generally strive to preserve the benefits of tax-preferred accounts for as long as possible. If the client has already reached age 70½, he should obviously take his required minimum distributions (RMDs) from traditional retirement accounts first to avoid any penalties that might otherwise apply.
Often, the client’s taxable accounts will consist of assets that will be taxed at the lower capital gains rates, while funds withdrawn from a traditional retirement account will be taxed as ordinary income. This provides an incentive for clients to access these taxable accounts first, allowing the tax-deferred funds to continue to grow so that there is a larger pool to draw upon once taxable accounts are depleted.
Selling off assets with the highest cost basis first will result in a lower immediate tax liability, while it can be advisable to wait to sell assets with a low cost basis later in life when medical expenses can often be higher, thus producing larger tax deductions to offset the tax that a sale generates.
As a general rule, funds held in a Roth account should be drawn upon last, as they will be received tax-free, and therefore offer the potential for the highest rate of return if allowed to grow for an extended period of time.
Circumstances do exist in which a client who has not reached age 70½ and, therefore, is not yet required to take RMDs from traditional accounts might wish to tap those assets before taxable accounts.
For clients with high IRA balances, for example, withdrawing from the tax-preferred account early in retirement can reduce the amount of the RMD (and associated tax liability) in subsequent years. This strategy can avoid a situation where RMDs unexpectedly push the client into a higher tax bracket later in life.
Additionally, a client who holds highly appreciated taxable assets may wish to keep those assets if possible, instead leaving them to heirs in order to take advantage of the step-up in basis that the heirs will receive upon the client’s death, thus reducing the total eventual tax liability that the sale generates.
Further, a client who is pushed into an unusually low income tax bracket during any given year—perhaps because of high deductible medical expenses—may wish to withdraw from a tax-preferred traditional retirement account during that year. This will not only reduce the tax liability associated with the withdrawal but can also allow more aggressive taxable investments more time to grow, “saving” assets taxed at the lower capital gains rate for a year in which ordinary income tax rates are higher.
Savings withdrawal sequencing during retirement is an issue that will consistently be important for every client, and while these guiding principles can help the client maximize retirement income, it is also important that the client’s strategy is reviewed each year in order to determine whether extenuating circumstances require that the withdrawal strategy be changed.
Originally published on National Underwriter Advanced Markets. National Underwriter Advanced Markets is the premier resource for financial planners, wealth managers, and advanced markets professionals who provide clients with expert financial and retirement planning advice.
To find out more, visit http://info.nationalunderwriteradvancedmarkets.com. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.