We routinely rail against rules of thumb, as demand for customization from boomer retirees renders them increasingly obsolete — and dangerous.
Two areas of financial planning in particular bring this to bear — the coordination of Social Security with the overall retirement portfolio, and the subsequent tax-efficient distribution of accumulated assets.
Conventional wisdom dictates that retirees withdraw assets from their taxable accounts first, their tax-deferred accounts (401ks) second and their tax-exempt accounts third.
The sequence is so ingrained it’s almost repeated as rote, and that’s a problem. Here’s why:
A large percentage of the taxable account is its basis, or a return of principal, and therefore not taxed. Consider a retiree who has yet to reach age 70½ and therefore has no required minimum distributions. He might be in a 10% or 15% tax bracket with his taxable accounts. But once RMDs begin, he’ll jump to 25%.
In early retirement years, he should withdraw funds from tax-deferred accounts to take full advantage of the 15% tax bracket. But it begs the question — why not withdraw from a taxable account since the majority of assets are tax-free anyway? Because he blows the opportunity to take from the tax-deferred account at a 15% (or lower rate). It’s better to pay 15% before 70½ than to take these withdrawals after 70½ and pay the higher 25%.
The correct sequence would therefore be to take tax-deferred income first up to the top of the 15% bracket and then taxable income second. After the taxable account is exhausted, he can take tax-deferred income first at the 15% bracket and then withdraw any additional needed funds from his tax-exempt account.