How much a retiree withdraws from retirement funds will certainly impact how long those funds last. With that in mind it’s important for retirees and their advisors to adopt a tax-efficient plan for withdrawals.
“Implementing an informed withdrawal-order strategy can minimize the total taxes paid over the course of one’s retirement, thereby potentially increasing both the amount of spending the portfolio can support and the portfolio’s longevity,” according to a recent Vanguard report on goals-based retirement spending.
Colleen Jaconetti, senior investment strategist at Vanguard, recently laid out the most tax-efficient way to sequence withdrawals in retirement in a discussion with Morningstar’s director of personal finance, Christine Benz.
1. Start With Required Minimum Distributions
This first step is in some ways the most important because anyone over 70 and a half years old with assets in a tax-deferred retirement account must take a required minimum distribution (RMD) or face a 50% penalty on that withdrawal. That’s equivalent to paying a 50% tax on that amount.
2. Consider Taxable Accounts
Any interest, dividend or capital gains distributions of assets held in taxable accounts are taxed, whether they’re spent or reinvested. If they’re reinvested and then withdrawn after being held for one year or less they will be taxed at one’s income tax rate, not the lower long-term capital gains rate for anyone whose marginal tax bracket is 25% or higher.
The goal is “to minimize the taxes because every dollar someone pays in taxes is that much less than they have to spend,” said Jaconetti.
To keep that money investors need to sort investments by their tax liabilities.
Long-term capital gains – on investments held for more than one year – and qualified dividends are taxed at 15% for most taxpayers but 20% for those whose marginal tax rate is 39.6%.
Bond income is generally taxed at ordinary income rates but funds that hold U.S. Treasury bonds exclusively may be exempt from state income taxes and income from municipal bonds are tax-free.
3. Compare Tax-Advantaged Accounts to Tax-Free Accounts
This exercise compares the taxation of 401(k) and traditional IRA accounts to Roth IRA accounts.
Since deposits into 401(k), traditional IRA and rollover IRA accounts have never been taxed – why they are labeled “tax-advantaged” or “tax-deferred” – their withdrawals are taxed at one’s income tax rate. Roth IRA deposits are aftertax so their withdrawals are tax-free.
Before deciding whether to take funds from a tax-advantaged account or from a tax-free account retirees need to consider their current tax rate versus their expected future tax rate. The goal is “to spend from your tax-deferred accounts when your tax rate will be the lowest,” said Jaconetti.
4. Consider Your Heirs
Early retirees who work part-time, for example, may want to withdraw funds first from their Roth IRA account because their income now is presumably higher than it will be when they aren’t working at all and subject to a higher income tax rate.
But retirees who want to pass along assets to their heirs tax-free may want to delay any withdrawals from their Roth IRA. Those assets will pass to their heirs tax-free. Other inherited assets such as those from a 401(k) or rollover IRA are taxable to their heirs, whose tax rates could be higher than that of the retiree. In that case, the retiree may want to spend down his or her tax-deferred assets to remove them from the estate.
The retiree may also want to defer withdrawals of taxable assets with a very large embedded gain, such as an individual stock. If those assets become part of the estate, they will get a step-up on value for tax purposes. The inheritors of those assets, then, will pay a much lower tax on capital gains than the retiree because the basis of those gains will be the value of the asset when the retiree died, not when they were first purchased.
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