Retirees who have various types of funds, such as taxable and tax-advantaged, can extend the tax savings available in their portfolios by creating a sequence-of-withdrawal plan, Morningstar says. The goal is to first withdraw funds that must be withdrawn because of required minimum distribution (RMD) rules; the last type of fund to withdraw from is Roth IRAs. Here’s what a sequence of withdrawal plan looks like and how to create a plan that fits your net worth, portfolio and spending. Consider working with a financial advisor for valuable insight and guidance on how to manage your money in retirement.
Why This Matters
One of a retiree’s goals should be preserving the tax-saving benefits of his or her tax-sheltered investments as long as possible. Of course, the possibility of doing this depends on a retiree having assets in various types of accounts: taxable, tax-deferred (such as 401(k)s and traditional IRAs) and Roth IRAs. The key is hanging on to the accounts with the most generous tax treatment while spending down less tax-efficient assets.
Doing this reflects the reality that it’s not just what you have earned or the capital appreciation you have experienced; it’s also – especially in retirement – what you get to keep that matters.
An Example of a Tax-Efficient Sequence
The following sequence of withdrawals will make sense for many retirees.
1. If you’re older than 72, your first withdrawals should be from accounts that carry required minimum distributions, or RMDs, such as traditional IRAs and company retirement plans.
2. Assuming you’re not required to take RMDs or already have taken them but still need cash, your next stop should be taxable accounts. Begin by selling assets with the highest cost basis and then move on to those assets where your cost basis is lower (and your tax hit is higher). Relative to tax-deferred or tax-free assets, these carry the highest costs while you own them.
Other factors to consider as you withdraw from your taxable accounts:
- Start with your most liquid assets, like money market accounts, short-term CDs and short-term bonds.
- Taxable assets can also be valuable to draw on in higher-tax retirement years because the taxes on withdrawals are at your capital gains rate, less than your ordinary income tax rate and 0% for people in the lowest tax bracket.
- If your taxable assets are sizable and you leave them to your heirs, they’ll completely avoid capital gains tax.
3. Lastly, take money from company retirement-plan accounts and IRAs, with tapping Roth IRAs being your final move.
Creating a Sequence-of-Withdrawal Plan
There are three steps to follow as you create a sequence-of-withdrawal plan that fits your resources and needs. You should have, according to Morningstar, six months’ to two years’ worth of cash flow needs that can be withdrawn from highly liquid portfolio assets, such as savings and checking accounts, short-term CDs and bonds. Cash flow needs are monies that aren’t being supplied by a pension, Social Security or other non-portfolio source. Determine whether your RMDs will meet your income needs if you’re older than 72. If you’re not 72 or younger or your RMDs won’t cover your income needs, see if your taxable accounts will meet your income needs over the next one to two years. If that’s not enough withdraw monies per the three-step sequence outlined above.
Secondly, use the bucket strategy to refill your cash stake so you can survive on this money for one or two years. Thirdly, create a sequence of withdrawal plan based on the three guidelines outlined in the example above.
Guidelines, Not Iron-Clad Rules
Morningstar reminds investors that these are guidelines, not iron-clad absolutes. For example if you have a lot of taxable deductions in a year, consider tapping tax-deferred accounts – and paying ordinary income tax at a lower rate – instead of withdrawing from a taxable account. Another example: if you find yourself in a high tax year, it may be better to tap Roth accounts and avoid taxes on distributions.
Finally, if you have strong capital appreciation of some assets, and you can’t offset that with tax-loss harvesting, consider passing some or all of those assets on to heirs or donating them to a charity. The tax consequences of such a move are more benign than keeping them.
Bottom Line
Retirees have ways to maximize their tax savings by the way they withdraw funds. The sequence of these withdrawals matters, so see if the Morningstar process of determining which of your assets to draw down first, last and in between is a good fit for you. Consider also working with a financial advisor who has experience with tax filing. Though complex, the U.S. tax code offers several ways to stretch you tax savings.
Tips on Retirements
- Deciding which parts of your portfolio should be drawn down first and which should be drawn down last can be difficult. That’s where a financial advisor can be extremely helpful. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Income in America is taxed by the federal government, most state governments and many local governments. The federal income tax system is progressive, so the rate of taxation increases as income increases. Check out our federal income tax calculator.
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