Congratulations, after years of hard work and successful planning, you’ve achieved financial independence and are ready to start withdrawing your hard-earned savings! Which accounts should you start drawing from? Conventional wisdom is to first utilize your taxable savings and then start withdrawing from your tax-advantaged accounts (i.e., IRA’s, 401(k)’s and Roth IRA’s). But is this the best approach? As with most things, the answer is that it depends; everyone’s situation is different.
The rule-of-thumb withdrawal strategy is to withdraw funds from accounts in the following order:
The idea behind this strategy is to first deplete all of the funds that create current taxes in order to push tax payments as far into the future as possible. However, focusing on pushing taxes into the future may not result in the maximization of one’s lifetime portfolio. There might be instances where paying some amount of current tax may result in a better outcome for your lifetime financial plan. A couple of individual examples where the conventional wisdom may not be optimal are:
Example 1 – Retire early with a significant tax-deferred account balance
Let’s say you’ve done very well by reaching financial independence at age 55 and you are ready to start tapping into your savings. You’ve consolidated all of your retirement assets into a very respectable $2 million IRA. If you also have enough taxable savings to meet your needs through age 72, you might not need to tap into the IRA until that age. However, you may face a very hefty future tax bill if you let those IRA assets grow while only tapping into your taxable accounts.
At age 72 (per current tax regulations), you will need to start taking “Required Minimum Distributions” (RMD’s). If your IRA were to grow at an annual rate of 6%, from age 55 through age 72, your IRA balance at that time will be approximately $5.4 million dollars. The RMD on $5.4 million, per current tax regulations, will be $210,000 for the first year of withdrawals and the RMD will likely go up every year after that. That $210,000 distribution from your retirement account alone will immediately put you into the 25% tax bracket (again per current tax regulations) not including any other income you may have. Future RMD distributions may even push you into the next tax bracket as they continue to grow. For example, if portfolio growth were to remain at 6%, the RMD distribution at age 85 would be approximately $410,000, which might be in the 28% tax bracket.
The whole idea behind tax-deferred retirement accounts is for participants to delay paying taxes at the time contributions are made and to push those taxes into the future when participants would theoretically be in a lower tax bracket. In this case, you may end up in a higher tax bracket at age 72 (or age 85) than the bracket you were in during your working years, when you made the contribution.
Additionally, depending upon your income after age 55, you may be in lower tax brackets during the years between age 55 and age 72. Tax planning should take a long-term view and seek to maximize the lifetime portfolio value. Therefore, an optimized distribution strategy in this instance might be to start withdrawing funds from the IRA beginning at age 59½, when tax-advantaged distributions can be made without penalty and while you are in the lower tax bracket. The optimal strategy might be to take distributions from both your taxable accounts and the IRA during these years.
Another form of distribution could also be employed to further maximize lifetime portfolio value between ages 55 and 59½. A Roth conversion is a form of distribution where tax-deferred funds are distributed and converted into a Roth tax-exempt account. Taxes on the tax-deferred IRA withdrawal are paid at the time of conversion and the funds then continue to grow in a tax-exempt Roth IRA account. In the time period before turning 59½, some IRA funds could be converted to a Roth IRA while staying in a lower tax bracket and paying a low tax rate at the time of conversion. In this example, let’s say your annual income in 2022 at age 56 will be $10,000. It might make sense to do a Roth conversion that year while staying within the 22% tax bracket. The amount of conversion and tax due would look like:
In this example, the effective tax rate paid for the conversion would be 16.5%. If the tax were paid utilizing funds out of the taxable savings account, the entire $91,500 conversion could be left to grow tax-exempt in the Roth account and any future distributions would be tax-free.
Example 2 – Retire at age 67 with all retirement assets in tax-deferred and tax-exempt accounts
In this example, you do not have assets in a taxable account and will immediately need to begin taking distributions from your retirement accounts to support your lifestyle. Remember that any distribution from your tax-deferred retirement accounts will be taxed as ordinary income. The conventional wisdom is to take all of the assets out of the tax-deferred accounts (such as a 401(k)) first, paying your taxes along the way, and then tap into the tax-free accounts (such as a Roth IRA).
Let’s say you are single and you need to withdraw $60,000 each year to cover expenses and pay taxes. If all of these funds come from your tax-deferred account, your 2021 tax burden will be:
That last $6,925 distributed from your tax-deferred account came with a 91% tax increase over the amount paid for the lower tax bracket distributions. Seems like a better distribution strategy could be to withdraw $53,075 from your tax-deferred account and to take the remaining funds from a tax-exempt account. With this strategy, your total tax and required distribution would be:
In the optimized scenario, the total amount withdrawn can be reduced by the $1,524 tax reduction as you would not need to pay the tax that was figured into your annual budget when all funding came from the tax-exempt account. This hybrid withdrawal strategy would likely provide for a larger lifetime portfolio value, depending upon your overall financial picture.
As these examples demonstrate, the conventional wisdom does not always provide the ideal solution. This is particularly true when you factor in potential future tax rates knowing that current tax rates are low by historical standards. So, what is the optimal distribution method? The answer is that every situation is different and every person’s scenario will likely result in a different strategy. A customized distribution strategy should be tailored to each individual and potentially refined every year. In some cases, distribution strategies that include converting traditional IRA accounts into Roth accounts can also provide tremendous benefit to an overall financial plan. A financial planner should be able to work with you to develop the plan and assist in its implementation.