When it comes time to withdraw money in retirement, many investors choose to take money from accounts in the following order: taxable, tax deferred, and tax free.
The motivation behind this conventional wisdom is often to preserve tax-deferred assets for as long as possible. However, depending on an individual’s tax situation, the conventional wisdom may not be the best course of action.
Consider this table, which highlights retirement situations and corresponding withdrawal strategies that may be optimal from a tax standpoint.
| Situation: | Then consider: |
| Lower marginal tax rate | Draw from tax-deferred assets to maximize use of lower relative tax bracket, which may help reduce RMDs at age 70½ |
| Higher marginal tax rate | Use tax-free or taxable assets to avoid higher income tax rate and/or take advantage of lower capital gains tax rates |
| Significant capital appreciation in taxable account* | If legacy goal exists, preserve taxable assets to take advantage of “step-up” in basis at death* |
| Working in retirement | Avoid tax-deferred assets, which will increase overall income (e.g., higher income may result in Social Security benefits being taxed) |
*Assumes unlimited stepup in cost basis for inherited assets is in effect.
Generally, it might make sense to draw income from different tax sources as you gradually transition from lower to higher tax brackets, that is, draw enough income from tax-deferred sources such as Traditional IRAs or 401(k)s to reach the limit of the 15% income tax bracket ($34,000 for single filers). This approach maximizes use of the relatively low 15% tax bracket for ordinary income. This also reduces the balance of tax-deferred accounts, which lowers required minimum distributions (RMDs) in the future. As more income is needed, consider drawing from other sources (taxable or tax-free) to avoid increasing ordinary income, which is subject to higher tax rates. Preserving tax-free accounts such as Roth IRAs can provide valuable benefits. Since there are no RMDs for the Roth IRA account owner or the spousal beneficiary, more funds can be preserved in the account and passed along tax free to beneficiaries.† As is the case with any tax-related decisions, clients should seek assistance of a qualified tax professional.
†Assumes spousal beneficiary opts to treat the inherited Roth IRA as his/her own.
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