By Jane Young, CFP, EA
After years of saving and investing, upon retirement you will need to decide how to withdrawal money to cover your expenses. It is important to consider how taxes will impact your portfolio. The withdrawal strategy you chose will impact how long your money will last and how much is available to spend. To cover expenses that exceed Social Security and pensions, most retirees have investment accounts to meet their additional spending needs.
There are three main types of accounts: taxable accounts, traditional retirement accounts, and Roth accounts. A taxable account is a standard brokerage or bank account that is created with after-tax money. A taxable account is the least tax efficient. You generally pay taxes on interest, dividends, and capital gains during the life of the investment plus additional capital gains tax upon liquidation, assuming it has increased in value. Traditional retirement accounts include 401(k), 403(b), or traditional IRAs. They are funded with pre-tax dollars and are taxed at ordinary income tax rates upon withdrawal. A Roth IRA or Roth 401(k) is funded with after-tax dollars, but you generally do not pay taxes upon withdrawal.
Conventional wisdom on the sequence of withdrawals directs us to deplete taxable accounts first, then traditional retirement accounts, and lastly from Roth accounts. The objective is to use the least tax efficient accounts first to allow your tax advantaged accounts time to grow and compound.
However, there are other considerations and exceptions to this rule, especially if you have periods of unusually low income. Low income is common in the first few years of retirement, before you begin taking Social Security benefits or required minimum distributions. If you are in a very low tax rate, consider taking withdrawals from your traditional accounts to cover expenses or to convert to a Roth IRA. Withdraw money from your traditional account to bring your tax rate up to a more reasonable level. This will help reduce your required minimum distributions and tax rate in the future. The tax bracket that you want to fill depends on the size of your portfolio and your future tax rates.
Additionally, consider your financial goals and your estate plan. Is the money for you or do you plan to leave money to heirs or a charity? If you plan to leave a legacy to your heirs, consider leaving highly appreciated assets in your taxable account for them. When your heirs inherit a taxable account, they receive a step-up in basis. Meaning the capital gains you would have incurred, if you sold the assets, get reset to zero on the date of your passing.
If you are planning to give or leave money to charity, earmark traditional retirement dollars for this. If you or your heirs take a distribution from a traditional account, it will be taxed at ordinary rates but, a gift to the charity is tax free. Additionally, you can gift your required minimum distribution to a qualified charity tax free.