You’ve been disciplined by saving and heeding advice to diversify between taxable accounts (banking and investment), tax-deferred accounts (401k, IRA, etc.), and non-taxable accounts (Roth, HSA, etc.) Now it’s time for retirement and the question arises: in what order should I use them?
We will use two principles to order withdrawals: 1) Assets that appreciate without incurring taxation should be allowed to grow for as long as possible; 2) Withdrawals must be orchestrated to reduce the total tax burden throughout retirement. With these two principles in mind, let’s move on to establishing a possible strategy [1]. For simplicity’s sake, we’ll assume that at the time of retirement, the age [2] for required minimum distributions [3] (RMDs) has not been reached.
The first source should be cash reserves in banks. To supplement this source, it might be a good time to realize some capital gains. Long-term [4] gains and qualified dividends are subject to lower tax rates than those applied to other types of income.
This would be followed by the gradual liquidation of taxable investment accounts, seeking a reasonable mix of interest, dividends, and capital gains. Tax-free interest-bearing assets (such as municipal bonds) or qualified dividends, as well as the regular practice of tax loss harvesting, are effective mechanisms for managing taxes.
It should be noted that if the projected future amount for the required minimum distributions (RMDs) were high enough, it would be wise to start making voluntary withdrawals to smooth the income profile and thereby reduce the levels of the marginal tax rate [5] throughout the retirement.
Once the regular accounts are depleted, it would be the turn of tax-deferred accounts, such as 401Ks and IRAs, taking care that the minimum required distributions are made to avoid penalties for non-compliance.
Lastly, it is the turn for non-taxable accounts, i.e. Roth and HSAs [6]. This way they would have had more time to appreciate and there would be no impact if taxes were to increase in the future. If these assets are not fully utilized, Roth accounts have some advantages when received as an inheritance.
In summary, the optimal strategy is one that maximizes the duration of savings through appreciation and minimizes the total tax burden.
Sources: Savvy tax withdrawals | Fidelity, How to Plan Your Retirement Withdrawal Strategy | Charles Schwab, Which Retirement Accounts Should You Withdraw From First? | Kiplinger, Qualified Dividends vs Ordinary Dividends: What to Know | Kiplinger, What Happens to the Funds in an HSA After the Account Holder Dies? (thomsonreuters.com)
Disclaimer: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendations as we do not give tax or legal advice. Consult a tax professional to ensure that recommendations are appropriate for your particular situation.
[1] Each case is different, and this discussion should be taken as general and not particular. Your advisor will tailor it to your case.
[2] 73 years for those born between 1951 and 1959. 75 years for those born after 1960.
[3] Required Minimum Distributions (RMDs) are set by the IRS using actuarial tables.
[4] More than one (1) year since acquisition.
[5] The aim is to maintain a stable income level to avoid “tax spikes” when RMDs begin.
[6] Attention should be paid to the conditions required for withdrawals to be non-taxable. [1] Which we will cover in another article dedicated to each product.