- There are alternatives to the conventional strategy of drawing on a taxable account first, followed by tax-deferred and then Roth accounts.
- Many people can take advantage of income in a low tax bracket or tax-free capital gains.
- If planning to leave an estate to heirs, consider which assets will ultimately maximize the after-tax value.
Many people will rely largely on Social Security benefits and tax-deferred accounts such as individual retirement accounts (IRAs) and 401(k) plans to support their lifestyle in retirement. However, a sizable number of retirees will also enter retirement with assets in taxable accounts (such as brokerage accounts) and Roth accounts. Deciding how to use that combination of accounts to fund spending is a decision likely driven by tax consequences because distributions or withdrawals from the accounts have different tax characteristics (see Figure 1 and Appendix 1).
A commonly recommended approach, which we’ll call “conventional wisdom,” is to withdraw from taxable accounts first, followed by tax-deferred accounts, and, finally, Roth assets. There is some logic to this approach:
- If you draw from taxable accounts first, your tax-advantaged accounts have more time to grow tax-deferred.
- Leaving Roth assets until last provides potential tax-free income for your heirs.
- It is relatively easy to implement.
Unfortunately, the conventional wisdom approach may result in income that is unnecessarily taxed at high rates. In addition, this approach does not consider the tax situations of both retirees and their heirs.
This paper considers three objectives retirees may have:
- Extending the life of their portfolio
- More after-tax money to spend in retirement
- Bequeathing assets efficiently to their heirs
The first two go hand in hand: If your goal is to have more money to spend in retirement, a strategy that extends the life of the portfolio can also meet that need.2 In both cases, the focus is on the retiree, not the heirs. For people focused on the third objective—leaving an estate—the withdrawal strategy can include techniques to minimize taxes across generations.
So what can investors do, and how can financial professionals navigate these conversations? We evaluated different withdrawal strategies for a variety of situations and summarized the key techniques for three general scenarios (types of people).
1 Generally, owner over age 59½ and Roth account open at least 5 years.
2 Because these goals are similar, our analysis focuses on longevity of the portfolio. Note, however, that the percentage improvement in spending capacity may be lower than the improvement in longevity.