- Investors who have more than one type of account for retirement—taxable, tax-deferred, and tax-exempt (Roth)1—should take advantage of those accounts’ different tax characteristics.
- A common strategy (“conventional wisdom”) is to draw on taxable accounts first, followed by tax-deferred and then Roth. While this approach has some logical appeal, there are ways to improve upon it.
- Many people can benefit from taking some tax-deferred distributions early in retirement, before required minimum distributions, when their tax rate is low or even zero.
- Selling taxable investments can be a good strategy when taxable income is below the threshold for long-term capital gains taxes.
- If planning to leave an estate to heirs, consider what their tax situation might be and whether it’s better to leave them tax-deferred or Roth assets.
- Holding taxable assets until death allows heirs to benefit from tax-free gains via the step-up in basis.
- The tax treatment of Social Security and taxable account income is complex, so we recommend consulting with a tax advisor or financial planner.
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 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:3
- 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.4
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 advisors 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 Tax-exempt income can come from sources including Roth accounts, health savings accounts, and municipal bond interest. The tax treatment for each is subject to restrictions. In this paper, we only consider Roth accounts and assume distributions from those accounts are tax-free.
2 Generally, owner over age 59½ and Roth account open at least 5 years.
3While reducing taxes helps achieve these goals, we do not consider tax reduction one of the primary objectives.
4 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.