Tax-Efficient Sequencing of Accounts

[ats5g]

This topic has probably been discussed umpteen times here, but I thought this article by William Reichenstein would be a good handbook for people unsure about how to go about tapping their various retirement accounts:

Tax-Efficient Sequencing of Accounts to Tap in Retirement

This study discusses strategies for selecting the sequence of withdrawing funds from savings vehicles during retirement. For example, should a retiree withdraw funds from the taxable account then the traditional IRA and then the Roth IRA or would another sequence be preferable? (In this study, “traditional IRA” includes 401(k), 403(b), and other tax-deferred accounts.)

Most of the study’s key ideas flow from two principles. The first principle is that returns on funds held in Roth IRAs and traditional IRAs grow effectively tax exempt, while funds held in taxable accounts are usually taxed at positive effective tax rates. This gives rise to the general rule of thumb to withdraw funds from taxable accounts before retirement accounts—e.g., Roth IRAs and traditional IRAs. Models suggest that this withdrawal strategy might help a retiree’s financial portfolio last a few years longer than a strategy of withdrawing funds from retirement accounts first. The years of additional portfolio longevity increase with the retiree’s level of wealth and rate of return on assets.

There are at least two times when a retiree should deviate from this rule of thumb. First, before required distributions begin at age 70½, retirees may have minimal taxable income in which case they should withdraw sufficient funds from traditional IRAs (or convert sufficient funds from traditional to Roth IRAs) to fully use low tax rates. Second, retirees who have substantial unrealized gains on taxable assets and will await the step-up in basis at death should withdraw funds from retirement accounts before liquidating the appreciated asset.

The second principle affecting withdrawal strategies is the idea that (1- tn) of a traditional IRA’s principal belongs to the investor with the government “owning” the other tn, where tn is the tax rate when the funds are withdrawn. The objective is to minimize tn, the government’s share of the principal. The retiree should withdraw funds from a traditional IRA whenever she is in an unusually low tax bracket. As discussed earlier, this could occur before required distributions begin if the retiree has minimal taxable income. In addition, it could occur in a year when the retiree makes a large one-time contribution. Finally, a retiree will likely be in a low tax bracket in years when she has large medical expenses, perhaps due to a stay in a nursing home.

Finally, this study considers factors that should influence the decision to withdraw funds from a traditional IRA before a Roth IRA or vice versa. Withdrawing funds from the traditional IRA makes sense 1) in years when the retiree is in a low tax bracket and 2) if the retiree’s beneficiary will be in a higher tax bracket. For example, if the retiree is in the 25% tax bracket and her beneficiary is in the 33% bracket then a $100 withdrawal from the traditional IRA would be worth $75 after taxes to the retiree but only $67 for the beneficiary. An additional benefit of withdrawing funds from the traditional IRA is that it would reduce future required minimum distributions. In contrast, withdrawing funds from a Roth IRA instead of a traditional IRA makes sense 1) in years when the retiree is in a high tax bracket and 2) if the retiree’s beneficiary—whether an individual or a charity—will be in a lower tax bracket. For example, if the retiree is in the 25% tax bracket then a $100 withdrawal from the traditional IRA would be worth $75 after taxes to the retiree but $100 if saved for the charity. In addition, Roth IRA withdrawals should be preferred if the retiree expects to have large deductible medical expenses later in retirement.

In sum, as a rule of thumb retirees should withdraw fund from taxable accounts before retirement accounts. However, there are exceptions to this rule. Retirees should try to time the withdrawal of funds from traditional IRAs for years when they are in or will be in an unusually low tax bracket. These years could occur early in retirement before required distributions begin and late in retirement years when medical expenses are high. The preferred sequence for withdrawing funds from traditional IRAs and Roth IRAs depends upon uncertain factors such as the retiree’s lifespan, future health, the retiree’s and individual beneficiary’s future tax rates, and whether the retiree wishes to leave funds to a charity. Nevertheless, knowledge of the key factors should help retirees develop an informed withdrawal strategy.

- Alec

[Nords]

Today's tax law seems to make it better to cash in taxable accounts with high cap gains first, then worry about the tax-deferred accounts.

And if the tax-deferred accounts are Roth IRAs with no RMDs, then I'd stop worrying.

[JohnEyles]

Originally Posted by Nords

Today's tax law seems to make it better to cash in taxable accounts with high cap gains first, then worry about the tax-deferred accounts.

I can't quite figure out how to reconcile this "conventional wisdom" about
tax-efficient withdrawal sequencing with the conventional wisdom that you're
generally spending in the sequence: cash & cash equivs, then bonds, then
stocks (of course migrating money from stocks to bonds to cash, call it buckets
or portfolio rebalancing or whatever).

In other words, one way of thinking says you want your bond allocation mostly
in taxable accounts because you're going to spend it first (or spend it during
the "recovery" years if stocks do badly) - whereas the other way of thinking
says you want your stock allocation mostly in the taxable accounts because
that way you pay capital-gains taxes (instead of ordinary income tax) on the
gains in the stock.

[. . . Yrs to Go]

Originally Posted by JohnEyles

I can't quite figure out how to reconcile this "conventional wisdom" about
tax-efficient withdrawal sequencing with the conventional wisdom that you're
generally spending in the sequence: cash & cash equivs, then bonds, then
stocks (of course migrating money from stocks to bonds to cash, call it buckets
or portfolio rebalancing or whatever).

In other words, one way of thinking says you want your bond allocation mostly
in taxable accounts because you're going to spend it first (or spend it during
the "recovery" years if stocks do badly) - whereas the other way of thinking
says you want your stock allocation mostly in the taxable accounts because
that way you pay capital-gains taxes (instead of ordinary income tax) on the
gains in the stock.

I wouldn't say that the conventional wisdom is to sell down cash and bonds before stocks. Conventional wisdom is to maintain a targeted allocation, which may mean selling more stocks or more bonds depending on market performance. In down equity markets you'll be dipping more heavily into your fixed income hoard to maintain your target allocation. But that is why they are there so you don't have to sell equities when equities are getting hammered.

And you don't have to keep your fixed income assets in a taxable account to sell them down. For any equity sales in your taxable account you can execute offsetting transaction in your IRA that rebalances the portfolio to your target asset allocation.

[JohnEyles]

Originally Posted by 3 Yrs to Go

Conventional wisdom is to maintain a targeted allocation, which may mean selling more stocks or more bonds depending on market performance. In down equity markets you'll be dipping more heavily into your fixed income hoard to maintain your target allocation. But that is why they are there so you don't have to sell equities when equities are getting hammered.

And you don't have to keep your fixed income assets in a taxable account to sell them down. For any equity sales in your taxable account you can execute offsetting transaction in your IRA that rebalances the portfolio to your target asset allocation.

So if stocks do badly, so you need to sell some fixed income to maintain your allocation
(and to get your current income, of course), you're saying to sell the badly-performing
stock in the taxable account, and then replace it in the IRA by selling some fixed-income
and then re-buying the stock (in the IRA) at the same low price you sold it at ?

Clever idea - never thought of it !

[lazyday]

This may be a stretch, but:
If all remaining assets in taxable accounts have low cost basis, and one were living in a time when cap gains tax rates are the same as income tax rates, but there's hope that cap gains rates will be reduced again, then it might make sense to do withdrawals instead of spending from taxable account.