If you’re well along in your career, you may have already built up a sizeable nest egg for retirement. However, unless you’re independently wealthy, you’ll soon have to start withdrawals from your investments and accounts. What’s the preferred order?
Of course, every situation different, but the conventional wisdom is to withdraw from taxable accounts first, tax-deferred accounts second and tax-free accounts third.
For simplicity, we’ll assume that the main sources of your assets are comprised of (1) personal accounts such as bank accounts and table investment accounts, (2) qualified retirement plans like 401(k) plans and traditional IRAs and (3) non-taxable accounts, including Roth IRAs and tax-free investments like municipal bonds. Where do you go from here?
Traditionally, the basic idea is to withdraw funds from taxable personal accounts, then tax-deferred accounts and tax-free accounts last. This distribution order will most likely produce a lower current tax bill, provide more tax-deferred growth and allow you to achieve higher account balances. The key is to allow tax-advantaged accounts to grow for as long as possible.
But you may want to switch this order in retirement depending on your personal and financial situation, your estate planning goals and your current tax rate vs. future rate. For example, most people expect to be in a lower tax bracket in retirement, but your case may be the opposite.
Also, be aware that distributions from qualified plans and traditional IRAs generally result in a 10% tax penalty, on top of regular income tax, unless an exception applies.
Important: You must begin required minimum distributions (RMDs) from qualified plans and traditional IRAs once you attain a specified age threshold. The threshold was recently increased from 70½ to 72 and then 73 (scheduled to increase to 75 in 2033). Thus, you may benefit from additional tax-deferred compounding of funds.
After RMD obligations are met, it’s generally advantageous to start cashing in taxable assets. Reason: Withdrawals from taxable accounts are taxed at favorable dividend and capital gains rates and only on the capital appreciation amount. This compares favorably to withdrawals from tax-deferred accounts where you must pay a higher tax rate on a higher amount of income.
Therefore, taking withdrawals sooner than necessary from tax-deferred accounts accelerates income tax and reduces tax-deferred growth.
Once your taxable portfolio has been depleted, consider tax-advantaged accounts where the decision to spend from tax-deferred or tax-free investments depends primarily on current versus future tax rate assumptions. If you expect future tax rates will be higher than current rates, it generally makes sense to spend from tax-deferred accounts first. Conversely, if you anticipate your future tax rate will be much lower than your current one, take distributions from tax-free accounts first.
In other words, while the guidelines for the distribution order are usually beneficial, they aren’t written in stone. Your situation may vary depending on circumstances.
Furthermore, the decision about which account to access first also could have estate planning implications. For instance, an elderly investor who owns highly appreciated stock with built-in capital gains may consider spending from tax-deferred accounts first, passing on their taxable accounts to heirs who receive a step-up in basis and can avoid paying capital gains tax.
This is not a one-size-fits-all proposition. Obtain expert assistance for your situation.