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If you retired tomorrow, do you know where you’d start to withdraw your money from for your living expenses? Over the course of a 30+year period in the workforce, the chances are you’ve saved in a few different types of accounts for retirement: 401ks, IRAs, Roth IRAs, Brokerage accounts, etc.
Because these accounts have different tax consequences, choosing the right sequences and amounts to take out of each one each year can be the difference in hundreds of thousands of dollars in taxes over your retirement.
In this article, we’ll go over the steps you need to take to determine how much you need from your portfolio in retirement, the tax characteristics of each of the 3 types of accounts as well as one of the conventional withdrawal methods and some of the flaws associated with it, and finally we’ll look at an example of a client household using our planning tool to compare the potential tax savings of a few different withdrawal methods. This post is more or less a written version of this YouTube video I recently published - check it out if you're more of a listener than a reader.
Before we dive into different withdrawal strategies there’s a few steps you’ll need to take first:
1. Figure out how much you want to spend to live your desired lifestyle in retirement. And remember you don’t need to replace your pre-retirement income, just your expenses. Make sure to be conscious of any changes in expenses once you retire. Will your mortgage be paid off? Will you still need life insurance, disability insurance? Factor those in when adding up your expenses. Let’s say you want to have $8,000 per month / $96,000 per year after-taxes to live your ideal lifestyle in retirement.
2. Determine what your income floor is going to be. This will be fixed/guaranteed income sources like social security income, rental income, annuities, pensions, anything that is more or less guaranteed income that will be deposited to your bank account each month. Continuing with our example, let’s keep it simple and say your social security benefit is your only fixed income source at 3,500 per month, or $42,000 per year – that’s your income floor. That’s the bare minimum you can count on being deposited to your bank account each month.
3. Fill the gap. Easy math here – subtract your floor from your desired spending amount to get the gap that you need to fill using your portfolio. So in our example that’s $8,000 - $3,500 = $4500/mo. or $54,000 per year that you need to withdraw from investment accounts.
Every investment account out there falls into one of three “tax buckets” based on how (and when) the earnings of the account are taxed.
These are your Individual, Joint, and Trust-titled brokerage accounts. They are commonly called “taxable” accounts because dividends and interest from your investments are taxable in the year they are received in these accounts. Income taxes do not apply on contributions or withdrawals on these accounts like they do with the other two buckets.
The good thing about these accounts, though, is that long-term capital gains taxes apply to investments held over 1 year and long-term capital gains are taxed separately from ordinary income and at lower rates. Depending on how much of your total savings is in these accounts, they can provide a lot of flexibility when it comes to controlling your total tax liability as we’ll see in a minute.
Contributions: Non-deductible
Earnings (in the year received): Taxable
Distributions: Non-taxable
Tax-Deferred accounts may also be referred to as “pre-tax” accounts – they are your Traditional 401(k)s, 403(b)s, 457s, and IRAs. Contributions are typically tax deductible, capital gains, interest and dividends are not taxed as they accrue inside the account, and withdrawals are subject to ordinary income tax.
Contributions: Deductible
Earnings (in the year received): Tax-deferred
Distributions: Taxable
Roth IRAs, Roth 401(k)s, HSAs, and 529s are all known as
tax-free accounts because withdrawals are not subject to income taxes. Contributions are made after-tax and all growth and earnings in the accounts are also tax-free if conditions are met (for Roth IRAs & 401(k)s: Account must be 5 years old & Owner Age 59.5)
You generally want to leave these accounts untouched as longas possible to allow for compounding to do its thing, since all earnings are tax-free.
Contributions: Non-deductible
Earnings (in the year received): Tax-free
Distributions: Non-taxable
This is a household that we work with - we’ll call them Kevin & Katie. Of course, these are not their real names, and some other details have been redacted for simplicity. They have approximately $1.8million between all of their retirement accounts – They are 59 and 57 years old and wish to retire in about 4 years. The cost basis of their joint brokerage account is $200,000, meaning the other $200,000 is long-term capital gains.
Here are their current salaries - $170K for Kevin $110K for Katie, and their respective social security benefits are expected to be about $3300for Kevin and $2500 for Katie at full retirement age (67). As the higher earner, we are recommending that Kevin delay his social security benefit until 70, and Katie will claim at full retirement age 67.
So, since they want to retire a few years before social security kicks in, this is where we will begin to help them create the most tax-efficient withdrawal plan to fund those early years as well as the rest of their retirement. Here’s a look at their tax buckets:
Most retirees default to withdrawing from each of their buckets on a pro-rata basis to avoid depleting any one account quickly. So, if you have 75% of your total account balances in tax-deferred accounts and 25% in taxable accounts, you’d withdraw 75% of your monthly need from tax-deferred and 25% from taxable accounts.
However, in the case of Kevin and Katie, we can see that if they pull 100% of their monthly spending amount from their taxable account first, and then tax-deferred and finally tax-free, it makes a nearly $450Kdifference taxes paid over the course of their retirement. Just think about what you could do with another 450K over your retirement!
This is also not considering any Roth conversions, although when we see a big drop in income like this it usually is a prime opportunity for them.
To dig a little deeper, the reason for this massive difference is that while they are pulling money from their taxable accounts first and paying those low tax rates on capital gains, all that tax-deferred and tax-free money is continuing to compound uninterrupted inside their IRAs and Roth IRAs. Tax-free accounts are drawn from last because you want to give those investments the most time to grow since all growth is tax-free.
This $434,948 number is the result of a Monte Carlo analysis, which is essentially projecting out 1000 different scenarios of what their balances could possibly be based on different market returns over the rest of their lives. This is the median result, in other words not the best outcome, not the worst but right in the middle – one that is reasonable to expect and plan around.
A few things I wanted to touch on with this case study:
At Age 73 or 75 depending on how old you are now, you lose some flexibility around which accounts you can withdraw from since the IRS will start to require you to take out money from your tax-deferred accounts. Oftentimes the amount required is more than you need to live off of, so the double-edged sword of withdrawing from taxable accounts first is that your IRAs will have more time to grow and cause your RMDs to be higher as a result.
The domino effect of higher RMDs is that it increases your MAGI, which could cause you to owe taxes on up to 85% of your Social Security income.
Same thing with Medicare surcharges, known as IRMAA (Income-Related Monthly Adjustment Amount). If your MAGI is over certain thresholds, you will have surcharges each month on Medicare part B and D.
So, this is really where we would start to see if Roth conversions would make sense to reduce or avoid some of these negative effects of RMDs. I did a YouTube video on Roth conversions, so if you want to check out, here’s the link.
To recap, the order in which you withdraw from your various tax buckets can have a substantial effect on the overall success of your retirement plan and how much taxes you pay. You’ll also want to keep an eye on anticipated RMDs and how those will affect social security and IRMAA during your retirement years.
And lastly, if you found this informative but maybe a bit overwhelming and would rather not be responsible for doing this all yourself in retirement, feel free to schedule a call with me to see if we’d be a good fit to work together.
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