Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

Investing success during the pre-retirement years hinges on getting a few key things right: saving enough, diversifying, and avoiding big behavioral mistakes, such as chasing performance.

But successfully managing during retirement? That is more complicated, unfortunately. First you have to determine whether you have enough money to retire, and that is no small feat in and of itself. You will also have to reposition your assets for drawdown mode, staking at least a portion of your investment portfolio in stable, liquid assets to avoid tapping securities when their prices are gyrating wildly. Finally, you will need to think about asset location and the appropriate sequence to use when tapping your retirement accounts
for cash.

Why is sequencing withdrawals a key component of successful retirement portfolio management? Because it helps you save on taxes. To the extent that a retiree has both taxable and tax-sheltered assets like IRAs and company retirement plans, it is best to spend the taxable money first. The assets with the most generous tax treatment, meanwhile, should be last in a retiree's spending queue, thereby stretching out the tax benefit for the longest possible period of time.

There is not a one-size-fits-all sequence of withdrawals; your age and your tax rate when you take withdrawals also play a role. But assuming that you have more than one pool of assets to draw on during retirement, the following sequence makes sense for many retirees.

1. Take Required Minimum Distributions
If you are over age 70 1/2, your withdrawals should come from those accounts that carry required minimum distributions, such as traditional IRAs and company retirement plans. RMD assets go first in the withdrawal queue because you will pay penalties if you do not take these distributions on time.

2. Turn to Your Taxable Accounts
If you are not required to take RMDs or you have taken your RMDs and still need cash, turn to your taxable assets. Relative to tax-deferred or tax-free assets, money in your taxable portfolio carries the highest tax costs. You will pay ordinary income tax on income from taxable bonds and cash, and you will also owe taxes on dividends and capital gains—year in and year out. When liquidating assets from your taxable accounts, start by selling assets with the highest cost basis first and then move on to those assets where your cost basis is lower (and your tax hit is higher).

A key exception to the rule about selling taxable assets early, however, is if you have highly appreciated assets and plan to leave money to your heirs. If, for example, you own stock that has appreciated significantly since you bought it (and you have no way of offsetting that gain with a loss elsewhere in your portfolio) you may be better off leaving that position intact and passing it to your heirs. The reason is that your heirs will receive what is called a "step up" in their cost basis, meaning that they will be taxed only on any appreciation in the security after you pass away.

3. Move On to Company Retirement Plans and IRA Assets
Unlike taxable accounts, you will not pay taxes on your company retirement plan and IRA assets from year to year (at least on the money that remains in the accounts), so the ongoing tax costs are relatively low. Thus, tapping those assets last is usually a good idea because it helps stretch out those tax-savings benefits.

For those with both a traditional company retirement plan and IRA assets as well as those who are eligible for Roth treatment, the decision about which pool of money to tap first is a bit complicated. Intuitively, it seems to make sense to save Roth IRA assets for last because they are less costly from a tax standpoint. In contrast with traditional IRA and 401(k) assets, your distributions are not taxable and you are not required to take distributions at age 70 1/2. And if you expect your heirs to inherit part of your IRA, Roth assets will be the most valuable to them because distributions will be free of income taxes. However, a study by Baylor University professor William Reichenstein argued that saving Roth assets for last is not always the best course of action. For example, if a retiree is in a particularly high tax bracket in a given year, tapping the Roth assets to meet living expenses may be preferable to paying ordinary income tax on traditional IRA or company retirement plan withdrawals.

Impact on Asset Location
The sequence in which you tap your accounts should help you determine how to position each pool of money. The money that you will draw upon first—to fund living expenses in the first years of retirement—should be invested, at least in part, in highly liquid securities like certificates of deposit, money market accounts, and short-term bonds. The reason is pretty common-sensical: Doing so helps ensure that you are taking money from your most stable pool of assets first, and therefore you will not have to withdraw from your higher-risk/higher-return accounts (for example, those that hold stocks or more risky bonds) when your account is at a low ebb. That strategy also gives your stock assets, which have the potential for the highest long-term returns, more time to grow.

 

This information may answer some questions, but is not intended to be a comprehensive analysis of the topic. In addition such information should not be relied upon as the only source of information, competent tax and legal advice should always be obtained.

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