Some annoyances in life seem impossible to avoid each year – mosquitos in the summer, holiday shopping in the fall and winter and tax filing in the spring. While it may be difficult to avoid some of these unpleasantries, there are strategies investors can employ to reduce the effect of portfolio withdrawals on taxes.
A common tax question posed by retirees is, "If I have a traditional IRA, a Roth IRA and multiple taxable accounts, how should I withdraw money to fund my retirement?" The reason this question plagues taxpayers so consistently is because ideally they would give it serious thought every year. While retirees could create a plan during the first year of retirement and never change it, as cash flow needs and sources of income change over time, so should their approach to withdrawing their funds.
Take the hypothetical example of Mr. and Mrs. Johnson, both aged 60. Due to planned trips, healthcare costs and car purchases, they expect their after-tax income needs will vary widely each of the upcoming five years. The Johnsons could follow the traditional rule of thumb and withdraw from their taxable accounts first until those accounts are used up, then proceed to exhaust the traditional IRA, followed by the Roth IRA. However, our research has shown that if these withdrawals are going to vary year by year, the Johnsons may be better off with a more flexible and strategic withdrawal plan that takes advantage of all their available accounts.
In the popular video game Tetris, the goal is to place falling pieces of varying shapes into gaps created on the board. Like with the game, investors following this strategy would be strategic about their decisions, basing their withdrawals on their tax bracket for that particular year. And if investors expect their spending needs or tax brackets to vary in each of the coming years, this strategy gives them the most flexibility in managing the tax cost of their withdrawals.
The Johnsons' sources of income in retirement include taxable accounts as well as a traditional IRA and a Roth IRA.
Spending down their taxable accounts first is one option, though it may require them to pay more in taxes and limit their distribution options in the future.
By strategically withdrawing from each income bucket, the Johnsons can meet their spending needs, preserve all three types of accounts for future withdrawals and remain in the 15% tax bracket.
In our example, the Johnsons are in the 15% marginal income tax bracket based on their typical annual income, though the additional withdrawals they need to meet their spending goals could push them into a higher bracket. With this more tactical strategy, the Johnsons would make withdrawals from each of their accounts, making sure no one withdrawal pushes them beyond their 15% tax bracket. In some cases, the additional tax burden could be kept low enough that the Johnsons are able to take advantage of a 0% long-term capital gains rate – a benefit available since 2008 but often overlooked by investors.
There are three advantages to this customized approach.
It's worth making one final point regarding the Tetris-type method of spending down assets in retirement. This strategy is designed to provide the most flexibility given a retiree's changing cash flow needs, especially when the impact of tax law changes is considered. What may be an appropriate strategy under one set of assumptions could change dramatically under a different set. For example, if capital gains tax rates were to increase or if overall income tax rates were to fall significantly, then a change in the priority of spending down assets might be appropriate.
As with any financial strategy, the important thing is to maintain as much flexibility as possible and realize that plans need to change from time to time. This is where working with a team of experienced financial and tax specialists, who can identify when and how to best modify a plan, can provide a significant benefit.
Chris Dolan is a Financial Planner for Baird Private Wealth Management.