Withdrawal Strategies: Tax-Efficient Withdrawal Sequence
Key Takeaways:
Retirees’ portfolios may last longer if they incur the least amount of income tax possible over their retirement period.
Retirees should focus on minimizing the government’s share of their tax-deferred accounts.
Make sure your advisor is helping you select the appropriate dollar amount and the appropriate assets to liquidate in order to fund your retirement lifestyle.
Asset Placement Decision
A winning investment strategy is about much more than choosing the asset allocation that will provide the greatest chance of achieving one’s financial goals. It also involves what is called the asset location decision. Academic literature on asset location commonly suggests that investors should place their highly taxed assets, such as bonds and REITs, in tax-deferred accounts and place their tax-preferred assets, such as stocks, in taxable accounts.
In general, your most tax-efficient equities should be held in taxable accounts whenever possible. Holding them in tax-deferred accounts can result in the following disadvantages:
The potential for favorable capital gains treatment is lost.
The possibility of a step-up in basis at death for income tax purposes is lost.
For foreign equities, foreign tax credit is lost.
The potential to perform tax-loss harvesting is lost.
The potential to donate appreciated shares to charities and avoid taxation is lost.
Asset location decisions can benefit both your asset accumulation phase and retirement withdrawal phase. During the withdrawal phase, the decision about where to remove assets in order to fund your lifestyle should be combined with a plan to avoid income-tax-bracket creeping. This will ensure that your financial portfolio can last as long as possible.
Tax-Efficient Withdrawal Sequence
Baylor University Professor, William Reichenstein, PhD, CFA wrote a landmark paper in 2008 that’s still highly relevant today. It’s called: Tax-Efficient Sequencing of Accounts to Tap in Retirement. It’s fairly technical, but it provides some answers about the most income-tax-efficient withdrawal sequence to fund retirement that are still valid today. According to Reichenstein, “Returns on funds held in Roth IRAs and traditional IRAs grow effectively tax exempt, while funds held in taxable accounts are usually taxed at a positive effective tax rate.”
Reichenstein also noted that only part of a traditional IRA’s principal belongs to the investor. The IRS “owns” the remaining portion, so the goal is to minimize the government’s share, he argued.
Tax-Efficient Withdrawal Sequence Checklist
In our experience, retirees should combine the goal of preventing income-tax-bracket creeping over their retirement years with the goal of minimizing the government’s share of tax-deferred accounts.
To achieve this goal, the dollar amount of non-portfolio sources of income that are required to be reported in the retiree’s income tax return must be understood. These income sources can include defined-benefit plan proceeds, employee deferred income, rental income, business income and required minimum distribution from tax-deferred accounts. Reporting this income, less income tax deductions, is the starting point of the retiree’s income tax bracket before withdrawal-strategy planning.
The balance of the retiree’s lifestyle should be funded from his or her portfolio assets by managing tax-bracket creeping and by lowering the government ownership of the tax-deferred accounts. The following checklist can assist the retiree in achieving this goal:
Avoid future bracket creeping by filling up the lower (10% and 12%) income tax brackets by adding income from the retiree’s tax-deferred accounts.
If the retiree has sufficient cash flow to fund lifestyle expenses but needs additional income, convert traditional IRAs into Roth IRAs to avoid tax-bracket creeping in the future. This will also allow heirs to avoid income taxes on the inherited account balance.
Locate bonds in traditional IRAs rather than in taxable accounts. This will reduce the annual reporting of taxable interest income on the tax return.
Manage the income taxation of Social Security benefits by understanding the amount of reportable income based on the retiree’s adjusted gross income level.
Liquidate high-basis securities rather than low-basis securities to fund the lifestyle for a retiree who needs cash but is sensitive to additional taxable income.
Aggressively create capital losses when the opportunity occurs to carry forward to future years to offset future capital gains.
Allow the compounding of tax-free growth in Roth IRAs by deferring distributions from these accounts.
Consider a distribution from a Roth for a year in which cash is needed but the retiree is in a high income tax bracket.
Consider funding charitable gifts by transferring assets from a traditional IRA directly to the charity. This avoids the ordinary income on the IRA growth.
Consider funding charitable gifts by selecting low-basis securities out of the taxable accounts in lieu of cash. This avoids capital gains on the growth.
Manage capital gains in taxable accounts by avoiding short-term gains.
Conclusion
You and your advisor should work together closely to make prudent, tax-efficient withdrawal decisions to ensure your money lasts throughout your retirement years. Contact us any time if you have questions about your retirement funding plans or important changes in your life circumstances.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
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