You probably know the conventional wisdom: When spending retirement savings, drain taxable accounts first, to give the money in tax-deferred 401(k)s and individual retirement accounts more time to grow, and leave tax-free Roth IRAs for last.
But with many nest eggs today smaller than they should be, a better approach, some financial advisers say, is to tap these accounts simultaneously in order to minimize taxes over time.
The key is to make full use of the lower federal and state income-tax brackets many retirees are in early in retirement. To further reduce taxes, it may make sense for those with after-tax incomes between $40,000 and $90,000 to defer Social Security, says James Mahaney, vice president of strategic initiatives at Prudential Financial Inc.
Those who stick to the convention of annually spending no more than 4% of their initial retirement savings — adjusted each year for inflation — can "use the tax code to make their portfolios last up to seven years longer," says Baylor University Prof. William Reichenstein, a principal at Retiree Inc., a Leawood, Kan., company that helps retirees plan tax-efficient withdrawals.
How It Works
For simultaneous withdrawals to work, retirees should have at least two of the following three types of accounts: regular tax-deferred IRAs and 401(k)s; tax-free Roth IRAs and 401(k)s; and regular taxable accounts.
To start, consider a couple who retires at age 62 with $1 million in assets, including $700,000 in a regular IRA and $300,000 in a taxable account. If they need $70,000 in annual income before taxes, the conventional solution is to claim Social Security and withdraw the rest from the taxable account. Assuming the couple gets $33,000 in Social Security, they would need $37,000 from the taxable account to make ends meet.
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But Dean Barber, a financial adviser in Kansas City, Kan., suggests a different approach, based on simultaneous withdrawals. It is a strategy that works best for those with little in the way of capital gains in their taxable accounts — something that has become more common in this era of reduced portfolio returns.
The first step, he says, is to put off claiming Social Security. A delay will increase their future benefit and reduce the amount of those benefits subject to tax. (More about this in a moment.)
In the interim, Mr. Barber says, the couple should withdraw the $70,000 from the taxable account. At that rate, the $300,000 account will support them for about four years.
This approach, Mr. Barber figures, is likely to land the couple at the low end of the 15% federal income tax bracket, which ranges from $17,001 to $69,000. By claiming a standard deduction, a 62-year-old couple can have as much as $88,000 in gross income and still qualify for the 15% rate, says Mr. Barber.
Here's why Mr. Barber figures the couple's taxable income will be on the low end of that range. First, assuming the taxable account is set up to meet their short-term spending needs in retirement, most of the money is likely to be in a bank account, certificates of deposit or recently purchased bonds. Thus, the bulk of the funds available in this account will have already been taxed; they won't be taxed a second time upon withdrawal. (Of course, the couple will pay a 15% tax rate on any qualified dividends or long-term capital gains they realize. They will also owe ordinary income tax on any interest payments they receive.)
In short, withdrawing $70,000 from the taxable account might result in taxable income of only $15,000 or so. Remember: This couple can have as much as $88,000 in taxable income and stay in the 15% tax bracket.
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The next step: withdrawing about $70,000 from the tax-deferred retirement account to take full advantage of this relatively low tax rate — and then converting those funds into a Roth IRA, where the money can grow tax-free.
Assuming the couple is able to convert roughly $70,000 annually (again, before reaching the 15% bracket's $88,000 cutoff), the Roth IRA will grow to about $300,000 within four years, calculates Mr. Barber, who assumes a 5% annual return.
As the Roth's balance grows, the couple's tax-deferred retirement account will shrink—to about $550,000 from $700,000 over four years. That combination will help them reduce tax on their Social Security income.
To see why, consider what will happen in four years, when the couple drains the $300,000 taxable account. At 66, they will qualify for a combined $44,000 in Social Security—or 33% more than they would have received at 62, says Mr. Barber.
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From a tax perspective, a bigger Social Security benefit is good news. Why? The formula that determines how much of an individual's Social Security is taxable counts only half of a person's Social Security income. So, in contrast with income from a regular IRA, "you can receive twice as much Social Security income before you ever trigger a tax" on your benefits, says Mr. Mahaney of Prudential.
The couple is also likely to reap future tax benefits. Thanks to the Roth conversions, their tax-deferred IRAs will be smaller. Thus, when required distributions from those IRAs begin at 70½, the withdrawals — and the taxable income they create — will be lower. And tax-free Roth withdrawals can supplement income in years in which tapping other accounts would push them into a higher tax bracket.
The math is sticky, but the benefits can be large. Says Mr. Barber: "Given the uncertainty in the stock market and the possibility that Congress may raise tax rates, it's especially important to use the tax code wisely."