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Don't Be Dogmatic About Retirement-Portfolio Withdrawals

Note: This article is part of Morningstar's Tax Relief Week. A version of this article appeared on Sept. 21, 2016.

Required minimum distributions first. Taxable accounts next, followed by traditional IRAs and 401(k)s. Roth IRAs and 401(k)s last.

That's the standard sequence for tax-efficient portfolio drawdown during retirement. The overarching thesis is to be sure to tap those accounts where you'll face a tax penalty for not doing so (RMDs) while hanging on to the benefits of tax-sheltered vehicles for as long as possible. Because Roth assets enjoy the biggest tax benefits--tax-free compounding and withdrawals--and are also the most advantageous for heirs to receive upon your death, they generally go last in the withdrawal-sequencing queue.

That's a helpful starting point for sequencing retirement-portfolio withdrawals, and it goes without saying that you should always take your RMDs on time. That said, it's a mistake to be dogmatic about withdrawal sequencing--burning through taxable accounts first, then depleting traditional IRA/401(k) assets before finally moving on to your Roth accounts. The reason is that your tax picture will change from year to year based on your expenses, your available deductions, your investments' performance, and your RMDs, among other factors.

In order to keep your total tax outlay down during your retirement years, it's often worthwhile to maintain holdings in the three major tax categories throughout retirement: taxable, tax deferred, and Roth. Generally speaking, Roth withdrawals will be the most tax friendly (qualified distributions will be tax-free), whereas withdrawals from tax-deferred accounts like traditional IRAs and 401(k)s will face the most punitive tax treatment: ordinary income tax rates on any deductible contributions and investment earnings. Taxable portfolio withdrawals occupy a middle ground: Bond income and nonqualified dividends will be taxed at investors' ordinary income tax rates, while qualified dividends and long-term capital gains are taxed at rates as low as 0% for the lowest-income investors.

Armed with exposure to investments with those three types of tax treatment, retirees can consider withdrawal sequencing on a year-by-year basis, staying flexible about where they draw their income bases on their tax picture at large. They can help limit the pain of an otherwise high-tax year by favoring taxable and Roth distributions, for example, while giving preference to tax-deferred distributions in lower-tax years.

For example, in a year in which they have high medical deductions that push them into a lower tax bracket, they might actually give preference to withdrawals from their traditional IRA accounts, even though they have plenty of taxable assets on hand, too. The reason is that it's preferable to take the tax hit associated with that distribution when they're paying the lowest possible rate on that distribution. Moreover, aggressively tapping tax-deferred accounts like traditional IRAs in low-tax years will mean that fewer assets will be left behind to be subject to RMDs.

On the flip side, in a high-tax year--for example, when RMDs are bigger than usual due to market appreciation--a retiree might reasonably turn to her Roth accounts for any additional income needed. Although those Roth assets usually go in the "save for later" column under the standard rules of withdrawal sequencing, those tax-free Roth withdrawals (versus, say, paying capital gains on distributions from a taxable account or paying ordinary income tax on tax-deferred withdrawals) may help the retiree avoid getting pushed into a higher tax bracket than would otherwise be the case.

This is an area in which a trusted tax advisor--or a financial advisor who's knowledgeable about tax matters--can help provide guidance on an ongoing basis, strategizing on where to go for income and how to get the most bang for your deductions. Here are some key situations when it can be advantageous to flout the rules of thumb about withdrawal sequencing, as well as alternative tactics to consider.

Situation: You want to convert traditional IRA assets to Roth.
Tactic: Favor lower-tax distributions from accounts.

Converting traditional IRA assets to Roth can jack up a tax bill, as you'll owe ordinary income tax on the converted amounts that consist of deductible contributions and investment earnings. Thus, one of the best times to consider converting all or a portion of a traditional IRA or 401(k) kitty to Roth is after retirement (and, thus, there's no salary income coming in the door) and before that traditional IRA or 401(k) is subject to RMDs. To limit the total tax bill, the retiree can take the lowest possible distribution that year, favoring distributions high-cost-basis positions in taxable accounts.

Situation: Your deductions are unusually high.
Tactic: Favor tax-deferred distributions.

If you find yourself with unusually high deductions in a given year--for example, you've made large charitable contributions or incurred extensive tax-deductible healthcare expenses--that can be an ideal time to take more from your tax-deferred accounts than might otherwise be the case. You'll be paying taxes at a lower rate for the year, and expediting your tax-deferred distributions can also serve to reduce the amount that will be subject to RMDs in the future. (The opposite tack is also reasonable: Favor distributions from Roth and taxable accounts if you find yourself in a high-tax year and have few available deductions.)

Situation: Your RMDs are unusually high.
Tactic: Favor lower-tax distributions from Roth or taxable accounts.

Once RMDs start after age 70 1/2, you lose some of the control over your tax situation that you had before. And because the percentage of your required minimum distribution will depend on your age, and the actual amount will be based on the size of your tax-deferred portfolio, there may be some years when your RMDs could leave you with more income subject to ordinary income tax than would otherwise be desirable. In those years, favoring additional distributions from taxable or, ideally, Roth accounts will be preferable to taking those additional distributions from your tax-deferred account.

Situation: One spouse is still working.
Tactic: Favor lower-tax distributions from Roth or taxable accounts.

As the above examples demonstrate, retirees have some flexibility to use withdrawal sequencing to finesse the amount of taxable income they receive in a given year. But if one partner in a couple is still working and the other retired, the couple may have reason to favor lower-tax distributions (from Roth and taxable accounts) in the years in which one partner is still drawing a salary. After all, the salary will be taxed as ordinary income, whereas the portfolio distributions don't necessarily have to be.

Situation: You have substantial tax losses.
Tactic: Favor tax-deferred distributions.

The ability to take tax losses on depreciated investments can be a silver lining in a difficult market, especially if you wanted to sell the investment anyway or can swap into a similar investment. You can use those losses to offset up to $3,000 in ordinary income or an unlimited amount of capital gains; what losses you don't use in a given year can be used in future years. In years they've taken tax losses, retirees might give preference to distributions from their tax-deferred accounts, in that they can use the losses to offset at least a portion of the distribution.