Source: Tax-Efficient Withdrawal Strategies, Financial Analysts Journal, March/April 2015.
If you’re approaching or already in retirement, you know that there are many things to consider when it comes to your personal finances and investments. Of course there are the obvious ones: Social Security, required minimum distributions (RMDs), and ensuring that you have the proper asset allocation for your risk profile.
In addition, most investors are aware of the fact that taxes are a critical issue in retirement. Aside from the taxation of Social Security, the biggest issue that most retirees face is withdrawing money from their IRAs, 401ks, and other investment accounts.
Retirement withdrawal strategies can be quite complex. However, as the chart above shows, smart tax planning can add several years to the life of your portfolio. Let’s explore this concept further to understand the implications.
The Conventional Wisdom on Retirement Withdrawals
The conventional wisdom for tax-efficient withdrawals during retirement is to tap your accounts in the following order:
- Taxable accounts
- Tax-deferred accounts (e.g. traditional IRAs and 401ks)
- Tax-exempt accounts (e.g. Roth IRAs and 401ks)
The idea behind this approach is to preserve the funds in Roth accounts for as long as possible in order to allow them to continue to grow tax free. This advice is widely cited by most personal finance and investment publications, as well as the largest mutual fund families and brokerage firms.
A Smarter Approach
However, as I discuss with all of my clients who can benefit from smart tax planning, the conventional wisdom is generally not the best strategy.
Instead of simply following the order outlined above, your focus as an investor should be on minimizing the actual taxes paid. This may sound obvious, but the conventional wisdom effectively ignores the details in favor of a broad brush rule of thumb.
It’s also important to note that the idea of minimizing your total taxes paid starts well before retirement. In fact, an intelligently designed tax minimization strategy applies both to the contributions you make as you build your nest egg and to the withdrawals you make during retirement.
The execution of such a strategy then becomes an ongoing process of optimizing contributions and making tax-efficient withdrawals:
- Optimize Contributions: Contributions should be made to tax-deferred (traditional) accounts during years in which you are in a higher tax bracket than you expect to be in during retirement. Conversely, you should make Roth contributions when you are in a lower tax bracket than you expect to be during retirement.
- Tax-Efficient Withdrawals: If a client has funds in a taxable account, it is generally advantageous to use this money to pay for living expenses first until the taxable account is exhausted. This is identical to the conventional wisdom. However, the next step is for investors to review their expected taxable income each year. To the extent that the investor is in the 10% or 15% tax bracket, they should strongly consider converting part or all of the funds in their tax-deferred (traditional) accounts to Roth funds. The idea, of course, is to execute conversions until the taxpayer reaches the top of the 15% tax bracket, thereby locking in low rates of taxation on the converted amounts. For some investors, it may also make sense to continue conversions into the 25% or even 28% tax bracket.
The above approach can result in significant tax savings, often to the tune of tens of thousands, or even hundreds of thousands, of dollars. Those savings can improve the investor’s lifestyle and also reduce the risk of the investor running out of money during retirement.
That said, it can be a bit challenging to illustrate the total benefit of tax-efficient withdrawal strategies because of how dynamic they can be. Thankfully, a recently released academic study helps to advance the merits and benefits of smart tax planning in retirement.
New Academic Research Sheds Light on Tax-Efficient Withdrawals
New research from professors Kirsten A. Cook and William Reichenstein, CFA, along with William Meyer, focuses on the impacts of several different retirement withdrawal strategies as it relates to the longevity of an investor’s portfolio.
Their paper, Tax-Efficient Withdrawal Strategies, appeared in the March/April 2015 edition of the Financial Analysts Journal (available for download here) and does a fabulous job illustrating the cumulative benefits of the conversion strategy I outlined above.
Here are a few key highlights from the paper:
- Investors should think about tax-deferred accounts (such as a traditional IRA) as a limited partnership in which the investor is the general partner and the government is the limited partner. The investor owns a portion of the partnership interest (1 – t) and the government owns the remaining amount (t).
- An investor receives 100% of the returns from a tax-exempt or a tax-deferred account. However, they typically only receive a portion of the returns from a taxable account (due to taxes on capital gains, dividends, and interest). This is a critically important point and one that I plan to explore in greater detail in a subsequent post. For the purposes of understanding the conclusions of this paper, just know that a fundamental concept of minimizing taxes on retirement account withdrawals is realizing that a Roth account is equally as tax-advantaged as a traditional account. Therefore, the conventional wisdom of simply withdrawing from traditional accounts before Roth accounts isn’t always going to be correct.
- In order to extend the life of an investment portfolio, the investor’s objective should be to identify opportunities to withdraw funds from tax-deferred (traditional) accounts at particularly low rates. Generally, this means taking withdrawals or executing conversions during years in which the investor is in the 10% or 15% federal tax bracket.
- The opportunities to make these withdrawals or conversions are often during the years before required minimum distributions begin and in years when the investor has large tax deductions, such as those from high medical expenses.
- Smart withdrawal strategies can add two to three years to the life of a portfolio compared to the approach advocated by conventional wisdom. What should be even more eye opening for investors is that the worst withdrawal strategy (i.e. the most tax inefficient) can shorten the life of your portfolio by as many as five or six years.
The last bullet is obviously where the rubber meets the road. If you don’t have a clear plan around making withdrawals during retirement, it’s absolutely vital that you sit down to consider your options. Ultimately, you don’t want pay any more taxes than you need to!