Which Accounts to Spend Down First in Retirement

The traditional belief about which order you’re supposed to spend down your retirement accounts is essentially flawed. You run the risk of deducting years from the longevity of your portfolio if such conventional wisdom is taken at face value.


The Problem With the Conventional Approach

As a retiree, you must have constantly heard about utilizing your taxable assets first, such as bank accounts and stocks. Next in line should be tax-deferred assets like 401ks and traditional individual retirement accounts (IRAs), then tax-free accounts last (e.g., Roth IRAs). The rationale behind this concept is that you can extend the life of your retirement assets if you defer large tax bills as long as possible. This premise makes sense to some degree, but the flaws become clear once you mull over the actual mechanics. 

For instance, think about emptying all of your other assets before touching your Roth IRA. What happens if your only sources of income at that point are Roth IRA and Social Security withdrawals? You will likely end up with no taxable income because your Social Security benefits would likely be non-taxable. Yet, your personal exemption, as well as the standard deduction, would still apply and are essentially wasted. Keep in mind that a tactic that wastes any valuable deduction is fundamentally inefficient. 

Besides, those who blindly follow this investment advice and completely deplete their taxable assets usually find themselves in a dilemma. They’re caught in a high tax bracket after Social Security benefits as well as required minimum distributions (RMDs) start. As soon as they commence, it would be difficult to keep these income sources from filling the tax brackets. What if the consolidated amount is sky-high? There’s a risk of triggering higher taxes on other items. These include capital gains and dividends, Social Security benefits, and even certain Medicare premiums. 

Every type of account has its own advantages. With thorough planning, though, there’s a chance of having them work well together, thus reducing lifetime tax bills. Any approach that unreasonably drains assets one at a time, instead of trying to integrate them properly, should be regarded as incomplete. 

A Better Approach

It would be foolish to think that there’s a one-size-fits-all method for all investors. The optimal strategy for every retiree will be different, and there’s no way that all those possibilities can be covered in one sitting. Fortunately, some general principles may apply to everyone. Here are some useful tips to help you get started:

Start With Placing Assets in the Right Account

Before you decide which accounts to spend down first, you must make the most of every account type. The principle of assigning classes of assets in the right account is called asset allocation. For instance, think about highlighting stocks in your taxable accounts, where they gain desirable tax treatment on long-term capital gains as well as qualified dividends. One way of keeping your asset allocation intact is by emphasizing the bonds in your IRAs in the same way. This concept alone can help add years to the life of your portfolio by reducing your lifetime tax bills. When this strategy is applied with the best draw-down techniques, the outcome can be even more compelling. 

You also need to make sure you run various strategies through a solid financial planning application. You can do this on your own or use a financial planner. If you decide to do this on your own, use a financial and retirement planning software package that is detailed and accurate, such as WealthTrace or RightCapital.

Stick to the 15% Income Tax Bracket

Should your situation permit, try to stay in the 15 percent federal tax bracket as long as you possibly can. Here are the primary reasons why: 

  1. There’s a big jump between the 15% bracket and the next rate, which is 25%.
  2. Investors in this tax bracket may qualify for a zero percent tax rate on long-term capital gains as well as qualified dividends.

Perhaps the biggest challenge to staying in the 15% tax bracket is the RMDs. If your IRA growth is not monitored, it can push you into a higher income tax bracket. A similar but possibly stronger alternative is to convert this same amount into a Roth IRA. This is presuming that you can live off taxable assets for the time being and that you’re capable of paying the tax bill for such conversion. 

Utilize Your Roth IRA

Many investors have never touched their Roth IRAs during their lifetimes. When asked, these people usually argue that given its numerous advantages, they refuse to squander this particular account. But what’s the point of keeping a Roth IRA all this time if you’re never going to use it?

An excellent way to utilize your Roth IRA is to use it together with your other tax planning. For instance, if you want to sell an appreciated equity position, allowing a portion of your living expenses to be covered through withdrawals from Roth IRA instead may potentially make you eligible for the previously mentioned zero percent rate on that gain. 

Another known strategy is tapping your Roth IRA account during the years when you have the highest income tax. This way, you can dodge the odds of being propelled into an even higher income tax bracket. So, if RMDs push you atop the 15% bracket, you may be able to avoid the next bracket by using your Roth IRA withdrawals to cover your remaining living expenses. 

Charitable Contributions

A lot of retirees make regular contributions to charitable institutions. With the special tax treatment associated with this, you’d want to pay close attention to how you will cover this expense. Generally, the most powerful strategy is donating appreciated positions from your taxable assets when you itemize your deductions. If you don’t itemize and you’re over the age of 70½, the best course of action is to make a qualified charitable distribution from your tax-deferred account. This will keep the donation from your income. 

A framework for future tax changes has been discussed by the current administration. But it’s likely too soon to take risks and make big adjustments to your plans. It’s best to keep a close watch on the details, so you can evaluate the implications of your draw-down tactics. 


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