A Basic Framework for Retirement Distribution Planning

One of the most important financial decisions a retiree can make is determining which assets should be withdrawn to fund everyday life. The optimal distribution strategy would minimize the overall tax impact and save you money over time.  

There are three general types of accounts that retirees have and each has different tax implications.

  • Taxable accounts, which include checking accounts, savings accounts, and regular brokerage accounts. Interest and dividends from these accounts are taxed at ordinary income rates (10% to 37% in 2018) and capital gains rates (0% to 23.8% in 2018) are incurred when the investments are sold.

  • Tax-free accounts (Roth IRAs) are funded with after-tax money and grow tax-free indefinitely. No taxes are incurred when distributions are made.

  • Tax-deferred accounts (regular IRA, 401K, 403B and 457 accounts) are where you received a tax deduction when they were funded, and are fully taxed when a distribution is made.

The optimal order to distribute assets in retirement depends on your expected tax rates in the future.  Assuming your tax rates will be the same or lower in the future, here's the optimal distribution order.

retirement distribution planning
  1. Any income you receive and your required minimum distributions (RMDs). The first retirement money you should spend is from current income sources, like pensions and Social Security, and RMDs. If you are older than 70.5, then you’ll have to make RMDs on your tax-deferred accounts based on the IRS formulas. A common misconception is that the RMD has to come out of each account. While the calculation amount is based on all of your IRA and old 401(k) balances, you can take the RMD out of one or more account. You’ll have to pay taxes on these distributions at ordinary income rates, and failing to take your RMD can result in a massive 50% IRS penalty.

    One strategy to consider for charitably inclined retirees is to take a Qualified Charitable Distribution, which essentially allows you to avoid taxes on the IRA distribution as long as it’s distributed directly to a charity. Your Roth IRAs don’t have RMDs since the contributions were already after tax funds.

  2. Taxable accounts. The first money that should be distributed after your RMDs should be from your taxable accounts. Ideally, you would choose to sell specific taxable securities held for 12 months or longer with a high basis relative to its current price to minimize taxes. Using the taxable investments before your tax-free and tax-deferred funds allows you to maximize the tax benefits of tax-deferred and tax-free funds.

  3. Tax-deferred accounts. The long-term financial benefit of tax-free assets (Roth IRA) is more valuable than the benefit of tax-deferred assets, so preserve the Roth benefit by distributing from the tax-deferred accounts before your Roth IRAs.

  4. Tax-free accounts. You can maximize the value of tax-free assets by spending these assets last. Depending on how much income you earn in retirement, you might want to consider converting some of your tax-deferred assets into tax-free assets through a Roth conversion. The Roth conversion allows you to pay taxes on a tax-deferred distribution and put that money in a Roth account where all future growth and income would avoid taxation. This is particularly effective in years of low income or in conjunction with a charitable giving program. Perhaps you can do a partial Roth conversion on amounts that bring you up to the 10% or 12% bracket. Moreover, this strategy is most effective when the conversion taxes are paid with taxable funds and not with IRA funds.

    Roth conversions can help maximize Social Security benefits and minimize Medicare premiums. Higher income levels in retirement are penalized with more of your Social Security benefits being taxable and higher Medicare premiums. For example, monthly Medicare Part B premiums increase for 2018 based on 2016 income for couples with over $170,000 in income from $134.00 to $187.50, and couples with more than $44,000 in income can have up to 85% of their Social Security benefits taxable. As more money converts into Roth IRAs, the result is lower IRA balances, which translates into lower RMDs and lower overall income levels.

    Our experience with clients has been that for many retirees, Roth conversions in early retirement years can allow assets to last longer. The Roth conversions result in an increase in near term taxes, but allow for a more consistent tax rate over the retiree’s lifetime, lower lifetime RMDs amounts to be taxed, fewer Social Security benefits to be taxed, and possibly lower Medicare premiums. As well, if you do Roth conversions early in retirement, they’re subject to married filing joint tax rates. If you delay doing Roth conversions until later in retirement, the same conversion amount would potentially be subject to filling at higher single tax rates due to one of the spouses passing.

Minimize taxes in retirement

Estate considerations. You should also consider inheritance plans in your distribution strategy. For example, someone in their 80's or 90's may want to not sell low basis stock in their taxable estate, since their heirs would get a step-up in basis when they inherit that stock and owe little or no taxes when they sell.

Charitable financial planning. Distributing from the right accounts to charities can help maximize the tax efficiency of gifts. For those that can itemize, it’s ideal to give the charity directly low basis stock rather than selling stock and giving the charity cash. Giving the stock directly avoids capital gains taxes. If you’re donating a mutual fund to charity, you’ll want to do so ahead of annual capital gain and income distribution in December. Doing so will maximize the distribution and avoid the extra taxable income from the distribution.

For those over 70.5, a Qualified Charitable Distribution (QCD), which is a direct distribution from an IRA to a charity under $100,000, can help lower overall tax bills. Since the QCD counts toward the annual RMD and lowers AGI, it could potentially help some people lower taxes on their Social Security benefits by getting below the taxable thresholds.

If expecting higher future income tax rates. If you are expecting your income to push you into a higher bracket later in retirement, or you believe that Congress would increase overall tax rates, the optimal distribution strategy changes. Under this situation, you’ll likely want to distribute from your tax-deferred accounts before your taxable assets, given that distributing from tax-deferred accounts later would result in a much higher tax bill. After distributing the tax-deferred assets, you should distribute from the taxable accounts, and then your tax-free accounts.

Rebalancing and portfolio risk. It’s important to consider your overall portfolio objectives and risk while distributing assets in retirement. For example, avoiding selling a large low basis taxable position can delay paying taxes, but it could also significantly increase the overall risk of the portfolio. As well, if you were optimizing which securities go into which accounts in pre-retirement by buying your stocks in taxable accounts and bonds in tax-free accounts since capital gains on stocks are lower than ordinary income rates, you’d start to have an overall portfolio increasingly weighted to bonds as you sold your taxable assets first in retirement. Regular rebalancing can help avoid any mismatch between your risk tolerance and overall portfolio risk.

Don’t forget tax basics in the taxable account. In conjunction with optimizing your retirement account withdrawal order, you should continue to employ tax-minimization best practices in your taxable accounts: harvesting positions with losses to offset gains, minimizing high-turnover investments to avoid frequent capital gain distributions and costly short-term capital gains, and being careful not to buy mutual funds towards the end of the year that would present you with a large deferred capital gains.

David Flores Wilson, CFP®, CFA, CDFA®, CCFC is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Wealth Advisor at Watts Capital.  He can be reached at dwilson@planningtowealth.com.