Conventional Wisdom on Withdrawals isn’t Always Right

There’s more to a financially successful retirement than accumulating a large portfolio. You also need to make good decisions about how to withdraw your assets once you’re no longer working full time.

For many savers, developing a retirement income strategy is an afterthought, and they run the risk of losing a significant chunk of their retirement savings to taxes. To maximize the odds of achieving your lifestyle goals in retirement, it’s important to come up with an income strategy that accounts for the tax consequences of making withdrawals.

Merits of variable withdrawals

When it comes to retirement income planning, conventional wisdom isn’t always appropriate. Consider the oft-cited recommendation that retirees should withdraw approximately 4% of their retirement portfolio annually. This can be a good general guideline, but some may find it poorly matched to their income requirements.

An alternative approach is to vary annual retirement withdrawals based on a combination of factors, such as economic and market conditions, the size of the portfolio, and the expected length of retirement. You’ll also need to look at your spending needs. Many people have higher expenses in the first phase of their retirement as they pursue travel and other costly leisure activities, while their goals and income needs may change in their later years.

Inflation may influence your withdrawal strategy too. Low anticipated inflation can support higher withdrawals. But if inflation is climbing or expected to climb, you may need to adjust your withdrawals accordingly to reflect the reduced value of your portfolio.

Taxable vs. tax-deferred accounts

Another common maxim is that you should liquidate securities from taxable investment accounts before you tap into tax-deferred accounts. The logic here is that withdrawals from taxable accounts with appreciated assets are taxed at a maximum 20% capital gains rate if they’re held for more than one year. In contrast, withdrawals from tax-deferred accounts are taxed as regular income, at federal rates as high as 39.6% (plus any state income tax owed).

Accordingly, you’d need to make larger withdrawals to end up with the same amount of after-tax money. Plus, leaving assets to accumulate in a traditional IRA or 401(k) account gives those assets more time to enjoy compounded, tax-deferred growth.

Research by Rider University professors Lewis W. Coopersmith and Alan R. Sumutka confirms that liquidating taxable investments first makes sense — in some situations. For example, it might benefit individuals with limited taxable savings whose return on taxable assets is similar to or less than the return generated by their tax-deferred assets.

But other individuals might want to consider the opposite approach. Withdrawing from taxable accounts first can increase the required minimum distributions (RMDs) you must begin taking from traditional IRAs, 401(k)s and other tax-deferred accounts starting at age 70½. If you neglect to take your RMDs, you face a big tax penalty — 50% of the amount you didn’t withdraw — so it should never be considered a viable option. (Note that RMDs don’t apply if you have tax-free accounts such as Roth IRAs and Roth 401(k)s.)

By delaying your RMDs until the last possible moment, you can increase your taxable income over a shorter time frame, which could place you in a higher tax bracket when RMDs begin, thus reducing your overall income. Taking this longer-term view when withdrawing funds for retirement, rather than simply minimizing your current tax, may allow you to increase the total amount of money you can keep after taxes.

Strategy that reflects your needs

Conventional wisdom regarding retirement account withdrawals may work for you, but probably only to a certain extent. Your retirement needs are unique, which is why it’s important to work with a knowledgeable tax advisor. Your advisor can recommend a withdrawal strategy that maximizes your retirement income when you need it most and make it possible for you to achieve your retirement goals. Don’t hesitate to give us a call and speak with one of our tax team if you have questions that need further explanation.

Sidebar: Realizing your wealth transfer objectives

If you expect to pass along wealth to your loved ones, you have another important reason to pay close attention to the income tax impact of your withdrawal strategy: Your heirs will owe income taxes on any assets they inherit from tax-deferred retirement accounts.

If your primary goal is to maximize the amount that goes to your beneficiaries, it may make sense to withdraw from a traditional IRA or 401(k) before you do so from a Roth IRA or other tax-free account. This may allow your beneficiaries to take more or all of their distributions from the Roth IRA, free of income taxes. Note, however, that these proceeds will still be considered part of your estate and thus subject to estate taxes — an important consideration if your estate is large.