For many retirees, the conventional way of thinking may not be the most tax-efficient.
After having accumulated a (hopefully) big pot of savings over the course of their careers, investors are faced with a daunting task upon retirement — drawing down those assets in a tax-efficient way.
The conventional wisdom goes as such: Take distributions first from taxable accounts, such as a brokerage account; then from tax-deferred accounts, such as 401(k)s and IRAs; and then from tax-exempt, or Roth, accounts.
That traditional way of thinking is based on the mantra of deferring taxes for as long as possible, but that might not always be the most tax-efficient drawdown approach, advisers say. Some advocate for so-called tax smoothing, or managing distributions over time to pay some taxes along the way rather than deferring taxes for as long as possible and potentially taking a larger hit down the road.
“If you rely exclusively on taxable accounts first, what you're doing is giving up valuable opportunities to get money out of your tax-deferred account at relatively low rates,” according to Stephen Horan, managing director of credentialing at the CFA Institute.
Advisers can potentially help clients draw down assets more efficiently through strategic use of “low” tax brackets, or by taking advantage of low marginal tax rates, Mr. Horan said.
Each tax situation is different, Mr. Horan explained, but as a general rule of thumb, that strategy involves filling the low brackets with tax-deferred withdrawals, and then pulling from taxable accounts to make up the remainder of cash-flow needs, preserving Roth money as long as possible.
For many retirees, filling up to the limit of the 15% tax bracket will be the appropriate route, Mr. Horan said, because it's relatively low and they can make a lot of taxable distributions at that rate.
Married couples filing jointly, for example, can realize $96,000 of income and still be in the 15% tax bracket. (That factors in a $12,600 standard deduction and $8,100 of personal exemptions, in addition to the $75,300 upper income limit for the 15% marginal tax rate.)
Drawing primarily from tax-deferred accounts to reach the upper limit of that bracket could reduce the required minimum distributions mandated from these accounts after age 70 ½. By not taking smaller distributions from these accounts over time, there would be larger RMDs in the future, which could push retirees into a higher tax bracket and create an overall higher tax burden.
Of course, “low” is a relative term — the 25% bracket might be more appropriate to fill with tax-deferred assets for a wealthier investor, or someone with $2 million of tax-deferred assets and $1.5 million of Roth assets, for example, according to Mr. Horan.
The tax-smoothing approach “would be an ideal plan,” but not all investors will have the ideal mix of retirement accounts for the strategy to be realistic, according to Steven Siegel, president of The Siegel Group.
Also, while filling up low tax brackets with tax-deferred money is a good approach, it ignores the “time value of money,” said Tim Steffen, director of financial planning in Robert W. Baird & Co.'s private wealth management group. It's a tradeoff — accelerating the tax and paying it now at a low rate, versus deferring until later but at a potentially higher rate.
Pulling from these accounts prior to needing to take RMDs means investors essentially incur a tax liability they don't need to, according to Mr. Steffen. Allowing that money to grow tax-deferred into the future could perhaps make up for a potentially higher marginal tax rate, he added.
One reason an investor might choose to pull from IRAs or 401(k)s first and minimize distributions from a taxable brokerage account is due to the basis adjustment investors receive upon death, whereby capital gains tax is eliminated because basis steps up to the security's market value. (An asset owned jointly by a married couple only gets a 50% basis adjustment if one spouse dies.) For an older investor planning an estate, and who wishes to minimize taxes for heirs, this could be an attractive route, Mr. Steffen said.
Further, the tax smoothing approach might more easily allow an investor to delay claiming Social Security until age 70, the maximum age to claim, thereby maximizing the Social Security income stream, Mr. Siegel said.
However, advisers also need to pay attention to some tax-return “ripple effects,” according to Mr. Steffen. For example, Social Security benefits are tax-free for low-income people, and portions of those benefits become taxable as taxable income rises. By pulling money from an IRA and increasing taxable income, an investor could inadvertently turn some Social Security income into a taxable benefit.
