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Which Money Will You Spend First

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Updated November 27, 2017

Trust Point

We are proud of Trust Point’s century of service reputation of excellence. But, our approach and purpose has always been focused on the future. Not just our own company’s future - but, more importantly, our client’s futures.

Darwin F. Isaacson, CPA, PFS – Executive Vice President, Wealth Management Group

Sooner or later you will need to start spending the money you’ve been saving and investing during your working years.  Hopefully by that time, you will be fortunate enough to have accumulated several potential retirement income sources such as traditional IRAs, 401(k)s, taxable investment accounts, and Roth IRAs.

When it comes time to tapping into your portfolio during retirement, most retirees have the goal of generating as much income as possible without paying large amounts of income tax.  But not all sources of income are taxed the same as the tax laws vary depending on the source and type of income.  And the stage of retirement and your estate planning goals can also make a difference in which account you tap first and also how much.  At Trust Point, we believe in spending the time to help our clients develop a realistic plan to achieve their personal goals and objectives.

We believe the first step for retirees is to make a list of all potential sources of retirement income, including tax-deferred 401(k) plans, individual retirement accounts, taxable brokerage accounts, Social Security, and pensions.  Then come up with a strategy for drawing on them in the order that will make the nest egg last the longest while minimizing income taxes, if possible.

Taking a middle of the road approach and withdrawing some money from a taxable account and some from a tax-deferred account can be an effective strategy.  Taxable accounts are useful because long-term investments and dividends can be taxed at very favorable Federal tax rates for long-term capital gains, which can range from 0% to 24%.  In addition, the fixed income portion of the taxable account might be invested in tax-free municipal bonds to reduce the federal income   tax bite.  By contrast, ever dollar withdrawn from a traditional IRA or a 401(k) is taxed as ordinary income, which under current law could be taxed up to 40% Federal tax rate. 

However, the “standard rule of thumb” for many retirees has been to take income from taxable accounts first and from tax-deferred traditional IRAs and 401(k)s next, while allowing Roth IRAs to compound tax-free indefinitely.  This allows the traditional IRAs and 401(k)s to continue to grow tax deferred until distributions are required to begin at age 70-1/2 and thus reduces the current income tax bill.  But there are exceptions to every rule and the timing of withdrawals may depend on several factors such as the size of your tax-deferred accounts, when you claim social security, the age at which you retire, and your estate planning goals.  Our professionals believe the best approach is what works best for the client at that particular point in time.

For example, if you have attained age 70-1/2, you will be required to begin taking a minimum distribution from either a traditional IRA or a 401(k).  Thus, at that stage of your retirement it makes sense to take your required minimum distribution (RMD) from your traditional IRA or 401(k) before you withdraw from any taxable investment accounts.

In some cases it might make sense to start drawing down your IRA or 401(k) before the time when minimum distributions begin at age 70-1/2.  The RMD amount is determined by your age and account balance and a high balance can be a curse as well as a blessing when it comes to paying taxes on the distributions.  For very large tax-deferred accounts, the solution might be to start taking at least some IRA withdrawals before turning 70-1/2 even if it wasn’t needed and putting the funds in a Roth IRA.  This might help to avoid much larger RMDs which could force you into higher income tax brackets in later years called the “tax torpedo”.

This strategy of pulling more out of IRAs or 401(k)s might also depend on your estate planning goals.  For example, these tax-deferred accounts do not get a step-up in cost basis at death so they can be very “expensive” assets to leave to heirs.  On the contrary, hanging on to taxable account investments with a view to getting the step-up in basis at death is a very common and effective estate planning strategy.  This is especially true if the taxable investment accounts contain “legacy holdings” of highly appreciated stocks with very large unrealized gains.  In this scenario, your heirs will owe capital gains taxes only on the gains that occur after death so you avoid paying tax on the pre-death appreciation. 

If the estate plan provides for leaving money to charity, usually the best strategy is leave traditional IRA funds to the tax-exempt charity while bequeathing taxable accounts to heirs.  This is especially true if your heirs are in a higher income tax bracket as they will also be required to take RMDs.  So it may not be as beneficial tax wise to designate your children as beneficiaries of the pre-tax IRA.  So it is clear that the overall estate plan can be a huge factor in deciding which accounts to tap and the extent of those withdrawals.  Our team of credentialed staff which includes CPAs, CFPs, and JDs can help with income tax and estate tax planning.

One clear strategy, however, is to leave any withdrawals from a Roth IRA for last or not at all.  Withdrawals from Roth IRAs aren’t taxed at all (under current law) provided you are 59-1/2 when you take the withdrawals and you’ve held the account for at least 5 years.  By saving the Roth for last, you enjoy the maximum benefit of tax-free growth for as long as possible.  This is because contrary to traditional IRA’s and 401(k)s, there are no RMDs at age 70-1/2 from Roth IRA accounts.  Thus, holding funds in a Roth IRA gives retirees a lot of flexibility with no required minimum withdrawals and very attractive income tax-free assets to leave to heirs.

In conclusion, turning your nest egg into a paycheck isn’t easy and while there is a standard rule of thumb for retirees, there are also many factors to consider.  They key to a successful retirement is to enjoy your money and have a financial advisor who can navigate the tax rules while helping you plan your distributions to achieve your goals and objectives.  The professionals at Trust Point can assist you in planning distributions to save income taxes while advising you on strategies that make long term sense for you and your heirs.  Our goal is to make your assets last as long as possible and good unbiased advice from a fiduciary like Trust Point can make a world of difference.  Contact us now, we can help!

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Trust Point

We are proud of Trust Point’s century of service reputation of excellence. But, our approach and purpose has always been focused on the future. Not just our own company’s future - but, more importantly, our client’s futures.