Guidelines for tax-efficient spending from your portfolio

At retirement, many investors turn to their investment portfolio to help meet their spending needs. If you hold both taxable and tax-deferred accounts, here are some guidelines to help you determine the most tax-efficient way to spend from your portfolio.

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Amy Chain: And Kathy’s asking us about where to start drawing down from and what order should you start taking from which account in retirement? Christine, you want to kick us off?

Christine Benz: Sure. And I know, Maria, you and your team have looked a lot at this issue. So, kind of the standard sequence of withdrawals starts with anyone subject to required minimum distributions. Well, you have to take those because the penalty for not taking them is 50% of the amount that you should have taken but did not. So, start there if you’re subject to RMDs.

Assuming you’re not yet subject to RMDs or you need additional cash above and beyond what your RMDs provide, there the next in the queue would be your taxable accounts, so your nontax-sheltered retirement accounts. Those would be next in the withdrawal queue, mainly because you just get less benefit from holding the assets there. You have to pay, at a minimum, capital gains taxes on your withdrawals. If you’ve got bonds or something that’s kicking off ordinary income, you will owe ordinary income tax on money that you have housed within that account. So taxable accounts next, followed by tax-deferred accounts, followed by Roth accounts.

So, if you have Roth accounts, it’s important to remember that those are the most valuable to you from a tax standpoint. Their tax benefits are the greatest, there are no required minimum distributions, and they’re also really valuable assets for your heirs to inherit. So, you would probably want to put those further down in the queue.

But there are also reasons to sometimes think about bending these rules. There may be situations where, in fact, you’d want to put Roth assets ahead of other account types. So, these rules aren’t meant to be rigidly adhered to. They’re just kind of guidelines that people can use when thinking about positioning and sequencing.

Maria Bruno: Yes, I think that’s the conventional spend down. Christine and I were talking earlier today about this in that, you know, I think there may be more reason to think about does the conventional become less conventional going forward? When you think about retirees today leaving the workforce with large traditional deferred balances, they could be facing some pretty substantial required minimum distributions when they reach age 70. So, there could be some unpleasant tax surprises on those withdrawals when they’re made at a time when you’re also taking Social Security and that could trigger Social Security to get taxed if it wasn’t otherwise. So, some things that may be going on once you hit age 70 that you may want to plan for before that.

So, for instance, maybe someone who’s retiring at age 65, well, maybe it makes sense to, if you’re going to be in a relatively lower tax bracket, to draw down from those tax-deferred accounts first because it could presumably be taxed at a lower marginal tax rate. So, you’re accelerating the income tax, but you’re paying taxes at a lower rate. That’s a good thing.

The other thing is maybe a series of partial Roth conversions. So, taking advantage of those years when you may be in a lower tax rate and accelerating some income tax there to the benefit of being taxed at a lower rate. So, I think there’s some opportunity for some annual tax planning before you reach age 70 to think through whether it make sense to alter that.

Christine Benz: I love that research that you and your team have done, Maria, on what you call the preretirement sweet spot or the postretirement—

Maria Bruno: Oh, the Roth conversion zone, frankly, the sweet spot?

Christine Benz: Yes. It makes a lot of sense to me that people should look at that period from whenever they retire, whether it’s 65 or 66 or whenever, until those RMDs kick in as maybe a period to do some good tax planning.

Maria Bruno: It’s a little difficult sometimes because you really are in that situation accelerating an income tax liability. And that’s tough sometimes to think through, but it’s really understanding, well, I’m doing this, but it’s actually benefiting the longevity of the rest of the portfolio, or I might have multiple goals in retirement. Maybe have some legacy planning or charitable giving strategies. And you can be strategic on an annual basis. And that’s a highly personalized decision.

Christine Benz: Another thing in the mix is this issue of the years immediately following someone’s retirement, those are oftentimes high spending years. My colleague, David Blanchett, has done work on what he calls the retirement spending smile. And what he is seeing and observing actual retiree expenses is that that’s when people are feeling good, they might want to do their travel that they weren’t able to do so much when they were working; and so, from a practical standpoint, that might be when they want to spend more than they would in the sort of post-75-year period.

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