The order of withdrawals can have a big impact on your tax bill
Vanguard investing expert Michael DiJoseph explains why the order in which you take your retirement withdrawals can have a big impact on your yearly tax bill. 

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Notes:
  • All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation.
© 2016 The Vanguard Group, Inc. All rights reserved.

TRANSCRIPT

Gary Gamma: And this one’s about sequence of withdrawals; something else we hear a lot about. And Bob from North Carolina says, “Pensions/Social Security versus taxable versus tax-advantaged. I asked the same questions for years and never get a great answer. It seems like the pension and Social Security component are not being taken into account.” What’s the thought there?


Michael DiJoseph:
All right, well, let’s answer today then for him. So we would say, take a step back before we decide Social Security versus pension versus portfolio withdrawals, potentially. We would say that the Social Security, pension income, maybe other employment income, things like that, should go—kind of what we were talking about with the plan—we should use those to determine, these are my income sources. Take a nice hard, long look at what your expenses are. And to the extent that there is a shortfall there, then we would say, “Dip into the portfolio.” But I don’t think we would say to spend from the portfolio before taking Social Security or pension, because you’re going to get taxed on those anyway. So if you’re reinvesting them, you’re going to end up getting double-taxed. So, again, to the extent that there’s a shortfall from there, then we would say, “All right, well, let’s turn our eyes to the portfolio now.” And that’s where we’ve kind of developed a methodology for those who are really seeking to maximize income in retirement. We would basically say, “Spend your RMDs first. They’re already required by law if you’re at the age where that’s applicable to you. And, again, if you were to reinvest them and spend them later, you’ll get double-taxed again.” Now from there we would say, “Spend the flows from the taxable aspect of the portfolio.” So things like dividends, income payments that you might be getting from assets held outside of your retirement accounts. And this is where it might get a little bit different. So I think the story kind of goes, “Well, I’ve spent my whole life saving for retirement. Where? In my retirement accounts. Right? So, obviously, now that I’m retired, I’m going to spend from my retirement accounts.” But the key here is that those accounts are often tax-advantaged, emphasis on “advantaged.” And we would say that before dipping into those, again, with the caveat that you’re looking to maximize your lifetime income, we’d say, “Spend from that taxable portion of the portfolio before dipping into those assets. And now keep an eye open for things like tax-loss harvesting to the extent that you can, minimizing gains to kind of minimize the taxes when you actually spend from that portion. But do that, allow the tax-advantaged to compound over longer periods of time before dipping into those retirement assets.” And then from there, to answer the question about tax-free, tax-deferred, meaning traditional versus Roth, we would say, “To the extent that you can, have some kind of insight into your future tax rates. If you’re going to have a higher tax rate in the future, you probably want to spend the traditional assets first and kind of take advantage of the lower tax rate today, or vice versa.” The reality is most people don’t know for sure, so we would say, “Maybe practice some sort of tax diversification, where you’re spending a little bit from each type of bucket.”

Gary Gamma: Yeah. And I think it’s important, your first answer, it kind of goes along with this, which is, “If you’re really tight on that income, maybe when the market’s doing well, you can spend a little more, but then keep an eye on how you’re spending when the market’s not so good.”

Michael DiJoseph: Absolutely! To the extent that that’s possible and you have the flexibility.

Important information All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation. © 2016 The Vanguard Group, Inc. All rights reserved.