A common approach to retirement income relies on withdrawing money from taxable accounts first, followed by 401(k)s and IRAs, and finally Roth accounts. Conventional wisdom holds that withdrawing money from taxable accounts first allows a retiree’s 401(k) assets to continue growing tax deferred, while also preserving Roth assets to potentially pass on to heirs to leave.
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But this relatively simple and straightforward approach to generating retirement income can result in tax bills you could otherwise avoid. In a 17-page study, T. Rowe Price examined alternative withdrawal strategies that suited retirees whose primary focus was meeting spending needs, as well as those with significant assets and the desire to leave an estate for their heirs .
By changing the order in which assets are withdrawn from different accounts, especially by tapping tax-deferred accounts earlier than usually recommended, a retiree can actually reduce his tax liability, extend the life of his portfolio and leave a legacy for his heirs. , T. Rowe Price found.
“If you follow the conventional wisdom, you start to rely on Social Security and taxable account withdrawals,” Roger Young, a certified financial planner and director of thought leadership for T. Rowe Price, wrote in the report. “Since some of that cash flow is not taxed, you may pay little or no federal income tax in retirement before required minimum distributions (RMDs). That sounds great, but you may be leaving low tax income ‘on the table’. And if the RMDs go into effect, you may pay more taxes than necessary.”
A better way to meet spending needs and reduce taxes?
Choosing which accounts to use and when is critical to an effective withdrawal strategy. T. Rowe Price studied alternative withdrawal strategies that suited retirees primarily focused on meeting their spending needs, as well as those with significant assets and the desire to leave an estate for their heirs.
To illustrate how the conventional withdrawal strategy could cost you tax returns and how you can improve it, T. Rowe Price examined several hypothetical scenarios involving retired couples with both taxable and tax-deferred accounts.
In the first example, the company looked at a married couple with a relatively modest retirement income and an annual budget of $65,000. The couple collects $29,000 in Social Security benefits and has $750,000 in retirement savings, with 60% in tax-deferred accounts and 30% in Roth accounts. The remaining 10% ($75,000) is kept in taxable accounts.
Under the conventional strategy of using withdrawals from taxable accounts to supplement Social Security benefits first, the couple saves their Roth assets to use later in retirement. However, they would have to pay a federal income tax of $2,400 in years 4 through 17 of a 30-year retirement as a result of relying too heavily on their tax-deferred assets, which are taxed as ordinary income.
“A better approach is to ‘fill’ a low tax bracket with ordinary income from tax-deferred distributions,” Young wrote. This income could fill the 0%, he noted, where income is less than deductions, or the 10% bracket.
“Any spending needs above these benefits and Social Security can be met by liquidations of taxable accounts, followed by Roth distributions,” Young added.
By spreading the distributions from their tax-deferred accounts over several years (years 1 through 27), the couple would completely eliminate their federal income taxes, according to the analysis. This alternative approach also relies on taking Roth distributions earlier in the retirement year (year 8), rather than waiting until the 18th year of a 30-year retirement before taking these tax-free distributions.
T. Rowe Price’s analysis shows that the couple’s portfolio lasts almost two years longer (31.6 years) compared to the conventional method (29.8 years). “That’s an improvement of 6%. If both spouses die between the ages of 80 and 95, their heirs would receive between $19,000 and $63,000 more after-tax value than under the conventional method,” Young wrote.
A financial advisor can help you draw up a plan.
Retention of assets for your estate
A retired couple looks at their retirement portfolio. T. Rowe Price studied alternative withdrawal strategies that suited retirees primarily focused on meeting their spending needs, as well as those with significant assets and the desire to leave an estate for their heirs.
While the first scenario looked at how a couple with modest income and savings could optimize their withdrawal strategy to limit taxes and expand their portfolio, T. Rowe Price also explored how even wealthier retirees could keep more of their assets to leave to heirs.
Because money withdrawn from Roth IRAs is not taxable, many people choose to limit or avoid distributions from Roth accounts while they are still alive so that they can leave those accounts to their heirs. This makes Roth IRAs powerful and popular components of estate plans. But a couple expecting to leave an estate might consider keeping taxable accounts for a legacy instead of Roth assets, according to Young.
“Under current tax law, the cost basis for inherited investments is the value at the owner’s death,” Young wrote. “This is known as a ‘step-up’ basis, and it effectively provides gains during the original owner’s lifetime, tax-free to heirs. This can be a major advantage for people with assets that will not be spent during retirement.”
It is important to note that President Joe Biden proposed closing this legal loophole last year. As part of his Build Back Better agenda, Biden proposed eliminating the step-up in basis for assets over $1 million when a single taxpayer dies and $2.5 million for couples filing jointly. However, the provision did not gain enough support on Capitol Hill and was dropped from the bill that ultimately passed the House of Representatives.
In short
The conventional strategy for withdrawing retirement assets often begins by taking distributions from taxable accounts early in retirement so that the tax-deferred accounts can continue to grow. But research from T. Rowe Price shows that retirees with taxable accounts may want to consider alternative withdrawal tactics, including taking distributions from 401(k)s and other tax-deferred accounts earlier in retirement and spreading the money over more years.
Doing so may limit a retiree’s federal income tax liability on such distributions in a given year. Additionally, retirees hoping to leave an estate to heirs may consider keeping their taxable accounts deeper in retirement and passing them on to heirs instead of Roth IRA assets.
A financial advisor can help you navigate the many decisions you need to make when it comes to your retirement plan, including a withdrawal strategy. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Do you need help determining how much you need to save for your retirement? Fidelity’s 45% rule states that your retirement savings should generate about 45% of your pre-tax income before retirement each year, with Social Security benefits covering the rest of your spending needs.
SmartAsset’s retirement calculator helps you track the progress you’re making toward a savings goal. In the meantime, estimate how much your Social Security benefits will be using our Social Security calculator.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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