Strategies for Withdrawing Assets in Retirement

As you enter retirement, there are a number of issues you must address. In addition to enrolling in Medicare and deciding when to claim Social Security, you must determine your optimal withdrawal strategy in retirement. A key question with regards to withdrawal strategies is "Should I withdraw from my taxable or tax-deferred accounts first?" My colleague Kevin Grogan at Buckingham Asset Management takes a look at the academic literature on the topic.

A paper by William Reichenstein titled "Tax-Efficient Sequencing of Accounts to Tap in Retirement" provides some answers. Reichenstein states, "Returns on funds held in Roth IRAs and traditional IRAs grow effectively tax exempt, while funds held in taxable accounts are usually taxed at positive effective tax rates." Reichenstein's paper notes that only part of a traditional IRA's principal belongs to you. The IRS "owns" the remaining portion, so the goal is to minimize its share.

For those able, but not yet required to take distributions from tax-deferred accounts, it's typically best to withdraw from taxable accounts first. The withdrawals would be taxed at capital gains rates instead of ordinary income rates. Also, it may be preferable to sell tax-inefficient assets (such as bonds or REITs) held in taxable accounts before selling more tax-efficient assets.

There are some exceptions to these rules:

• If your main source of income comes from tax-sheltered accounts, consider withdrawing assets from these accounts until your taxable income at least reaches the lowest tax bracket. This exception should apply to any year when taxable income is low. An example would be a year in which you have sizable medical bills.
• Other withdrawal sequences may be preferable if your IRA beneficiaries will be in a higher tax bracket than you.
• If you have substantial unrealized gains on taxable assets, consider withdrawing funds from retirement accounts before liquidating the appreciated assets. The effective tax rate on the capital gains will be zero if these assets are passed on after you die, as there will be a step up in basis at death.
• Delaying withdrawals from an IRA can mean a higher tax bill if the tax rate later rises to higher levels. In addition, a Roth IRA conversion may make sense if you're in a lower tax bracket and don't need to withdraw funds from the IRA to meet spending needs. In these cases, it may not be appropriate to delay withdrawals from traditional IRAs for as long as possible.