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SMART INSIGHTS FROM PROFESSIONAL ADVISERS

A Retirement-Withdrawal Strategy for Millionaires

The way in which you tap your assets can have long-term tax consequences for you and for your heirs.

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It’s always nice to have options, and when retirees have $1 million or more in assets, they have a lot of options. But they also have a lot of decisions.

SEE ALSO: How Do You Know When You’re Ready to Retire?

A retirement-withdrawal strategy for such people varies for each person, but it begins by determining how all assets are structured and when any payouts begin.

People retiring from corporate life may have deferred compensation, a pension or stock options. A retiree who has just sold a business may be receiving payments over several years as part of the sale, and someone who purchased an annuity years ago may be planning to turn on that income stream soon. So before assuming that withdrawals from investment accounts are needed on Day 1 of retirement, it’s critical to map out a cash-flow plan. This plan also needs to include assumptions about any part-time or consulting income you’ll earn those first few years.

Mapping Out a Five-Year Cash Plan

To start, I recommend a multi-year cash-flow plan, covering at least five years. This provides a solid idea of how soon you’ll need to start tapping your nest egg. You may not need withdrawals right away, especially if you have income from other sources coming in the first few years of retirement, as mentioned above.

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Even before the mapping process begins, I advise pre-retirees to build cash to cover at least one to three years of their estimated retirement withdrawal needs and place it in their preferred bank. For example, if you anticipate needing $75,000 annually to pay for all expenses, keeping $75,000 to $225,000 in cash is reasonable.

This strategy provides flexibility, which is critical for a number of reasons.

  • If much of your portfolio is in stocks and those investments drop 20% or more, you can live on your cash instead of selling stocks when they are priced low. Having enough cash available helps ensure you’ll cover your spending needs, giving the stocks time to recover.
  • Next, cash is part of your fixed-income strategy. You are entering withdrawal mode vs. accumulation mode, so moving some stocks to cash is a reasonable decision to balance out your asset allocation.
  • Also, you may not truly know what your normal retirement spending needs are, or you may be planning to front load some vacations early on, so keeping a little extra cash available will help smooth out the transition from paycheck to portfolio years.
  • Finally, the year someone retires is often a big tax year, so extra cash can help cover a larger tax bill in that year.

Put a Withdrawal Plan in Place

When a retiree starts needing withdrawals, what accounts should they draw from first?

Start by evaluating the ratio of taxable account assets to tax-deferred and tax-free account assets. If all of the assets are in 401(k) or IRA plans, there isn’t much need for further analysis, because withdrawals will be subject to ordinary income tax.

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However, if a retiree has a mix of assets, we can determine which accounts should be tapped first by reviewing the person’s age and their tax bracket. A person with $1 million or more in assets may be in the top federal tax bracket when you factor in all of their other income sources, which means they will pay 39.6% in taxes. This means that any withdrawals should come from more tax-favored accounts if possible, such as cash or taxable brokerage accounts, which are taxed at lower capital gains rates.

For example, consider a person who has invested $500,000 in a taxable brokerage account, which has now grown by 20% to a grand total of $600,000. Approximately 20% of their withdrawals will be subject to capital gains taxes (15% - 30% federal and state combined rate, depending on the state you live in) and 80% of withdrawals could be subject to 0% tax as it’s a return of their principal.

Be Mindful of IRAs, 401(k)s and HSAs

I generally recommend that people don’t withdraw money from their IRAs or qualified retirement plans, such as 401(k) plans, right away. This is especially true for early retirees, and they should wait until they reach at least age 59½ to avoid the 10% early withdrawal penalty. It’s yet another argument for spending down cash or taxable accounts first.

One of the most important guidelines for anyone with $1 million or more in assets is to avoid withdrawing any funds from Roth IRAs or Health Savings Accounts (HSAs) for as long as possible. The reason: Allow these tax-free accounts as grow much as possible.

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See Also: This Will Make You Rethink Your Dividend Investing Strategy

Here’s a great example. Let’s say a retiree faces an unexpected $20,000 medical bill later in retirement. If this bill is paid from an IRA, the retiree will need to withdraw a pretax amount of $30,000 or more.

But if we have a sizable enough tax-free asset — like a Roth IRA or an HSA for qualified medical expenses — the client needs only to tap into $20,000. The more money a person has in tax-free assets, the lower their withdrawal needs, which increases the likelihood they won’t outlast their portfolio.

Keep Things in Balance

But be careful! There needs to be a reasonable balance between taxable and tax-deferred account withdrawals, as it could hurt you later in life. While taking money out of cash and taxable accounts means you are likely to pay less income tax in the early retirement years, if you allow those accounts to dwindle down as retirement progresses, you could be left with a portfolio consisting only of IRAs and other assets subject to ordinary income taxes. That could mean years of unpleasant tax bills or a faster drawdown rate later in retirement.

If the proportion of tax-deferred assets becomes significantly larger than taxable assets, it may make sense to start withdrawals from the IRAs sooner than age 70½, when the IRS required minimum distribution (RMD) rules kick in. You can calculate how much you can withdraw from your IRA without being bumped up into a higher tax bracket, and implement that strategy for several years. Once RMDs start, it may be the last time you ever see those low tax brackets!

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Not balancing your withdrawals can especially be an issue for retirees who need to live in a nursing home later on, which could result in annual withdrawals double or triple the amount they had planned for. To help safeguard against this possibility, I often recommend long-term care insurance. I like to refer to it as bubble wrap around a retiree’s portfolio.

Two Final Considerations

Finally, here are a couple of other strategies to consider.

For people in their 80s and 90s, and those with health issues, their withdrawal plan may shift to the goals of passing along assets to the next generation or making charitable contributions. A person could spend down their tax-deferred accounts — such as 401(k)s and IRAs — during their lifetime, while leaving the accounts that they’ve already paid the taxes on — such as bank accounts, real estate and Roth IRAs — untouched. That can be more tax beneficial to their heirs and is a particularly good strategy for retirees who are in a lower income tax bracket than their heirs.

Those late into retirement or with health issues may also want to consider making annual gifts to family or charities if their estate is large enough ($5.49 million or greater for 2017) where estate taxes are a potential issue. They could take up to $100,000 out of their IRA to take advantage of the qualified charitable distribution rules, or perhaps gift low-cost-basis stock in the taxable accounts to charity. Retirees can also take advantage of the annual gift tax exclusion by gifting $14,000 annually to an unlimited number of people.

See Also: Working Part-Time in Retirement Can Be Tricky

Lisa Brown is a partner and wealth adviser at Brightworth, an Atlanta wealth management firm with $3 billion in assets under management, serving over 1,200 families in 48 states. She works with high net worth families in investment management, executive compensation, retirement transition and estate planning. Brown is a Certified Financial Planner™ and an Accredited Estate Planner.

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