Tap Your Portfolio With Taxes in Mind

When it comes to tapping your portfolio during retirement, you have two major goals: generating as much income as you can while keeping the lid on your tax bill. A general rule of thumb is to pull income from taxable brokerage accounts first and from tax-deferred traditional IRAs next, while allowing Roth IRAs to compound tax free as long as possible.

For the typical retiree, that's a good place to begin. Many studies show that nest eggs often last longer when retirees follow that regimen. When you tap a tax-deferred account, you will pay ordinary income tax of up to 39.6% on every dollar withdrawn. If you pull from a taxable account, you're taking already-taxed funds. Even if you sell stocks to raise the cash you need, you only pay tax on the profit and probably then at the capital-gains rate, which is up to 20%. Tapping a tax-deferred account first, these studies show, will accelerate the payment of income taxes while reducing tax-deferred growth.

But there are exceptions to every rule. You may want to switch the order of withdrawals depending on the size of your IRA, when you claim Social Security and your estate-planning goals.

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To make the most of tax-efficient withdrawal strategies, many financial advisers suggest that investors open Roth accounts, either by converting part of their traditional IRAs or contributing to a Roth. Withdrawals from a Roth are tax free. Christine Fahlund, senior financial planner at T. Rowe Price, tells us she has been contributing to a Roth 401(k) for several years in anticipation of her retirement in June.

The downside is that you fund a Roth with after-tax money, but Fahlund, 69, says "tax diversification" is a long-term strategy. She says holding money in taxable, tax-deferred and tax-free accounts gives retirees "a lot more flexibility" when they tap their nest eggs.

The following circumstances show when it may be wise to buck the conventional wisdom on withdrawal strategies. To trim even more from your investment tax bill, be sure to place your assets in the most tax-efficient locations. (For information on asset location, read Boost Your After-Tax Investment Returns.) Once you turn 70 1/2, take your required minimum distribution from your traditional IRA before you withdraw from any other account.

Maximize tax-free income. You pay ordinary income tax on your withdrawals from a traditional IRA—but not necessarily on every dollar. Everyone gets a certain amount of income free of tax—the amount protected by the standard deduction (or itemized deductions if you itemize) and personal exemption. So it could be wise to tap a traditional IRA to the extent the withdrawals are protected.

Consider research by William Reichenstein, professor of investment management at Baylor University, in Waco, Tex. He looked at various withdrawal strategies for a 65-year-old single retiree who needs an annual after-tax $81,400 for expenses. Reichenstein assumed that the retiree has $904,400 in a traditional IRA, $245,000 in a Roth and $531,000 in a taxable account. (He assumed the portfolios contain taxable bonds earning 4% interest.)

If the retiree taps the account "inefficiently"—withdrawing from the Roth first and the taxable last—the portfolio lasts 30 years. With the rule-of-thumb strategy, the portfolio lasts slightly more than 33 years. But in both scenarios, Reichenstein says, the retiree has "blown the opportunity to take money from the IRA at a zero tax rate." Instead, in a third scenario, the retiree withdraws from the traditional IRA tax free up to the amount of the standard deduction and personal exemption. (In 2014, the standard deduction is $7,750 for someone 65 or older, and the personal exemption is $3,950.)

The retiree then withdraws from the traditional IRA up to the top of the 15% marginal tax bracket. (Part of this withdrawal is taxed at the 10% rate.) She takes the balance from her taxable account.

In later years, after the retiree depletes her taxable account, she continues tapping her traditional IRA up to the top of the 15% bracket. She gets the rest of her spending money with tax-free Roth withdrawals. The retiree's portfolio lasts 34.7 years.

Managing your tax bracket. Sometimes it's wise to withdraw from a Roth IRA and a traditional IRA simultaneously. Perhaps you've depleted your taxable account, and a large withdrawal from a traditional IRA would push you into a higher tax bracket.

Say you are single, have no other taxable income and need to withdraw $50,000 from your IRA. The top of the 15% tax bracket is $36,900. If you take the entire amount from your traditional IRA, you will pay 25% on the $13,100 between $36,900 and $50,000, adding $3,275 to your tax bill. You won't owe that extra tax if you pull the $13,100 from your tax-free Roth.

Also, it may make sense to tap a traditional IRA early in retirement to reduce the future size of the account. Large required minimum distributions in later years could boost you into a higher bracket.

In Reichenstein's third scenario earlier, in which the retiree tapped her IRA up to the standard deduction and exemption, the retiree's traditional IRA shrinks later in retirement because she tapped the account early. She never exceeds the 15% bracket. In his first two scenarios, her nest egg doesn't last as long in part because she ends up paying at the 25% rate when she eventually taps her traditional IRA. Her objective, Reichenstein says, is to avoid a higher marginal rate "for as long as possible."

If you have a large expense, consider tapping a Roth IRA. When Fahlund and her husband decided to buy a recreational vehicle in anticipation of her retirement, they pulled part of the payment from the Roth. "If we went into the IRA, we would be in a higher tax bracket," she says.

Moreover, withdrawals from a tax-free Roth can help you exploit the 0% long-term capital-gains rate, says Kevin Ruth, head of private wealth planning at Fidelity Investments. Investors who are in the 10% and 15% brackets qualify for the 0% rate if their 2014 taxable income does not exceed $73,800 for married couples and $36,900 for singles.

You can draw income from various sources, including the sale of appreciated stock. If your income needs threaten to exceed the 15% threshold, "you make up the difference by taking from the Roth," Ruth says. By staying within the 15% bracket, you don't pay capital-gains tax on your stock-sale profits.

Delay tapping taxable accounts. Perhaps you have large unrealized gains in a taxable account. If you don't need that money during your lifetime, consider leaving those assets to your heirs. They'll benefit from the "step-up in basis" rules. Say you own stock that you bought for $20,000 (the original cost is the basis), and it's now worth $120,000. If you sell, you will pay capital-gains tax of up to 20% on the $100,000 gain.

Instead, you could tap your traditional IRA and leave the taxable account to your heirs, says James Ciprich, a certified financial planner with RegentAtlantic Capital, in Morristown, N.J. "If you're in the 15% bracket and your children are in the 28% or 33% bracket, it's not beneficial to leave them the pretax IRA," he says.

They would be required to take minimum distributions from the IRA and pay income tax on the withdrawals in their top tax bracket. Instead, if you leave the appreciated stock to the kids, the basis of the shares is "stepped up" to the market value on the day you die. Your heirs will owe capital-gains taxes only on gains that occur after your death.

Limit taxes on Social Security. You are 62 and want to delay taking Social Security benefits until 70. You also want to reduce the size of future RMDs from your traditional IRA. Here's what you could do: You can pull money from your taxable account to live on while converting some of your IRA to a Roth. Keep an eye on your tax bracket when you're converting.

By the time you're 70, your Social Security benefit will be larger, your traditional IRA (and your RMDs) will be smaller, and you will have a sizable Roth. From a tax standpoint, you're in a good position. That's because the formula that determines whether your Social Security benefit is taxed counts only half of your benefit while it counts your entire IRA income.

Up to 85% of Social Security benefits are subject to tax once "provisional income" exceeds $44,000 for married people and $34,000 for singles. Up to 50% of benefits are taxable at lower income levels. Provisional income is adjusted gross income (not counting any Social Security benefits) plus 50% of benefits plus any tax-free interest income.

Sure, you may need more than $44,000 to live on, but you could use some Roth money for expenses—reducing the amount of income that will exceed the tax triggers. You may be able to keep the taxable portion of your benefits below 85%.

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