Which Accounts Should Younger Retirees Tap First? Not IRAs!

Much is written on how to prepare for retirement. Save early, save often. And many retirees have done just that, accumulating an appropriate nest egg invested across a combination of 401(k) plans, traditional and Roth Individual Retirement Accounts (IRAs), personal investments and real estate.

However, at the point of retirement, a new decision set emerges. Which assets do you take withdrawals from, and in what amount and order? Under the right circumstances, the answers to these questions can have a million-dollar impact on your lifetime net worth.

By using this recommended withdrawal strategy, a retiree can help achieve three key goals:

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• Make their money last longer
• Minimize their taxes
• Increase the amount of money available for their heirs

Here’s How the Withdrawal Strategy Works

At the onset of retirement, many people try their best to pay for living expenses from a variety of sources, such as a pension, Social Security income, rental income and part-time work. Few have enough passive income to fully cover their expenses, and therefore need to begin tapping into their investment accounts to cover the difference.

Since many people have most of their money in traditional IRAs and 401(k) retirement accounts, it’s often the first place where they begin. Plus, it would seem to make sense: These funds were saved with retirement in mind, right?

Unfortunately, this can be a mistake. By relying on these accounts first, retirees draw too heavily on assets that generate income that’s fully taxable upon distribution. Plus, these accounts have rules and potential penalties for early withdrawals before age 59½.

This logic, while well-intentioned, can reduce retirement savings by several hundred thousand dollars over 20+ years of retirement. No one wants to pay more taxes and have less money for themselves and their heirs.

Instead, we recommend focusing on a two-part strategy:

• First, withdraw funds in a way that minimizes your taxes.
• Second, selectively convert portions of qualified retirement plans – IRAs and 401(k) plans – into a Roth IRA.

In the example below, the impact of employing these tactics is dramatic. Using a tax optimization approach with the following specific parameters can increase our example couple’s assets by over 50% – or approximately $1,040,000 – over the rest of their lives.

Potentially even more important, by converting some money from traditional retirement plans into a Roth IRA in the years when income is low, the couple shift about approximately $1,175,000 from accounts that are taxable to those that are tax-free as part of a loved one’s inheritance.

Here's how a typical retired couple can put this strategy to work. We will refer to our example couple as Daniel and Jolie.

The Right Approach

At age 65, Daniel and Jolie have more than $4 million in assets. These include:

• $1 million in after-tax investments
• $2.5 million in IRAs, and 401(k) accounts
• $100,000 in a Roth IRA
• A house valued at $500,000

We have estimated the distributions they will need from their accounts (after Social Security and pensions) to be $120,000 annually. Additionally, we have assumed annual investment returns of 4.83% for all accounts, based on a diversified conservative allocation and long-term inflation of 2.5%. Please note that this example is for illustrative purposes only.

Step No. 1: Tap After-Tax Investments First Instead of IRAs (until age 72, when RMDs begin)

Withdrawing money only from their traditional IRAs and 401(k) accounts at age 65 is not the best option for two reasons. First, the entire amount withdrawn is taxable. If our couple withdraw $120,000 annually, they will pay several thousand dollars in taxes each year. This would result in needing to take additional withdrawals to cover the income taxes generated, thus creating a negative feedback loop of higher withdrawals when compared to after-tax withdrawals at lower tax rates. When compounded over several years, the outcome would result in less funds in the IRAs due to income tax erosion.

Second, during this time of market volatility, the ability to withdraw from after-tax investments allows for the identification of tax lots and income management on withdrawals. With the markets already down, retirees want to be even more diligent in preserving long-term capital. If funds are withdrawn from an IRA, they are taxed at ordinary income tax rates regardless of the investment gain or loss. However, in an after-tax account, retirees can select lower basis securities or even perform tax-loss harvesting to exit positions with a minimal tax impact to preserve capital during these volatile times.

So, by withdrawing money from their investments on a tax-optimized basis, our couple strategically solve multiple issues simultaneously. Instead of withdrawing all of their funds from their IRAs, Daniel and Jolie instead decide to withdraw funds in the following order:

• After-Tax Investments: Starting out, from age 65 to 72, Daniel and Jolie will take 100% of their needed distributions from their after-tax investments. These withdrawals are taxed at advantageous capital gains rates, which in their case are 0% based on their low 12% federal marginal tax bracket.
• Traditional IRA/401(k): Once they reach age 72 and are required to begin withdrawing funds from traditional IRAs and 401(k) accounts, they will withdraw only the amount required and pay taxes at their ordinary income tax rate. They will reduce their after-tax investment distributions by the amount of their net RMDs.
• Roth IRAs: We encourage them not to take distributions from their Roth IRAs to allow them to grow tax-free.

The Impact: Using this pro-rata approach, over the course of 20+ years, by age 95 this step alone will increase the couple’s assets by approximately $1,040,000.

Step No. 2: Execute Strategic Roth Conversions

When appropriate, an opportunity exists to convert selected amounts of the funds in their traditional retirement accounts to their Roth IRA. While this step means the couple will need to pay taxes now on the amount converted to their Roth IRA, the material benefit is future tax-free growth.

To successfully execute this Roth conversion strategy, Daniel and Jolie will need to work with their advisers to identify potential years where they will be in a lower tax bracket than when taking RMDs starting at age 72.

While the cost of paying taxes at this point will reduce Daniel and Jolie’s long-term assets, they are creating hundreds of thousands of dollars of tax-free growth for their heirs.

Here’s how this can work: In coordination with their adviser and accountant, Daniel and Jolie estimate their income and the amount to be withdrawn each year will keep them below the top of the 12% federal marginal tax bracket. The goal is to withdraw just enough money and pay taxes at the lower 12% bracket, leaving 100% of the converted amount in the Roth IRA to grow tax-free.

If Daniel and Jolie start at age 65, over the next six years (until they turn 72 and must begin taking RMDs), the new balance in their Roth IRA will not only make up for the taxes paid, but grow tax-free. We estimate that if they didn’t do systematic Roth conversions, their Roth IRA would be roughly $270,000 at age 95, compared to a value of more than $1.4 million if they did.

The Impact: By paying taxes now at lower income tax brackets, the couple’s total amount of Roth IRA assets would be $1,175,000 higher by age 95 than they would have been had they not done the conversions. In addition, these additional assets will be passed to their heirs for additional tax-free accumulation.

A sound strategy that maximizes the amount of wealth an individual or couple has over the course of their retirement can help them live a fuller, more satisfying life. It also gives them more options – from traveling to contributing more money to their favorite charities and nonprofit organizations. And, of course, it allows them to provide more funds for their adult children and grandchildren.