Once you decide on the appropriate retirement spending range, the next question is how to implement a strategy to reach your goals. Many retirees hold money in a variety of different accounts and deciding how to withdraw cash from these various account types can help increase the longevity of your assets, both by helping you to manage your tax liability and by not depleting tax-deferred or tax-free money too quickly. Therefore, we would like to present three questions we use to help investors implement a tax liability management and withdrawal order strategy, which can help them maintain a comfortable level of spending while also being mindful of not running out of money.
Question 1: Are you 70 ½ and therefore subject to Required Minimum Distribution (RMD) rules?
If yes, then the first source of cash flow is your RMD, which will be taxed as ordinary income since contributions to accounts such as 401(k)’s was deposited pre-tax. If no, or if you need additional cash flow above your RMD, please ask yourself the following question.
Question 2: Do you have taxable investment accounts (e.g., brokerage account or trust account)?
If yes, then you will want to use cash flow from the investments in your taxable accounts (e.g., dividends) first since this money will be taxed anyway. If you still need more spending money, you should consider selling assets with low capital gains or even those with losses in order to take advantage of lower long-term capital gains rates and possibly to use losses to offset gains elsewhere. If you do not have taxable investment accounts or need additional cash flow please ask yourself the following question.
Question 3: Do you anticipate your future tax rate to be higher or lower than your current tax rate?
If you expect your tax rate will increase throughout retirement (e.g., due to RMD’s increasing annual income), it is best to begin taking distributions from tax-deferred accounts such as IRA’s before you take distributions from any tax-free accounts such as Roth’s. Alternately, if you anticipate your tax rate to decrease during retirement (e.g., no longer receiving part-time income) then it is best to reverse the order and take distributions from your tax-free accounts first followed by distributions from your tax deferred accounts when your tax rate declines.
We believe that answering these three basic questions can help those in or approaching retirement to begin to create a more strategic plan for maintaining their standard of living while also extending the longevity of their assets. The ultimate goal of our retirement spending implementation strategy is to delay depleting assets that can grow tax-deferred or tax-free while using assets that will be taxed, either through ongoing distributions or through sales, to help fund spending needs. By doing this, we can target maximizing the total value of your assets while minimizing tax liabilities.
We also understand that each client’s situation is unique and sometimes there are other considerations that take precedent, such as estate planning. Further, we also remind clients that there are additional tax planning strategies to consider, including charitable contributions, management of RMD’s prior to age 70 ½ and Roth conversions. Given all these variables, we believe it is important for investors approaching retirement or in retirement to specify what goals matter to them, decide on the appropriate retirement spending strategy and work with their team of advisors, accountants and attorneys to draft and continually revise a retirement plan that fits their life goals.