Withdrawal Strategies: Tax-Efficient Withdrawal Sequence

How wealth advisors can provide significant value to clients during retirement by selecting an appropriatewithdrawal sequence to fund the spend down

By Ernest Clark

Key Takeaways:

  • Retirees’ portfolios may last longer if they incur the least amount of income tax possible over their retirement period.
  • Retirees should focus on minimizing the government’s share of their tax-deferred accounts.
  • Wealth advisors add value to the process by selecting the appropriate amount and the appropriate assets to liquidate to fund the retiree’s lifestyle.

In an earlier article, we explored the value retirees receive by avoiding the income-tax-bracket creeping caused by the progressive income tax system in the United States. Retirees achieve this goal by paying the lowest dollar income tax expense over the entire retirement period. The challenge is that the short-term goal for most retirees is to pay no income taxes in the current taxable year. The previous article explained the education required for retirees to understand the long-term income tax goal, types of income taxpayers and their tax “buckets.”

Here, we’ll discuss the value retirees receive from understanding the asset placement decision, tax-efficient withdrawal sequence and other withdrawal considerations.

Asset Placement Decision

A winning investment strategy is about much more than choosing the asset allocation that will provide the greatest chance of achieving one’s financial goals. It also involves what is called the asset location decision. Academic literature on asset location commonly suggests that investors should place their highly taxed assets, such as bonds and REITs, in tax-deferred accounts and place their tax-preferred assets, such as stocks, in taxable accounts.

In general, your clients’ most tax-efficient equities should be held in taxable accounts whenever possible. Holding them in tax-deferred accounts can result in the following disadvantages:

  • The potential for favorable capital gains treatment is lost.
  • The possibility of a step-up in basis at death for income tax purposes is lost.
  • For foreign equities, foreign tax credit is lost.
  • The potential to perform tax-loss harvesting is lost.
  • The potential to donate appreciated shares to charities and avoid taxation is lost.

Asset location decisions can add value in boththe retiree’s asset accumulation and withdrawal phases. During the withdrawal phase, the decision about where to remove assets in order to fund the retiree’s lifestyle should be combined with a plan to avoid income-tax-bracket creeping. This will help ensure that the financial portfolio can last as long as possible.

Tax-Efficient Withdrawal Sequence

William Reichenstein’s paper “Tax-Efficient Sequencing of Accounts to Tap in Retirement” provides some answers about the most income-tax-efficient withdrawal sequence to fund retirement. According to Reichenstein, “Returns on funds held in Roth IRAs and traditional IRAs grow effectively tax exempt, while funds held in taxable accounts are usually taxed at a positive effective tax rate.”

Reichenstein’s paper also notes that only part of a traditional IRA’s principal belongs to the investor. The IRS “owns” the remaining portion, so the goal is to minimize the government’s share, he argues.

Tax-Efficient Withdrawal Sequence Checklist

In my experience, retirees should combine the goal of preventing income-tax-bracket creeping over their retirement years with the goal of minimizing the government’s share of tax-deferred accounts.

To achieve this goal, the dollar amount of non-portfolio sources of income that are required to be reported in the retiree’s income tax return must be understood. These income sources can include defined-benefit plan proceeds, employee deferred income, rental income, business income and required minimum distribution from tax-deferred accounts. Reporting this income, less income tax deductions, is the starting point of the retiree’s income tax bracket before withdrawal-strategy planning.

The balance of the retiree’s lifestyle should be funded from his or her portfolio assets by managing tax-bracket creeping and by lowering the government ownership of the tax-deferred accounts. The following checklist can assist the retiree in achieving this goal:

  1. Avoid future bracket creeping by filling up the 10 percent or 15 percent income tax brackets by adding income from the retiree’s tax-deferred accounts.
  2. If the retiree has sufficient cash flow to fund lifestyle expenses but needs additional income, convert traditional IRAs into Roth IRAs to avoid tax-bracket creeping in the future. This will also allow heirs to avoid income taxes on the inherited account balance.
  3. Locate bonds in traditional IRAs rather than in taxable accounts. This will reduce the annual reporting of taxable interest income on the tax return.
  4. Manage the income taxation of Social Security benefits by understanding the amount of reportable income based on the retiree’s adjusted gross income level.
  5. Liquidate high-basis securities rather than low-basis securities to fund the lifestyle for a retiree who needs cash but is sensitive to additional taxable income.
  6. Aggressively create capital losses when the opportunity occurs to carry forward to future years to offset future capital gains.
  7. Allow the compounding of tax-free growthin Roth IRAs by deferring distributions from these accounts.
  8. Consider a distribution from a Roth for a year in which cash is needed but the retiree is in a high income tax bracket.
  9. Consider funding charitable gifts by transferring assets from a traditional IRA directly to the charity. This avoids the ordinary income on the IRA growth.
  10. Consider funding charitable gifts by selecting low-basis securities out of the taxable accounts in lieu of cash. This avoids capital gains on the growth.
  11. Manage the 3.8 percent Medicare surtax on investment income that begins in 2013.
  12. Manage capital gains in taxable accounts by avoiding short-term gains.

Wealth managers can add significant value to clients by assisting them in making prudent, tax-efficient withdrawal decisions to ensure that their money lasts through their retirement years. Every client requires a custom solution for his or her particular situation, but the process and opportunities are the same for all of your clients.

About the Author

Ernest Clark, CPA/PFS, is a principal and the director of wealth management of BAM Advisor Services, LLC, a comprehensive service provider for independent Registered Investment Advisor firms across the country.