You’ve saved it up and squirreled it away. All those years of maxing out your IRA contributions, taking advantage of your employer’s matching contributions to your 401(k), maybe funding a taxable brokerage account when you could. You savored the bull markets and had to weather the bear markets, keeping the contributions to the accounts flowing even though it seemed like the world was coming to an end at times. But it wasn’t, and if you kept funding the accounts through the rough patches, pat yourself on the back, because that can be the hardest thing to do — and arguably the most important thing to do to ensure you stay on the path to retirement.
Now that you’re retired, or close to retirement, you have a lot of decisions to make, including how best to fund that retirement. You have the funds, but what’s the best way to use them?
The Taxman Waiteth
Mostly, this decision has to do with taxes. Continuing to defer them for as long as possible. If you have been a regular contributor to a traditional IRA, you’ve likely (hopefully!) incurred a lot of capital gains. Taxes on IRAs aren’t due until you start withdrawing–and then you’re taxed on income, not on capital gains (and that’s a good thing).
So, with some exceptions, it will probably make sense to hold off on tapping the IRA for as long as possible. To an extent, you won’t be able to. That’s what required minimum distributions (RMDs) are about. Uncle Sam won’t let you defer paying taxes forever. Right now, you’ll most likely (depending on your age) have to start taking RMDs from your IRAs at 72 years of age.
Roth IRAs (as opposed to traditional IRAs) are a different story. If you have a Roth, you probably recall that you’ve already paid the taxes due on it. So a Roth is a prime candidate for early use as a source of funds; you won’t pay any taxes on capital gains you (again, hopefully!) have accrued.
Any taxable brokerage accounts are probably fair game for the top of the retirement-funding list, too. If your brokerage accounts are invested in mutual funds or exchange-traded funds, you may not have a huge built-up cost basis. Portfolio turnover in those funds often means you would have realized, and paid taxes on, capital gains along the way.
If you’ve got directly held stocks in brokerage accounts, it could be a different story, particularly if you’re the buy-and-hold type. You might have decades’ worth of capital gains built up. Plan (for the tax bill) accordingly.
Still, the money has to come from somewhere, and you can’t avoid paying the taxman forever. In addition, you might have reasons unrelated to taxes to draw on (or hold off on drawing on) this or that account. You might have earmarked a specific account for an anticipated expense, for example, and don’t want to use it for any other purpose.
Let’s look at a typical real-world scenario and see what the best course of action should be for a couple heading into retirement.
Lining Up The Income Sources
Consider a couple that has done the math and knows they’re ready for retirement. They know what they intend to spend and have the income and the assets. They just haven’t yet figured out how best to optimize their use to minimize taxes. They also want to make sure certain non-tax-related aspects of their goals are handled.
- They have joint checking and savings accounts, a regular taxable brokerage account, and a relatively small Roth IRA. On the tax-deferred side, they each have traditional IRAs. One of them has a 401(k), which will soon be rolled over into one of the traditional IRAs.
- They both have Social Security coming but aren’t planning to use it until what the Social Security Administration calls Full Retirement Age, which for them is age 67.
- They own their home outright and aren’t planning on going anywhere.
- At some point, they could sell some valuable collectibles they own, but they don’t consider these investment assets and have not factored these into their plan.
- Finally, they would like to leave something to heirs but aren’t too concerned about inheritance tax ramifications for those heirs. (That’s their problem!)
This is a fairly typical setup for a couple looking at retiring nowadays. Pensions are increasingly rare, and IRAs are a prime source of funds for a lot of retirees.
With all of that spelled out, what’s going to make the most sense for our new retirees?
In their case, tax optimization appears to be the most important issue to consider. We say that mainly because their plan is straightforward and they’re not doing any real estate planning for heirs, other than to say they would like to leave something to heirs.
So let’s sketch out a drawdown plan for our couple.
We’ll start with the Roth IRA. If tax deferral is the goal, spending down the account with no tax ramifications whatsoever (because any taxes due were paid on it years ago, when it was funded) makes the most sense.
That account is relatively small, as we mentioned, so from there we’ll move to the taxable brokerage account. This could trigger some taxes, but it might not. It depends on how the account has been invested. Some mutual funds or exchange-traded funds aren’t terribly tax-efficient, meaning they might generate capital gains (which shareholders must pay taxes on) on a regular basis without trying to minimize them or offset them with capital losses. The good news, if you can call it that, is that there won’t be a giant tax bill due the way there would be when it came time to sell a bunch of buy-and-hold stocks after decades of holding them. (Though, just to reiterate, that giant buy-and-hold-and-finally-sell tax bill, deferred for many years, is actually almost always the desired effect versus paying taxes along the way, unpleasant though it would be when it hits.)
Next up will be the traditional IRAs. It’s reasonable to assume that there’s a whole lot of capital gains built up in these long-held accounts. But capital gains taxes don’t come into play. The whole point of the traditional IRA is (1) to defer taxes on income during your working years, which you can do by contributing up to $6,000 per year ($7,000 if you’re 50 or older) of your salary to your IRA, and (2) to start taking the money when you no longer have a salary, because you’ll likely be in a lower income tax bracket in retirement. IRA withdrawals are taxed as ordinary income.
We’ll leave the bank accounts untouched in case of emergency. Most people like to have a cash cushion of some sort. The bank accounts will provide at least some of this. Cash-equivalent holdings (such as money market funds) can provide the rest. How big that reserve needs to be will depend on a number of factors, not least the couple’s risk tolerance.
Finally, what about Social Security? We mentioned they weren’t planning to use it until age 67. But could they get away with waiting longer, thereby increasing the benefit amount? Or does it look like they will need it sooner than anticipated? They would need something like the WealthTrace financial planning application to model it and see. Depending on how their plan plays out, it could go either way.
We’re arguably oversimplifying here. For example, we didn’t touch on dividend income and what to do with it. If dividends are flowing via that taxable brokerage account, should the couple spend that income, or reinvest it?
But our main goal here is to not make any major tax mistakes, and we’ve done that. It’s important to think through the ramifications of these decisions because once you’re started down a certain withdrawal plan, it can be tough to reverse course.