Ah, the books, debates, software applications, and gnashing of teeth around the perfect order to tap into retirement savings. Herewith, two reasons I think the conversation is overblown, followed by three ways to think about the mysterious Order of Withdrawal.
Behold, I subject myself to ignominy and disgrace in the financial community when I say, gasp, getting withdrawal order perfectly right, for MOST retirees, is not a huge concern.
Reason One to not panic: Even though there is retirement software telling you that if you play the retirement tax game just right you can spend 10% more money per year, you are likely going to spend about what you did pre-retirement. It’s like being told that a $3,000/month mortgage is really only $2,700 if you count the tax write off. If you aren’t comfortable spending $3,000/month, the year-end tax benefit likely won’t change that.
Reason Two: Tax law regarding brackets, inheritance rules, RMDs, capital gains treatment, step-up in cost basis, etc. will change many times during a 25-year retirement. The assumptions made for your withdrawal plan may be moot in 18 months. It’s better to be flexible than try to be “perfect.”
Hopefully I’ve relaxed your mind a bit to where you can think about withdrawal order in a calm way. Remember, there is no just right way to do this. There is personal preference that comes into play. Here are three ways to approach the Order of Withdrawal question.
The Standard: This is the most recommended method. Spend down, in this order: taxable accounts, tax deferred accounts, and Roth IRA accounts. Lots of benefits here to the retiree. You are holding your tax rate down in the early retirement years where you presumably spend the most while tax-deferred and tax-free accounts continue their tax-advantaged growth.
The disadvantage here is if you leave a large bucket of tax-deferred money to your non-spouse heirs. It’s likely they will be inheriting this money during their highest earning years, subjecting the withdrawals over the 10 years following your death to very high income taxes. Also, it’s nice for heirs to receive taxable assets because there is no requirement to withdraw, and they (currently) would get a step-up in cost basis.
Flip the Standard: This method has you spending tax-deferred assets, taxable accounts, then Roth (or combining Roth with tax-deferred). Advantages are that you are spending down the tax-deferred accounts before RMD time, so reducing that hit later.
In this instance you are paying the taxes on your children’s inheritance. This may or may not be important to you. That is why this is part art, part science.
Pro-Rata Withdrawals: In this scenario, you spend out of each asset bucket in proportion to the total investment pool. If you have 50% of your money in tax-deferred accounts, 25% in taxable accounts, and 25% in Roth, you take out spending in those percentages from each account. So, $100,000 in annual retirement spending comes $50,000 from tax-deferred, $25,000 from taxable, and $25,000 from Roth.
This method allows the retiree to hedge their bets on changing tax law, and potentially provides a more predictable tax picture through all phases of retirement.
In conclusion, you want to have a strategy on how you will tap into retirement accounts. It is nice to not need to make a big decision every time your utility bill is due. Work with your financial advisor to create a plan that is repeatable, flexible, and supports both your values and spending.
Kristi Sullivan is the founder of Sullivan Financial Planning, LLC, a fee-only firm offering financial planning advice paid by the hour. She holds the Certified Financial Planner™ designation and has over 25 years’ experience helping people achieve their financial goals. For more information, see www.sullivanfinancialplanning.com.
Email Jeffrey Levine, CPA/PFS, chief planning officer at Buckingham Wealth Partners, at: AskTheHammer@BuckinghamGroup.com.