Which Account Should You Tap First When You Begin to Draw Retirement Income?

By Jimmy Pickert, CFA, CRPS®

Jimmy Pickert, CFA, CRPS®

Jimmy Pickert, CFA, CRPS® Portfolio Manager

Congratulations on your retirement. You’ve been preparing for this moment over the course of multiple decades, saving and investing as you should in order to live your retirement years on your own terms. You’ve just received your final paycheck, and from this point forward you’ll begin taking distributions from your investments as part of your retirement income. But what account should you draw from first? Chances are you have a 401(k) or an IRA, or both. Maybe you have a traditional IRA as well as some money in a Roth IRA. It might even be the case that a large chunk of your investment assets are in a normal, taxable brokerage account. Each of these accounts are different, and the order in which you draw them down over your retirement years can have a big impact on the growth and sustainability of your nest egg, not to mention how much you pay in taxes.

As with many other things when it comes to investing, there’s a general guideline but also a slew of caveats for which it might make sense to diverge from that guideline. The guideline suggests you withdraw money in the following order:

  1. Income streams—pensions, social security, other passive income like rental properties, etc.
  2. Taxable accounts
  3. Traditional IRA/401ks
  4. Roth IRA/401ks

The reasoning behind this guideline is to minimize and defer taxes wherever possible. First, any income streams you have should be considered when determining how much you take from your investment portfolio. This is money coming to you regardless of your actions, and you’ll likely be taxed on it, so you might as well use it as retirement income. It’s important to point out that this is not advice to begin taking social security right away—it may be that you’re be better off if you delay taking social security because you’ll receive a higher benefit. But once you have determined to take it, it should be the first source of your retirement income. If there is a shortfall between your income streams and your retirement needs, you should then begin to take distributions from your taxable investment accounts. While you will likely need to realize capital gains in order to take these distributions, the tax rate that you’ll pay on those capital gains are less than the income tax rate you will pay on traditional IRA withdrawals (assuming the capital gains are long term, or on assets you’ve held longer than one year). Again, caveats will be described below, but at this point we are describing the default case.

Only after you’ve depleted your taxable accounts would you then begin to withdraw from your tax-deferred or “qualified” accounts. By delaying withdrawals from qualified accounts you not only delayed the payment of income tax on distributions, but you have also given your investments more time to grow tax-free—no tax on capital gains or dividends—which can make a big difference.

After your taxable accounts, you should begin to take distributions from your traditional IRA. This is counterintuitive for those who have Roth IRAs—after all, if the goal is to defer taxes, shouldn’t you start with the Roth and save the traditional IRA for last? What’s important to keep in mind here, though, is that by saving your Roth for last you are giving that account the most possible time to grow. This means that you’ll have that much more that you can withdraw tax-free when the time does come.

The sequence defined above is the default order and it will be appropriate for many retirees. However there are a number of important caveats to keep in mind.

IRA Required Minimum Distributions (RMDs)

Beginning in the year in which you turn 70.5 years old, you will be required to withdraw a certain amount from your IRA each year. The exact amount depends on the account size and your life expectancy, and it injects two additional considerations that might cause you to diverge from the general guideline.

The first consideration is that if you need to take a required minimum distribution but also still have assets in other types of accounts, it’s likely advisable that you only take the minimum required from your traditional IRA and make up the shortfall with your taxable account.

The second consideration is for those whose IRAs are of a very high value. Imagine you are retired and in your sixties and that your IRA makes up a large portion of your liquid net worth. There’s a decent chance that by the time you’re forced to take an RMD, your RMD will be so big that it will push you into a higher tax bracket. There are a number of assumptions and tradeoffs involved with this consideration, but it may make sense to take a moderate amount from your IRA each year in your sixties so that by the time you turn 70.5 years old and start taking RMDs, your RMDs won’t be large enough to create an avoidable tax burden.

Highly Appreciated Investments

There’s also a scenario in which you may be better off not depleting your taxable investment accounts before withdrawing from your IRA assets. This scenario arises when you have one or more highly appreciated investments. There are a couple reasons you may want to avoid selling such an investment. First, if the unrealized gain is high enough, you could potentially be paying more in taxes from realizing a full or partial gain than if you withdrew the comparable amount of money from your IRA. Second, if you don’t anticipate needing to sell this investment at any point for retirement income, you might as well leave it alone because your beneficiary will see the cost basis step up to the investment’s value on the day you die, effectively eliminating the tax bill for them.

Other Considerations

While RMDs and highly appreciated investments are some of the more common reasons why your strategy might diverge from the standard order, there are a number of other factors that may come into play for you. You may have a complex estate structure that dictates how you generate your retirement income. You may have an annuity or the cash value of unneeded life insurance policy. You may be in anticipation of an inheritance or some other future source of income that will change your calculus. The reality is that over the course of one’s life, investors tend accumulate many things in their “financial attic.” An account here, an annuity over there, and so on. It’s best to work with your team of investment, legal and tax professionals to map out the components of your next egg so that you can build the best strategy tailored for your circumstances.

Talk to a Financial Advisor

— Posted on December 18, 2019 by Jimmy Pickert, CFA, CRPS®

— Topics: Wealth Management, Financial Planning