Retirement Withdrawal Sequencing Rules of the Road

Key Takeaways

• Tax management can be harder in retirement because it’s on you to make sure that the taxes get paid on whatever you’re taking out of your accounts.
• Roth accounts are the most tax advantageous in retirement, followed by a taxable brokerage account and traditional tax-deferred assets.
• Your best source of funds in retirement would be your taxable account, and specifically any sort of checking account assets.
• Retirees should be careful if they have taxable assets with a really low cost basis.
• For a lot of households, postretirement, pre-Social Security, and pre-RMD years can be very low-tax years, where you can accelerate withdrawals from a traditional IRA at an advantageous tax rate.
• Roth assets can be great assets to inherit, but they can also be a tool where you can have a withdrawal from an account with very light to no taxes associated with it in a year when you really need to keep your tax bill down.
• HSAs can be used to cover healthcare expenses as you incur them, and in some cases, you can even draw from that HSA on a tax-free basis for nonhealthcare expenses, but retirees shouldn’t wait to spend them.

Margaret Giles: Hi, I’m Margaret Giles from Morningstar. One of the major challenges for people spending from their portfolios is how to manage the tax bills from those paychecks. Joining me to discuss some best practices is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning. Christine, thanks for being here.

Christine Benz: Margaret, great to see you.

Why Tax Management Can Be More Challenging in Retirement

Giles: Why is tax management harder in retirement than it is when you’re working?

Benz: One of the reasons is when you’re working your tax bill kind of is what it is. The bulk of your income for most households is coming from your working income, and you don’t have a lot of ability to finesse the taxes that you pay on that income. When you are retired, and you’re pulling at least some of your cash flow needs from your portfolio, there’s an opportunity to add a little bit of art to where you are going for your cash on a year-to-year basis, with an eye toward limiting that tax bill. And the other key reason is that, for many of us, while we’re working, our taxes are just going to come right out of our paychecks. It’s not really something that we are managing in a hands-on way. When you’re retired and pulling from your accounts for your cash flow needs, you are typically going to be on the hook for those quarterly taxes. It’s on you to make sure that the taxes get paid on whatever you’re taking out of your accounts.

Tax Implications for Withdrawing From Your Retirement Accounts

Giles: Let’s discuss the three main account types that people are bringing with them into retirement. What kind of tax treatment do they receive when you begin withdrawing from them?

Benz: It’s helpful to think of them as the most advantageous, from a tax standpoint, to the least. Starting with the most advantageous, those would be Roth accounts, whether company retirement-plan assets or IRA assets. And they have two big tax benefits in retirement. One is that, provided you follow the rules. Around withdrawals and holding your money in the account for the right period of time, those withdrawals will generally be tax-free. That’s a big benefit. And then the other big benefit for Roth accounts is they aren’t subject to required minimum distributions. Those are two big feathers in the cap of Roths from the standpoint of taxes.

At the other extreme would be traditional tax-deferred assets, where, yes, you aren’t paying income or capital gains taxes on any distributions that they make, as long as those distributions stay inside of the account. But in retirement, you are paying full freight, you’re paying ordinary income tax on withdrawals on those accounts.

And then in the middle would be a taxable brokerage account, where you are not enjoying any sort of tax sheltering as long as the funds are in the account. If they’re making—If your investments are making income distributions or capital gains distributions, you are going to have to pay taxes on those distributions as they come around. But if you hold long-term investments in the account, and you hold them for at least a year, you will be eligible for what’s called long-term capital gains treatment on that appreciation. You will not owe ordinary income tax on those withdrawals; you will pay taxes at the long-term capital gains rate on the appreciation. That is something that puts, I would say, the taxable account kind of in that middle band from the standpoint of taxation and retirement.

Why Taxable Assets Are Best for Living Expenses in Retirement

Giles: That’s almost surprising, given that it’s not a tax-deferred or kind of tax-advantaged account. In the early years of retirement, you note that taxable assets are often a good place to go for living expenses. Why is that? And what should people keep in mind?

Benz: Mike Piper, who writes this great Oblivious Investor blog, often says. Your best source of funds in retirement would be your taxable account and specifically your … any sort of checking account assets. Those are the best ones to spend from, because they will tend to not have large capital gains tax bills attached to them. And they will just be money that will not be earning a lot in terms of investment gains. You might earn a little bit of interest. Those would tend to be the great first source of funds for people in retirement.

How to Handle Taxable Assets With a Very Low Cost Basis

Giles: You think that retirees should be careful if they have taxable assets with a really low cost basis. What should they be thinking about?

Benz: If you do have those low cost basis assets in your taxable account and you sell, yes, you will be eligible for that lower-capital, long-term capital gains rate, assuming you’ve held them for a long time. But if it’s a very large position that you’re unloading, that could affect your tax bill in the year. Get some help on the implications of doing that.

And then the other key thing to keep in mind is, an advantage to keeping those low-cost basis assets in the account longer, is that those are beautiful assets for your heirs to inherit from you because your heirs, if they inherit assets like that from you after death, will be eligible for what’s called the step-up in cost basis, which means that their new cost basis. After inheriting that asset from you, will go back to whatever the price was at the date of your death. Any appreciation in the security over your lifetime kind of evaporates in that situation. For people who have very, very low-cost basis assets, those can be really nice ones to earmark. Earmark for heirs.

When Should You Spend From Tax-Deferred Retirement Accounts?

Giles: Certainly helpful to keep in mind. It sounds like spending from the tax bill account is a good idea, with some caveats. When might spending from traditional, tax-deferred accounts make sense, or even maybe converting those to Roth assets?

Benz: The early tax years do tend to be pretty good years in terms of a lot of ability to keep your tax bills down because you’re not earning an income anymore. You may not have filed for Social Security yet, so that income might not be coming in the door. And unless you’re age 73, you won’t be subject to required minimum distributions. You have a lot of control over your tax rate during those years. Those can be good years to see whether it might make sense to accelerate withdrawals from traditional IRAs to help meet your cash flow needs during those years and/or consider. Converting some of those traditional IRA assets during that low-tax window. For a lot of households, this is postretirement, pre-Social Security, pre-RMD. Those can be very low-tax years, great years, to do some of these strategies to help take advantage of getting money out of that traditional IRA at an advantageous tax rate.

Should Retirees Wait to Spend From Roth Accounts?

Giles: You mentioned earlier that Roth assets have the most advantageous tax treatment in retirement. Does that mean that retirees should always preserve them for as long as possible?

Benz: Not necessarily. As I mentioned, they are really nice assets if you need to have some control over your tax bill in a given year. To use a simple example, let’s say I’ve got a big taxable account, and I want to make a big purchase. Maybe I want to buy a vacation home, or something like that, but I’m selling long-held assets with a big tax bill attached to them. If I need additional cash flows to supply my living expenses in that same year, the Roth gives me a tool to pull from an account with very light to no taxes associated with that withdrawal in a year when I really need to keep my tax bill down. Even though those Roth assets can be beautiful assets for your heirs to inherit, there might be years in your own lifecycle where it can be really advantageous to pull from that Roth account in an effort to keep your tax bill from being even worse than it otherwise would be.

Why Retirees Shouldn’t Wait to Spend Their HSAs

Giles: One account type that we have not discussed yet is the Health Savings Account, or HSA, and more and more people are bringing those with them into retirement. How do they fit into the picture?

Benz: This is a beautiful account type to bring into retirement. You can use your HSA to cover healthcare expenses as you incur them. If you’ve been someone who has been using your HSA as an investment vehicle throughout the years leading up to retirement, as you were paying healthcare bills, you were using non-HSA assets to cover them, as long as you have those receipts to substantiate the previous out-of-pocket healthcare expenses, you can even draw from that HSA on a tax-free basis for nonhealthcare expenses. These are really nice accounts for people to bring into retirement. The key caution is that you don’t want to hang on to it too long. Unlike a Roth IRA, where those great benefits persist, even if they’re inherited by someone else. In the case of a health savings account, if someone other than your spouse inherits that account from you, it becomes sort of like inheriting a traditional IRA, that the tax treatment, the beneficial tax treatment effectively goes away. Ideally, if you have those HSA assets, you would burn through them during your lifetime and or your spouse’s lifetime, rather than having some big leftover balance for someone else to inherit.

Resources for Planning Retirement Withdrawal Sequencing

Giles: Helpful to have. Make sure you use them. This is clearly a complicated area. To wrap up here, are there any resources that you’d recommend looking into?

Benz: A few, Margaret. And one would be Mike Piper’s blog. I mentioned the Oblivious Investor blog. Mike is so good about explaining complex tax topics in an easy-to-understand way. In fact, he contributed the chapter on this topic in my book. And then another resource, a relatively new book that came out last year is a book by Cody Garrett and Sean Mullaney. It’s called Tax Planning To and Through Early Retirement. And it’s really easy to understand, very clearly written. It’s a terrific resource for people who are getting their sea legs. And finally, a shoutout for some customized financial advice in this area. This is not back of the envelope time. This gets very complicated very quickly. If you pay for advice to help you manage your tax bill through retirement, I think that can really be money well spent.

Giles: Christine, thank you so much. Helpful context in a, again, complicated area.

Benz: Thank you so much, Margaret.

Giles: I’m Margaret Giles from Morningstar. Thanks for watching.

Watch Where’s the Best Place to Stash Your Cash? for more from Christine Benz and Margaret Giles.