Let’s say you have just moved from being an employee to paying yourself in retirement.  You’re about to take that first draw from the resources you have put aside for this very day and all those to follow.

Let’s say, too, that you’ve taken some good advice and have been putting aside funds in a variety of accounts: a tax-deferred retirement plan such as a 401(k) or 403(b), individual retirement accounts such as IRAs and ROTHs, taxable investment accounts, and perhaps an annuity.

So which “well” do you dip your bucket into first?  The answer depends on your age, the amount you need to withdraw, and your tax rate today and expected rate in the future.

While age is just a number for most retirees, not so for the IRS when it comes to your withdrawals.  If the IRS considers you are too young to be withdrawing from your qualified retirement accounts, or too old to delay taking these funds any longer, there are penalties to pay. Too young means you’re not yet 59 ½, and too old means you’ve passed your 70 ½ birthday. (You do celebrate half-birthdays, don’t you?) In the first case, you will pay a 10 percent penalty in addition to regular taxes on funds withdrawn before age 59 ½; in the second case, you are assessed a whopping 50 percent on the IRS-prescribed amounts you were supposed to take but didn’t.  While there are some exceptions to these rules, particularly on the “too young” side, the freedom to take what you want when you want it is a luxury reserved for retirees in their sixties.

It’s during that happy, penalty-free decade, that soft rules-of-thumb prevail. Conventional wisdom dictates that you draw first from your least tax-efficient accounts. This means tapping your investment accounts or immediate annuities — which produce taxable, ordinary income — to allow your 401(k)s, 403(b)s, IRAs and deferred annuities to continue their tax-free compounding for as long as possible.  Next comes those tax-deferred retirement accounts, and last of all would be your ROTH. As the most tax efficient asset of them all, your ROTH can be tapped tax-free whenever you please.  You have no required distributions with a ROTH as long as you live, which means, in fact, you can even pass this super-charged asset to your kids or heirs to let it compound for another several decades.  (Note: While your heirs must take money out of the inherited ROTH ratably over their lifetimes, these withdrawals can be very low to begin with.)

While this “taxable, then deferred taxable, then tax-free” rule works reasonably well for the average retiree trying to decide where to get his money, sometimes more flexible strategies are better.  Perhaps you are not the “average” retiree, and fall into one of these situations:

  • The amount you need to withdraw to cover necessary expenses is relatively low. If you have little or no debt or fixed expenses, you may be able to dial down the amount you take in a given year and as a result, end up in a very low tax bracket.  Throw in a large capital loss, and you may land in the 10 or 15 percent tax bracket, or even have no taxable income at all.  If such is the case, you may want to take money from your 401(k) or IRAs as a “cheap” way to access funds that may be taxed at much higher rates later. Even if you do not need this money for expenses, you should still take a distribution from your IRAs and convert it to ROTH.
  • Your qualified assets are extremely large. If you delay accessing these funds until after you turn 70 ½, you may find that your required distributions are taxable at the highest marginal rate. In this event, drawing qualified assets earlier than necessary can reduce the tax rate applicable to the later required withdrawals. The overall benefit of this strategy should be compared to the cost of losing the tax-free compounding by taking the funds earlier than required.
  • You expect income tax rates to go up in the future, and you and/or your beneficiaries will likely be subject to higher income rates than current rates.  Again, taking some of your IRA or qualified plan distributions now at lower marginal tax rates could outweigh the compounding benefits of taking them later, once future higher tax rates for you or your heirs are taken into account.

The most important consideration of all:

  • Following the conventional wisdom about retirement withdrawals may not allow you the flexibility to optimize your retirement wealth. For example, if you delay your IRA distributions as long as possible, you may find yourself needing to take your Social Security early, perhaps at age 62 or 66, rather than delaying till age 70.  Filling in the gap with draws from your IRAs could, in fact, be a better lifetime wealth building-preservation strategy than taking early benefits.  Similarly, the ROTH that supposedly works best if left untouched for as long as possible may be just the place to go now for money. Unlike capital gains or IRA distributions, funds drawn from the ROTH do not increase your adjusted gross income for purposes of the taxation of Social Security, or increases in Medicare Part B and D premiums.  If you’re concerned about the new 3.8 percent net investment income tax, then taking money from your IRA or other qualified retirement plan may be a better option than realizing a capital gain in your investment account.

Sound pretty complicated?  It is, but this doesn’t mean a tax-smart plan is difficult to create.  A CFP® professional with tax expertise and analytic tools can build the right withdrawal strategy for you as your life, income, and needs change in retirement.  So before dipping that bucket into one of your retirement wells, take it to a CFP® professional who will fill it with the best advice for your unique circumstances.