Taxes take a big bite out of investment earnings. An important goal of successful investing therefore is maximizing after-tax returns. This involves both assembling the correct mix of assets and placing them in the right types of accounts. Since different investments and different types of accounts are taxed at different rates, how investors allocate assets between taxable and tax-advantaged accounts can greatly affect the growth of their portfolio.
The guiding principle of “keeping more of what you earn” by minimizing unnecessary taxes becomes more complicated for those retirees who depend upon portfolio withdrawals to support living expenses. They face the dual challenges of investing and withdrawing their assets tax-efficiently.
Most retirees have accounts that are taxable, tax-deferred (traditional retirement), and tax-free (Roth retirement). If these accounts were taxed the same, an investor should be indifferent to the order in which they would be drawn down, because any order would produce the same results. However, because these accounts are subject to different tax rates and rules, a sensible withdrawal sequence can help reduce taxes and lengthen the portfolio’s life.
The guideline most often recommended is: First, withdraw from accounts where required minimum distributions (RMDs) are mandated. Second, spend cash flows (interest, dividends, and capital gains) from taxable accounts. Third, tap tax-deferred accounts. Finally, withdraw from tax-free (Roth) accounts. The rationale behind this approach is to allow tax-advantaged accounts to grow for as long as possible. Simulations conducted by academic and financial institutions generally support the notion that “all things being equal”, this spending order will usually produce a lower current tax bill, allow for more tax-deferred growth, and enable investors to achieve greater portfolio longevity.
However, in life, all things are rarely equal and retirees should avoid using this “one size fits all” approach before examining their specific situation. Each investor has unique personal and financial circumstances including: the type, size and cost basis of each investment account, estate planning goals, and current versus future tax rate expectations. All of these have important tax implications and therefore impact the preferred account withdrawal sequence.