Which Accounts to Use First in Retirement: 4 Factors to Consider

 

Turning your retirement savings into a monthly paycheck can be more complicated than it sounds; it’s hard to know which accounts to use first in retirement. Where the one-size-fits-all approach may work for some, it may be downright detrimental for others. Here are 4 factors (plus one bonus factor) to consider when creating a retirement withdrawal plan.

Three Types of Accounts

When creating a plan to determine which accounts to use first in retirement, we can group them into three major tax categories:

  1. After-tax accounts. These are accounts such as brokerage accounts or joint investment accounts.
  2. Tax-deferred accounts. Traditional retirement accounts such as 401(k), 403(b), or IRA accounts are included in this group, and
  3. Roth accounts, which include Roth IRAs and Roth 401(k)s.

It’s helpful to think of an after-tax account in the same way that you would think of a checking or savings account. You’ve already paid income taxes on whatever you’ve deposited. You’ll also owe taxes on any interest, dividends, or capital gains you receive in any given year.

For tax-deferred accounts, such as your 401(k), your savings are deposited before you’re taxed on your paycheck. However, you’ll eventually owe income taxes on those savings whenever you withdraw funds from those accounts. Hence, your taxes are deferred until a later date.

Roth accounts are similar to brokerage accounts in that any deposits are post-tax – you’ve already paid income taxes on those funds. Unlike a brokerage account, however, your investments grow tax-free and there are no taxes when you withdraw the funds. Of course, there are plenty of rules for Roth accounts, as you would expect.

Because each type of account is taxed differently, each can play a different role in your retirement withdrawal strategy.

The Rule of Thumb

The old rule of thumb for which accounts to use first in retirement is as follows:

  • Use your after-tax accounts first,
  • Use your tax-deferred accounts next, and
  • Use your Roth accounts last.

While this heuristic is oversimplified, it does provide a good starting point for any conversation about which accounts to use first in retirement.

One Size Does Not Fit All

Two common scenarios exemplify the dangers of blindly following the rule of thumb. First, automatically deferring taxes early in retirement can lead to much higher taxes later. While depleting your after-tax accounts first may lower your tax rate initially, at some point, you will be required to start making withdrawals from those tax-deferred accounts.

As a reminder, your required minimum distributions begin at age 72. You could potentially find yourself in higher and higher tax brackets each year since the percentage you’re required to withdraw increases over time.

In addition, since bigger withdrawals from tax-deferred accounts are considered ordinary income. This may cause higher Social Security taxes and higher Medicare premiums since these benefits are means-tested. It may or may not be possible to avoid some of these extra taxes in retirement, but it’s certainly worth examining.

Instead of depleting your after-tax accounts early on, it may be a better idea to blend in some withdrawals from your tax-deferred accounts along the way. While you may see a slightly higher tax rate in those first few years, you may ultimately save taxes later in retirement when RMDs begin.

Focus on the total taxes paid over your retirement rather than always deferring taxes in the present year.

Another scenario where the rule-of-thumb is lacking would be the use of Roth IRAs later in retirement. If you’ve exhausted your after-tax and tax-deferred accounts, that leaves you only with Roth assets. If that’s the case, depending on your deductions and other retirement income, you may have an effective tax rate of zero!

If you’ve paid higher taxes by dogmatically using your tax-deferred accounts before switching over to your Roth accounts, you’ve missed an opportunity to not only smooth out your taxes but to pay less in total.

These are oversimplified scenarios, of course. You may or may not have pension income or other situations that affect which accounts to use first in retirement. It’s important that you consult with your financial advisor and CPA to determine what’s best for you.

With all of this in mind, let’s look at four factors (plus one bonus factor) to consider when designing your own retirement withdrawal strategy.

Factor 1. Map Out Your RMDs

If you’re newly retired or within five years of retiring, mapping out your RMDs is a great starting point. While this may be easier with the assistance of a financial planner, a simple spreadsheet can do the job.

During the pre-RMD years of retirement (before age 72), you may find that some combination of withdrawals from both after-tax and tax-deferred accounts may be the most tax-efficient. You may also find that by dipping into your tax-deferred accounts early, you lower your taxes when you’re well into your RMD years.

This is also where you can plan for partial Roth IRA conversions or diversifying low-basis stock. Many high earners don’t have the opportunity to make Roth contributions or sell low-basis stock before retirement due to being in a higher tax bracket. Once you’ve retired, your tax bracket could drop significantly. At that point, it may make sense to integrate these tactics into your retirement withdrawal strategy.

Factor 2. Don’t Assume You Should Save The Roth Assets Until Last

It’s useful to question the dogmatic preservation of Roth assets until all others are exhausted. Since withdrawals from Roth accounts are tax-free, they can play a part earlier in retirement. Of course, this all depends on your objectives. If one of your goals is to leave assets to your children, then it may make more sense to preserve some (or all) of your Roth accounts.

However, if you’ve already told the kids they shouldn’t plan on an inheritance, then consider using some of your Roth assets as part of a blended strategy of account withdrawals. If you’re already blending withdrawals from both taxable and tax-deferred accounts – and they consistently push you into a higher tax bracket – it may make sense to dial back the use of tax-deferred accounts and layer-in distributions from Roth accounts to make up the difference.

Of course, this all depends on what types of accounts are available to you and how much is saved in each.

Factor 3. Think About Asset Location

Once you’ve mapped out your withdrawal strategy, it’s a good idea to think about which investments to place into each type of account. Since you owe taxes on interest, dividends, and capital gains in after-tax accounts, these aren’t the best place to put tax-inefficient investments such as bonds and REITs. They’re better off in tax-deferred and Roth accounts.

Of course, there’s no clear-cut rule here. If you plan to preserve your Roth accounts, then it doesn’t make sense to fill them with short-term bonds over higher-growth assets like stocks. While it’s important to keep taxes in mind, we don’t want the tax tail to wag the dog.

Finally, investments such as appreciated stock require careful forethought. It’s helpful to think of appreciated stock (as well as tax-deferred accounts) as having a tax liability attached to them. Just go ahead and put it on your mental balance sheet. Unfortunately, there’s no way any of us can escape paying those taxes in our lifetime. Our job is to simply do our best to minimize them and move on.

Factor 4. Revisit and Adjust

One of the few things we can count on is that tax laws will most likely change at some point. Indeed, the SECURE Act surprised many people by increasing the starting age of RMDs from age 70-1/2 to age 72. Even though we expect a few curveballs in the future, it’s still good practice to sharpen our pencils today and adjust when changes occur.

As part of your annual financial planning review, revisit your withdrawal strategy and course-correct as needed. Ideally, your financial advisor and CPA will work collaboratively to design a retirement withdrawal strategy that adapts over the years.

Bonus Factor: Charitable Giving Tactics

Finally, if you’re charitably inclined, there are a couple of tactics that can help when determining which accounts to use first in retirement. First, you can use tax-deferred accounts to make Qualified Charitable Distributions (or QCDs) directly to charities. Yes – that means that instead of paying taxes on those distributions and then giving what’s left to charity, you can skip the taxes entirely and make a charitable donation directly from your IRA.

If you’re charitable inclined, this is a great way to both give to important causes while simultaneously lowering your taxes. As an added benefit, you also reduce your future RMDs (and thus lower your future taxes on those distributions).

Donor Advised Funds (DAFs) are another tool in the toolbox that can help you reduce your total retirement tax burden. If you have appreciated stock or a big tax year early in retirement (due to stock options or deferred comp payout), then using some of these assets to front-load your future charitable giving can give you a huge help in reducing your taxes in that year. From there, you can make annual distributions from your DAF to your charities of choice.

Which Account to Use First in Retirement

When it comes to determining which account to use first in retirement, the old rule-of-thumb leaves quite a bit to be desired. Planning a retirement withdrawal strategy is not a simple calculation. What works for one retiree may be completely wrong for another. Hiring a financial planner to work collaboratively with your CPA to walk through these calculations is the best way to create a customized retirement withdrawal plan.

If you’d like help creating a retirement withdrawal plan that fits best with your circumstances, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.

As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.


The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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