Avoiding the Pitfalls of Retirement Distribution Order

Withdrawing from your investment portfolio in retirement is like walking through a minefield. If you don’t take the right path, you’re going to take a large tax hit. Most people don’t think about it, but your distribution strategy in retirement and the resulting taxes can significantly impact how long your money lasts and how much you can spend. Like asset location, withdrawal sequencing is an area where it’s easy to lose your way, but you can avoid major pitfalls by sticking to a couple of guidelines.

Standard Distribution Order

Taxes are the driving factor in withdrawal sequencing. To maximize after-tax spending, you have to maximize the benefits of your tax-advantaged accounts.

Investment accounts fall into three main tax categories:

• Taxable accounts – Your standard brokerage accounts. Funded with after-tax money. Taxes are paid on capital gains and any income from the account.
• Tax-deferred accounts – Accounts like your 401(k), 403(b), and traditional IRA. Funded with pre-tax money. Money is taxed upon withdrawal, generally at ordinary income tax rates.
• Tax-exempt accounts – Accounts like your Roth 401(k) and Roth IRA. Funded with after-tax money. but you don’t owe any taxes when you take the money out.

Just like anything related to taxes, withdrawal sequencing has a number of exceptions and wrinkles to consider, but this is a good starting point.

If all of your investment accounts are of the same type – for instance, all of your savings are in a 401(k) and traditional IRA – then you don’t have much to worry about, as your distributions will all be taxed the same way. Most retirees have more complicated situations.

This is a good baseline distribution order to stick to (we’ll delve into the exceptions in a minute):

1. Any income you receive (Social Security, pensions, etc…) and your RMDs
2. Taxable accounts
3. Tax-deferred accounts
4. Tax-exempt accounts

This gives your tax-advantaged accounts more time to grow before you start taking money out, helping you achieve a higher level of potential after-tax income.

Issues to Consider in Withdrawal Sequencing

Now for some of the exceptions: estate considerations and Roth conversions. There are other special cases, but these are the two big ones.

If you plan to leave money to others after you pass, you might consider leaving your taxable accounts alone. If you have taxable investment accounts in your estate, their cost basis gets reset to the account value, meaning that all of the unrealized capital gains taxes that you owe in the portfolio go away, and the recipient(s) of the assets essentially start fresh. This is known as a “step-up” in cost basis. This can be a big deal, depending on how long you have owned everything in your account.

Roth conversions might be something to consider, too. This is accomplished by taking money from one of your tax-deferred accounts, paying the income taxes on it, and then moving it into a tax-exempt account. You could pay a lower tax rate on the amount you’re converting and then have that money grow tax-free in the future. This can be especially useful in a year when you will have an unusually low income. This can be a very powerful strategy when combined with charitable giving, especially if you are considering funding a donor-advised fund.

A lot goes into optimizing retirement distribution order, but the basics are reasonably straightforward. As a first approximation, you want as much tax-advantaged growth as possible. This will allow you to spend more in retirement and leave more behind after you pass. Before implementing anything, you should consult your tax professional about how these strategies apply to your situation.