Optimal Withdrawal Strategy For Retirement Income Portfolios


Different Accounts Are Taxed Differently

Investing for Income in Retirement: Planning and Withdrawal Strategies

The reason theres so much value in great retirement withdrawal strategies is that your accounts have different tax consequences. In fact, that very same reason is why asset LOcation is so powerful!

First, you must understand the tax implications of your savings and investment accounts. For example:

  • Pre-tax accounts like IRAs and 401s force income taxes on all distributions
  • Roth accounts and Roth 401s are tax-free forever
  • Taxable accounts force a 1099 each year on the interest income, dividends, or capital gain distributions

Your retirement withdrawal strategy must take these tax implications into account or youre simply donating massive amounts of money to the government each year! Thats money YOU should be enjoying during retirement!

Expecting Relatively Large Long

Spreading traditional IRA withdrawals out over the course of retirement lifetime may make sense for many people. However, if an investor anticipates having a relatively large amount of long-term capital gains from their investmentsenough to reach the 15% long-term capital gain bracket thresholdthere may be a more beneficial strategy: First, use up taxable accounts, then take the remaining withdrawals proportionally.

The purpose of this strategy is to take advantage of zero or low long-term capital gains rates, if available based on ordinary income tax brackets. Tax rates on long-term capital gains are 0%, 15% or 20% depending on taxable income and filing status. Assuming no income besides capital gains, and filing single, the total capital gains would need to exceed $40,400 after deductions, before taxes would be owed.

Tax rates: Singles


One strategy for retirees to help reduce taxes is to take capital gains when they are in the lower tax brackets. For example, single filers with taxable income less than $40,400 are in the 2 lower tax brackets. That equates to a 0% tax on capital gains. If taxable income is between $40,401 and $445,850, long-term capital gains rate is 15%. Remember, the amount of ordinary income impacts long-term capital gain tax rates.

The big difference: Jamie pays zero on her long-term capital gains because her income is below that key threshold of $40,400, but David pays 15% on his $5,000 because of his higher earnings.

$995 $5,414

Traditional Approach: Withdrawals From One Account At A Time

To help get a clearer picture of how this could work, let’s take a look at a hypothetical example: Joe is 62 and single. He has $200,000 in taxable accounts, $250,000 in traditional 401 accounts and IRAs, and $50,000 in a Roth IRA. He receives $25,000 per year in Social Security and has a total after-tax income need of $60,000 per year. Let’s assume a 5% annual return.

If Joe takes a traditional approach, withdrawing from one account at a time, starting with taxable, then traditional and finally Roth, his savings will last slightly more than 22 years and he will pay an estimated $69,000 in taxes throughout his retirement.

Withdrawing from one account at a time can produce a “tax bump” midway in retirement

Note that with the traditional approach, Joe hits an abrupt “tax bump” in year 8 where he pays over $5,000 in taxes for 11 years while paying nothing for the first 7 years and nothing when he starts to withdraw from his Roth account.

In this scenario, a proportional withdrawal strategy in retirement cuts taxes by almost 40%

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Blending Withdrawals From Ira And Taxable Accounts

Given that taking full distributions from the IRA up front can drive the couple into higher tax brackets, and taking full distributions from the IRA in the later years will also drive the couple into higher tax brackets, the solution is actually remarkably simple: to take distributions from each account along the way.

The benefit of this tactic is that by taking only partial distributions from the IRA each year, the distributions can occur at “only” the 15% bracket without ever reaching the 25% bracket. Yet by taking at least some withdrawals from the IRA every year, the brokerage account lasts longer before it is ever depleted . For instance, the chart below shows the results when the retiree takes half the desired spending from each account every year, assuming their tax-savvy withdrawals keep them in the 15% tax bracket throughout.

Notably, the spend-brokerage-account-first scenario still had a higher final account balance, but this is due in large part to the fact that the IRA still has a significant looming tax liability that will have to be spent someday . On a net after-tax basis, the split-strategy that allows the IRA withdrawals to be blended across the 10% and 15% brackets actually fares better than either of the alternatives!

The Common Rule For Retirement Account Withdrawls

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The Common Rule is a withdrawal strategy that uses the following 4-step sequence*:

  • First, withdraw any Required Minimum Distributions from your tax deferred accounts. These accounts include 401s, 403s, 457 plans, as well as Individual Retirement accounts created with direct contributions or rollover from employer provided retirement plans.
  • Next, withdraw funds from your taxable brokerage account, until they reach a $0 balance.
  • Third, continue to withdraw funds from your tax deferred accounts s, 403s, 457 plans), until they reach a $0 balance. These accounts are all treated the same, so if you have more than one tax deferred account, it doesnt matter which you withdraw from at this step.
  • Lastly, withdraw funds from your tax free accounts, like Roth IRAs, Roth 401 and Roth 403. If these funds reach a $0 balance, you have no remaining retirement savings. Then, only lifetime annuities, such as pensions and social security, are available to cover your retirement expenses.
  • * source: Sumutka et al.

    The Common Rule is often what is advocated by large brokerage firms, including Fidelity and Vanguad. Unfortunately, it is well known to provide suboptimal recommendations. Consequently, the Common Rule can reduce the longevity of your retirement portfolio, and decrease the inheritance you may pass on to your heirs or your favorite charitable organization.**

    ** source: DiLellio and Ostrov

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    Strategy 1fixed Percentage Or 4% Rule

    • A period of historically low interest rates make traditional income-producing investments like bonds less likely to generate the income that many retirees expected.
    • If inflation erodes the purchasing power of your money over time, it may require you to withdraw larger amounts of money.
    • If you are invested in stocks and the principal value of the assets decline, you may have less of a portfolio to withdraw from.
    • Your income needs are not likely to be as consistent as your withdrawal plan, and you may need more income in some years and less than others.

    Rules To Make Your Retirement Savings Last

    You need retirement income, but how much money should you take out each year? You want to make sure you dont spend downyour accounts too fast. The answer is determined by calculating a safe withdrawal rate.

    A safe withdrawal rate is the estimated portion of money that you can withdraw from your investments each year while leaving enough principal so that the funds will last for your entire lifeeven if you retire during a time when the economy and/or the stock market is not doing well.

    For example, if you spend $4,000 for every $100,000 you have invested, you would have an initial withdrawal rate of 4%. Traditional calculations say this withdrawal rate is about right you can spend about 4% of your investments each year and most likely never run out of money.

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    Withdrawing Your Retirement Savings

    How much can you safely withdraw from your nest egg every year during retirement, without running out of money? Thats a question many Americans ask as they approach retirement age. Is there a magical formula to ensure that you dont outlive your savings? Unfortunately the answer is an emphatic no! Professional financial planners recognize this reality and focus much of their time on developing a process and strategies to maximize a clients safe withdrawal rate.

    Return Rates

    A key factor is the expected portfolio return. All too often the expected return is simply based on looking back at long-term market returns. Unfortunately, we are currently living in an economic environment in which future returns may be somewhat less than weve experienced in the past. Although no one can know for sure what those returns will actually be, intelligent planning will at least simulate the possible consequences of modest future returns.

    But, thats not the end. One of the biggest errors many investors make is to neglect the erosive effect of inflation. That friction is especially high during retirement. Even assuming a relatively modest 3 percent inflation during retirement, the net of expenses, net of taxes, and net of inflation result is 3.7 percent.

    Retiree Longevity

    Unique You

    Techniques and Strategies

    There are numerous techniques and strategies that a professional planner might suggest in assisting a client to design a retirement plan, including managing taxes and expenses.

    Summary: Optimal Withdrawal Strategies For Retirement Income Portfolios

    Retirement Withdrawal Strategy

    So, what have we learned?

    Optimal Withdrawal Strategy is about taking your assets and turning them into income while mitigating known risks. You get income from your portfolio, and you control risk with your product allocation.

    Use your various products and other assets in a cohesive retirement withdrawal strategy to accomplish retirement security.

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    The Critical Issue: Outliving Your Money

    While retirees may have different worries from those still in the workforce healthcare and living on a fixed income, for example one of the most vital is ensuring you dont outlive your income.

    The biggest concern people seem to have is running out of money in retirement, says Chad Parks, founder and CEO of Ubiquity Retirement + Savings in San Francisco. The first step is to take a look at the amount you want to withdraw from your retirement plan and ask yourself if this is your only source of income in retirement.

    In this regard, Social Security is a fantastic retirement plan that ensures at least one source of income wont run out. Youll receive your check for life. Thats also part of the appeal of annuities, which can promise a guaranteed retirement income for as long as you live.

    And your potential longevity is an important consideration in any calculation, too. Because there is a good chance that one person in a 65-year-old couple of average health will live to age 92, making sure that the money will last until age 95 or 100 is prudent, not far-fetched.

    One way to avoid outliving your money is to reduce what you need in retirement. For example, you may downsize your lifestyle to accommodate a lower income. However, you can take steps before you retire that minimize your need to tap retirement funds, too. For example, by paying off your mortgage or car loan while youre still earning money, youll reduce what you need to pay out later.

    Total Return Vs Income

    Your grandparents invested for income and crammed their portfolios full of dividend stocks, preferred shares, convertible bonds, and more generic bonds. The mantra was to live off the income and never touch the principal. They selected individual securities based on their big fat juicy yields. It sounds like a reasonable strategy, but all they got was a portfolio with lower returns and higher risk than necessary.

    At the time, nobody knew better, so we can forgive them. They did the best they could under the prevailing wisdom. Besides, dividends and interest were much higher in your grandparents’ time than they are todayand life expectancies after retirement were shorter. So, while far from perfect, the strategy worked after a fashion.

    Today, there is a far better way to think about investing. The entire thrust of modern financial theory is to change the focus from individual securities selection to asset allocation and portfolio construction and to concentrate on total return rather than income. If the portfolio needs to make distributions for any reason, such as to support your lifestyle during retirement, it is possible to pick and choose among the asset classes to shave off shares as appropriate.

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    What Withdrawal Method Is For You

    The appropriate withdrawal strategy that works best for you depends solely on your personal situation and preferences. You should consider the size and composition of your portfolio, your income needs, the amount of overall spending flexibility, and your risk tolerance.

    Keep in mind, regardless of which withdrawal method you use, the most critical factor in making your savings last a lifetime is taking the time to accurately estimate and plan out your expenses in retirement. Once you retire, review your retirement income plan at least annually, or whenever your circumstances change so you can adjust your spending strategy and withdrawal rate as needed.

    Guidelines For A Retirement Withdrawal Strategy

    5 retirement income strategies

    How much can we spend in retirement without dangerously depleting our portfolio or jeopardizing long-term financial goals? That question, in one form or another, is one of the most frequently asked by our clients. While there is no shortcut to the answer, a careful review of your situation will help produce the most appropriate withdrawal strategy and safe rate of spending.

    Even people with considerable wealth must be alert to the risk of spending getting out of control. But how can you determine a withdrawal rate that provides a steady income flow without worry that it will go too far? The following guidelines are points to keep in mind as you devise a retirement plan aimed at keeping your finances in optimal shape.

    1. Recognize what can and cannot be controlled, and create a minimum five-year budget.

    Spending is largely within your control. What is not is the rate at which your money will grow since growth depends heavily on the ebb and flow of the economy, stock market and changes in tax laws. With that in mind, we advise and help our clients to create a minimum five-year cash flow that identifies and includes their month-to-month lifestyle spending, short- and long-term spending goals and future cash inflows with the goal of creating a budget for a sustainable long-term financial path.

    2. Plan ahead for the most tax-smart withdrawal timetable involving multiple accounts.

    3. Do not rely on a rule to determine withdrawal amounts.

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    Examine Your Sources Of Retirement Income

    Once you know how much income youll need to generate each month, its time to examine potential income sources.

    This includes fixed income from Social Security and a pension. You may also receive monies from other retirement accountslike a 401 or an IRAor investment assets outside your retirement accounts. Do you have real estate, annuities, or whole life insurance? They can generate income as well. Also, consider an inheritance or if you plan on working part-time in retirement.

    Big Ira Distributions Drive Up Tax Brackets

    While the example above shows how deferring withdrawals from a pre-tax IRA can allow more wealth to compound, there is a significant caveat: the IRA is being subjected to a 20% average tax rate because the withdrawals are happening from the IRA all at once and driving a portion of the distributions into the 25% tax bracket.

    For instance, continuing the prior example, the reality is that initially the couple would likely only be in the 15% ordinary income tax bracket. After all, if the couple is receiving $30,000/year of Social Security benefits , and the taxable portfolio generates about $20,000/year of interest and dividends, and available exemptions/deductions are $25,000, their taxable income after all deductions would be barely over $20,000/year. This would put them at the bottom of the 15% tax bracket, and would actually mean any qualified dividends are eligible for a tax rate of 0%! Its only by stacking a $100,000 gross withdrawal from the IRA on top that drives them into the 25% bracket, with technically about half of the withdrawal taxed in the 15% bracket, and the other half of the IRA distribution taxed at 25%.

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    Maximizing Partial Roth Conversions To Minimize Rmd Obligations

    Another benefit of the approach of spending taxable/brokerage accounts first while doing partial Roth conversions is that if theres enough funds in the brokerage accounts that the IRA may not be needed at all, doing partial Roth conversions still helps to maximize long-term wealth, by minimizing the future impact of Required Minimum Distribution obligations.

    After all, for the retiree who doesnt need the IRA account, taking no distributions from the IRA and allowing the account to compound can actually create less wealth in the long run. The reason is that, as noted earlier, taking large IRA distributions all at once can drive up the retirees tax bracket. And this is equally true regardless of whether the large IRA distributions are because the retiree needed the withdrawal, or was simply forced to take it as a required minimum distribution.

    In addition, the fact that a Roth IRA does not have any RMD obligation also allows more dollars to stay in a tax-preferenced account for a longer period of time, which indirectly helps the Roth to enhance long-term wealth as well!

    Why You Can Trust Bankrate

    Tax Efficient Retirement Withdrawal Strategies to Reduce Taxes in Retirement

    Founded in 1976, Bankrate has a long track record of helping people make smart financial choices. Weve maintained this reputation for over four decades by demystifying the financial decision-making process and giving people confidence in which actions to take next.

    Bankrate follows a strict editorial policy, so you can trust that were putting your interests first. All of our content is authored by highly qualified professionals and edited by subject matter experts, who ensure everything we publish is objective, accurate and trustworthy.

    Our reporters and editors focus on the points consumers care about most how to save for retirement, understanding the types of accounts, how to choose investments and more so you can feel confident when planning for your future.

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