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Maximizing Your Tax Advantages: A Pecking Order For Retirement Spending

Many investors arrive at retirement with several different classes of assets. For instance, they might hold non-qualified deferred compensation plans, 401(k)s, IRA's, Roth IRA's, non-qualified annuities, and taxable investment accounts.  

Does it make any difference which they spend first? You bet! The tax treatment varies widely between types of accounts. So, determining the pecking order for withdrawals will have important implications.

Retirement is a very good time to review the entire financial plan to insure that the investments match the new financial situation. These decisions must not be made in a vacuum.  

As you already know, all other things are rarely equal. In this case, the different kinds of accounts may have differing or severely limited investment choices. For instance, a 401(k) plan may be heavily weighted with employer stock. Or the plan might offer only expensive annuities. And retirees may not have total control over the timing and form of payment for many assets. Finally a retiree may hold highly concentrated positions in company stock or options requiring sophisticated analysis and strategy. Retirement offers a chance to rationalize all these assets by freeing them up for more effective deployment.  

No two retirees have identical situations or objectives. But, here are some considerations and guidelines that might help you to prioritize your withdrawals.

As a rule of thumb, try to retain the assets with the best tax attributes. During your lifetime, you will be wealthier if you defer taxes on your tax qualified retirement plans as long as possible. So, consider liquidating personal accounts first before you tap into the qualified money.  

There is at least one exception to the above rule of thumb. If estate considerations are more important to you than current or lifetime income, you might wish to draw IRA's and other retirement plan assets down before your stock accounts so that the stocks can receive a "step up in basis" at your death. This assumes that you are wealthy enough so that you don't really need the retirement assets. Regular IRA's will be taxed in your estate, and then the beneficiaries must pay income tax as the proceeds are withdrawn, diminishing the value to them when compared to appreciated stock accounts.   

In all cases, if you have Roth IRA accounts, use them last. Roth accounts have the most favorable tax treatment both while you are alive and in your estate. 

Early retirees

If possible, try to live off your personal accounts until at least past the age 59 ½ early retirement penalty tax period. This maximizes deferral, avoids potential tax penalties for early retirement, and provides the greatest flexibility. For instance, consider liquidating any company stock, exercising options, and draw down non-qualified deferred compensation. Then liquidate your general brokerage accounts.    

If those assets are not sufficient, see my earlier article for early retirement withdrawal tactics.  

Normal retirees

Even though you are not faced with early withdrawal penalties, you will want to pursue the same strategy. Use your private taxable accounts first in order to maximize the benefits of tax deferral. Of course, you will want to keep enough on hand to handle emergencies.

At Required Minimum Distribution Date

If you have reached age 70 ½, you must take minimum required distributions (MRD). However, especially in the early years, these withdrawals allow you to keep most of the money at work earning more for you. So, don't accelerate distributions if you don't need the money. The odds are you are going to live a long time, and you will appreciate a healthy account balance later.  

Summary

As guidelines, most investors will want to liquidate assets during retirement in the following order:

  1. Personal taxable accounts including Non-qualified deferred compensation plans, and company stock accounts.
  2. Regular IRA's, other qualified pension plans, and non-qualified annuities.
  3. Roth IRA's

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