Prioritizing The Order Of Funds Used In Retirement

With all of the available advice about saving for retirement, one topic that doesn't get the attention it deserves is just how to prioritize using (i.e., spending) the different sources of funds that you have worked so hard to accumulate.
After decades of saving, careful thought needs to be applied to determining just how to maximize the effectiveness of those funds, how to preserve them for as long as possible, and how to minimize the "loss" to taxes.

Most people have a combination of taxable accounts (which include income from interest/returns on cash savings, Social Security, pensions, etc.), tax-deferred 401k/IRA accounts, and/or tax-free Roth 401k/IRA accounts to draw from. Figuring out when, and how much, to use from each source can be complex. If the only consideration was the source of funds, an argument could be made to use cash/taxable accounts first (always keeping a minimum of 2-3 years of cash available for liquidity purposes), then tax-deferred accounts, and finally tax-free accounts. The idea being that invested tax-deferred and tax-free accounts usually earn a higher return than cash savings and will have the longest possible time to grow.

However, there is one major component that significantly affects when each source should be used - taxes. There are no taxes on using money from cash or Roth accounts (after age 59 1/2), but ordinary income and capital gains are taxed, up to 85% of Social Security may be taxed, and all Traditional 401k/IRA withdrawals are taxed. At the very least, you will be taxed when you are forced to take Required Minimum Distributions (RMD's) from Traditional 401k/IRA accounts beginning at age 72. While you want a 401k/IRA account to grow for as long as possible, the risk of doing so is that the larger your balance, the greater the RMD's will be, and the larger the tax liability you will incur. Also, the RMD's count as income, which can then affect whether or not, and by how much, your Social Security income may be taxed. RMD's can significantly reduce your flexibility to manage taxes after age 72 so you need to develop a plan well ahead of that milestone. For this reason, it may make sense to use at least some of the taxable 401k/IRA funds before RMD's are required, as long as the annual distribution would not bump you into a higher tax bracket. Such "controlled" distributions would be based on tax consequences, current and future, rather than being based solely on what you may need to pay expenses. This strategy could slowly lower your account balance until RMD's start (any amount not needed for expenses could be kept in cash or invested), requiring lower RMD's and lower taxes later on. What you are trying to avoid is being required to take large distributions all at once (that are not needed for any particular purpose), thereby lowering the earning potential of the remaining funds and incurring a larger than necessary tax bill.

Another benefit to postponing the use of taxable accounts (at least in part) until later in retirement is that you will pay taxes on any investment withdrawals at your capital gains rate, which will likely be lower than your current ordinary income tax rate - and could even be 0% for taxpayers with adjusted income below $41,675 ($83,350 if married).

Many financial articles suggest using funds in the following order during retirement:
1) Taxable accounts and ordinary income
2) Tax-deferred accounts (Traditional 401k/IRA)
3) Tax-free accounts (Roth 401k/Roth IRA)

But the truth is, spelling out one specific approach is just as over-simplified and misleading as suggesting that you use generic benchmarks or retirement calculators to determine how much to save for retirement - it simply doesn't account for essential information. Each person's situation is unique, and may even change from year to year, so there is no over-arching right answer that will be advantageous for everyone. The best approach for efficiently using different sources of retirement savings is often a combination of options, taking into account the specifics for any given year.

Modeling a wide variety of scenarios has shown that exhausting one fund type at a time, while simpler in execution, could result in paying 10% - 38% more in taxes over the course of a 20 year retirement as opposed to using a more balanced approach that utilizes more than one fund type in any given year. Is a little more effort worth a significant tax savings and the possibility of having your savings last longer? Absolutely!

For example, consider utilizing a Roth IRA during your highest income years to avoid a significant jump in tax brackets. If RMD's push you to the top of the 12% tax bracket but you still need additional funds for expenses, take a withdrawal from your Roth IRA to cover the difference rather than taking additional funds from a tax-deferred account. This avoids the 22% tax rate on a larger distribution from a tax-deferred account.

Keep in mind that this is not an either/or situation. Depending on your circumstances, including account balances, account types, and available tax deductions, using a combination of accounts (or only one type) in any given year will likely yield the best short- and long-term results. This will require you to consider many factors on an ongoing basis,
but isn't it worth it to have your money last as long as possible while limiting your tax liability at the same time?

In short, there isn't just one right answer for which funds to utilize first. It depends on many factors and may change from year to year. It's not a situation where you "set it and forget it", but it is certainly worth the effort to figure out what will work best for your situation. If you're still in your savings years, having assets in multiple types of accounts could improve your flexibility for saving on taxes in retirement. If you're in your spending years, do your due diligence to keep from "spending" too much on taxes!

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