Prioritizing the order of funds used in retirement is an important consideration as it can have a significant impact on how long savings may last, and offer ways to minimize the "loss" to taxes. One way to do this is to model different scenarios in your financial plan.
Many financial articles suggest using savings in the following order during retirement:
1) Taxable accounts
2) Tax-deferred accounts (Traditional 401k/IRA)
3) Tax-free accounts (Roth 401k/Roth IRA)
But the truth is, using one fund type at a time is as over-simplified and misleading as using generic benchmarks or retirement calculators to determine how much to save for retirement in the first place - it simply doesn't account for essential information. For example, using all non-retirement savings first leaves you with no options for accessing
non-taxable distributions in later years. It delays using retirement savings, possibly leading to larger RMD's, larger taxes on those RMD's, and possibly a higher tax bracket than you would like in your mid 70's. If you are over age 65, will using only taxable distributions trigger IRMAA, increasing Medicare premiums? Will you be doing Roth Conversions,
which are more beneficial when taxable distributions are not needed to pay the conversion taxes? Will larger taxable distributions bump you into a higher tax bracket?
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 both taxable and non-taxable distributions in any given year. This approach can lower taxes on necessary distributions (by using smaller taxable distributions) which also slowly decreases retirement savings so that future RMD's will also be smaller, decreasing future taxes. Of course, the long-term effectiveness of this will also depend on the level of each type of savings, so distributions should be taken proportionally, based on the respective balances, so that neither savings balance is depleted more quickly than necessary.
This is one reason that TCRP's default approach is to use non-retirement and retirement savings together, which is generally more advantageous in a majority of situations. An example of this is with RMD's. Once they start, you are stuck with them, and their taxes. If you use some retirement savings before RMD age, taxes will be assessed on lower distribution amounts that you have some control over. This creates a smaller future savings balance when RMD's start, producing smaller RMD's and smaller corresponding taxes, compared to if you had maintained a higher balance until RMD's started.
As good as that is, it still may not be just the right the right solution for everyone. Each person's situation is unique,
so there is no over-arching right answer that will be most beneficial for everyone. The best approach for efficiently using different sources of savings to help pay expenses is often to use a combination of options, which is why TCRP also offers flexibility in how funds are used. This may not be obvious, so let's take a closer look.
There may be times when you do not want to use taxable distributions (e.g., to stay in a lower tax bracket if you have other income, to use only non-taxable distributions to pay taxes on Roth Conversions, to avoid triggering IRMAA, etc.), so TCRP allows you to specify at what age taxable distributions from retirement savings should start (up to your RMD start age). Before this age, only distributions from non-retirement savings will be used.
You could also do this the other way around (not usually advantageous, but it can be done), by not entering a non-retirement savings balance until a certain age/year. Before that age/year, only retirement savings would be used if distributions were needed. You could even stagger entering non-retirement savings balances since distributions are based, proportionally, on the available non-retirement and retirement savings balances. Adding non-retirement savings balances over time gradually increases the overall proportion used for expenses compared to retirement savings used.
So you have the option to let the planner operate as designed and access both non-retirement and retirement savings together, delay using retirement savings until a certain age, or delay using non-retirement savings until a certain age.
But wait, there's more! There is also an exception process (not usually recommended, but, again, it can be done) where you can opt to use a specific amount of retirement savings in a particular year, or for select years. You would enter a negative contribution from retirement savings (which the planner will tax automatically), and then enter the same amount as Non-Taxable Income (so it won't be taxed twice). This applies the distribution directly to expenses for that year. The planner sees this as an exception and will still calculate everything else as designed. The same could be done using Roth 401k/IRA savings, if specific non-taxable amounts are needed for a particular expense, or general expenses.
In short, there isn't just one right answer for which funds to utilize first. It depends on many factors and may change over time. 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!
Also keep in mind that modeling these scenarios can involve a lot of back and forth entries in the planner to see how each scenario plays out. To save a lot of time, and to easily compare the results for each scenario, you can make copies of TCRP to try each scenario separately. That way you are not constantly changing entries and you have a record of each result - no need to remember what the past result was, just open each planner and compare them!