Once you reach retirement and begin drawing from the storehouse of wealth you’ve worked so hard to accumulate, two questions arise.

First, how much can you withdraw each year without running the risk of depleting your reserves prematurely? We looked at that issue last month in How Much Should You Withdraw Each Year During Retirement? Second, which asset accounts should you draw from first? This is an often overlooked question because banks, brokers, and mutual fund companies are typically more focused on soliciting your business and guiding your investments than on helping you develop a strategy for withdrawing your retirement savings.

Let’s look at four of the most common retirement vehicles: traditional (i.e., tax-deductible) IRAs, Roth IRAs, tax-deferred annuities, and taxable investments. For purposes of this discussion, I’ll assume any Roth 401(k) assets have been rolled over into a Roth IRA and that any pension plan assets from your place of employment have been rolled into a traditional IRA.

The starting point is to answer this question: “Is my intention to pass a significant portion of these assets to my family, or will I be using them for myself?”

  • To favor your heirs, withdraw from your annuity and IRAs first.
    Let’s suppose your desire is to maximize what you can pass on to your family after your death. This means you’ll want to minimize the tax consequences to your heirs (even though it may cost you a little more in income taxes in the meantime). With this in mind, you’ll want to avoid generating current retirement income from the sale of assets that will receive a “step-up in basis” at your death.

    Suppose, for example, that you purchased Micro Inc. at $5 a share (your basis). On the date of your death, Micro is priced at $50 a share. That means $50 becomes the new tax basis enjoyed by your heirs — and a capital gains tax on the $45-per-share profit is avoided. This “step up” feature is a valuable attribute.

    For passing on wealth, therefore, it is best to draw first from your annuities or IRAs because these have no step-up in basis at your death. If you do it this way, what are the tax consequences? In the case of an annuity, you will be taxed on a portion (i.e., the amount above what you invested) upon withdrawal. In the case of a traditional IRA, all of the withdrawal will be taxable.

    If left to your heirs, however, the money would be taxable to them based on your tax basis. This means an heir in the highest bracket would pay 35% on your previously untaxed gains (or more, depending on state of residence). Further, if you have an estate valued at more than $5 million, federal estate taxes will take 35% above that threshold (along with a hefty state bite in certain states). When all is said and done, your children would net only a fraction of your tax-deferred retirement accounts.
  • To favor yourself, withdraw from your taxable investments and Roth IRAs first. If your priority isn’t maximizing inheritance but rather maximizing retirement income, withdraw first from your taxable investments. This will prolong the tax-deferral aspects of your annuity and traditional IRAs as long as possible. For a traditional IRA, you can postpone making withdrawals until age 70½; in the case of an annuity, required withdrawal varies from company to company.
  • To increase your giving, designate a charitable beneficiary. If your tax-bracket situation is such that much of your retirement wealth would go to taxes rather than to your heirs, consider leaving a considerable portion of your retirement assets to charity. A simple way to do this is to make your spouse the primary beneficiary and a church/charity a secondary beneficiary. Your surviving spouse will be taken care of financially, and then upon his or her death, the charity will get 100% of what remains.

Depending upon your goals, an ideal strategy may be to combine both of the above two concepts. Let your tax-deferred investments continue to grow and designate your spouse as the primary beneficiary and church/charity as the secondary beneficiary, while utilizing your taxable investments and Roth IRA as sources of income.

A word for heirs

  • To reduce the tax-hit to heirs receiving IRA assets, they should consider a “Stretch IRA.”
    Normally, an heir will receive IRA assets in a lump sum or over a five-year period (paying taxes as the money is received). A Stretch IRA, however, allows the beneficiary to stretch out receipt of the proceeds over his or her lifetime. This can reduce the amount of taxes owed, plus it allows the remaining IRA assets to continue to grow tax-deferred until withdrawn. Election of a Stretch IRA doesn’t have to be made prior to the owner’s death, but for this method to work to best advantage, it’s wise to get counsel from a CPA or financial planner.

Exceptions to the rules

Naturally, being a tax topic, there are exceptions to these general rules! For example, suppose at age 68 you make a major gift or have extremely high medical bills. Because such expenses will result in higher-than-normal tax deductions for that year, it may be possible to withdraw tens of thousands of dollars from a traditional IRA and owe no income tax on that money. (This differs from the conventional wisdom discussed earlier that might normally cause you to hold off on tapping that account until later.)

Additionally, drawing from your IRAs during years with high tax deductions would produce an added benefit later — at age 70½ — when Uncle Sam forces you to begin taking “required minimum distributions” from your IRA. Because you would have already withdrawn a significant amount of money, the yearly amount of forced IRA withdrawals would be less.

In some cases, depending on several factors, it can be more tax efficient to withdraw money from different types of asset accounts in the same year, rather than using a distinct sequencing arrangement. You might, for example, take a specified amount from an account that receives one type of tax treatment, and then meet the balance of your needs for that year with money from an account that gets a different tax treatment.

To have a confident retirement, it is critical to review what your monthy living expenses will be as you move into retirement, in covering both essentials and ensuring your lifestyle. Likewise, you should prepare for the unexpected, such as long-term care and other health issues which can disrupt your plan.

Determining when to depart from normal asset sequencing in favor of a more finely-tuned withdrawal strategy can be complicated. Figuring out how all the variables work together in the most tax-efficient manner isn’t easy, and the tax implications of any particular action may not be immediately apparent. This is a complex area, so have a CPA or financial planner run the numbers and find the approach that works best given the specific mix of assets in your portfolio.