Withdrawal Location with Progressive Tax Rates

Optimal withdrawal strategies are developed for retirees with multiple types of tax-advantaged savings accounts. In an environment of progressive tax rates, the ability to convert pretax funds in traditional IRAs at low tax rates substantially increases investors’ residual accumulations and withdrawal sustainability. Specifically, informed withdrawal-location strategies, in which traditional IRA distributions can be applied against exemptions, deductions, and lightly taxed tax brackets, can increase residual accumulations by more than $1 million. In these strategies, the optimal tax bracket through which an investor should take distributions is directly related to the investor’s wealth level.The introduction of a variety of tax-advantaged savings accounts [e.g., Roth IRAs, Section 529 plans, and Roth 401(k) plans] presents retirees with an array of new decisions. Retirees with multiple types of tax-advantaged accounts from which to withdraw funds must decide how to make optimal distributions from these accounts. For example, which is optimal: to first draw down balances in tax-sheltered accounts with front-end tax benefits (such as traditional IRAs) or to first drawn down balances in accounts with back-end tax benefits (such as Roth IRAs)? Or should a retiree use some combination of withdrawals from both accounts? This article develops optimal withdrawal-location strategies for investors in an environment characterized by progressive tax rates. The term “withdrawal location” refers to the type of accounts from which investors should make distributions.The withdrawal model recognizes that withdrawals from some types of accounts are taxed as ordinary income and withdrawals from other accounts are not taxed. It highlights opportunities for tax-efficient withdrawal locations created by a progressive tax rate system. In such an environment, investors may be able to apply distributions from a traditional IRA or similarly taxed account against exemptions, deductions, or lightly taxed tax brackets. This ability to convert pretax funds in traditional IRAs to after-tax funds at relatively low tax rates substantially increases investors’ residual accumulations and ability to sustain withdrawals.Examples in the article show that informed withdrawal-location strategies can increase residual accumulations by more than $1 million. The optimal tax bracket through which an investor should take distributions is directly related to the person’s wealth. For example, an investor with $1.7 million in retirement assets would optimally, as long as minimum distribution requirements permitted, take taxable distributions up through the 15 percent tax bracket. An investor with $3.33 million in retirement assets would optimally take taxable distributions up through the 25 percent tax bracket, and the optimal distribution tax bracket for investors with $5 million in retirement assets is 28 percent.