Tax-Efficient Withdrawal Strategies

The authors considered an individual investor who holds a financial portfolio with funds in at least two of the following accounts: a taxable account, a tax-deferred account, and a tax-exempt account. They examined various strategies for withdrawing these funds in retirement. Conventional wisdom suggests that the investor should withdraw funds first from the taxable account, then from the tax-deferred account, and finally from the tax-exempt account. The authors provide the underlying intuition for more tax-efficient withdrawal strategies and demonstrate that these strategies can add more than three years to the portfolio’s longevity relative to the strategy suggested by the conventional wisdom.The conventional wisdom suggests that a retiree should withdraw funds from taxable accounts until they are exhausted; then from tax-deferred accounts (TDAs), like a 401(k), until they are exhausted; and finally from tax-exempt accounts (TEAs), like a Roth 401(k). We demonstrate that the conventional wisdom is wrong.Properly viewed, a TDA is like a partnership in which the investor effectively owns 1 – t of the partnership’s current principal, where t is the marginal tax rate when the funds are withdrawn in retirement. The government effectively owns the remaining t of the partnership. When viewed from this perspective, the after-tax value of the investor’s portion of funds in the TDA grows tax exempt. Thus, assuming a flat tax rate, a retiree’s portfolio would last precisely the same length of time if the order of withdrawals were taxable account, then TDA, then TEA—or taxable account, then TEA, then TDA.The partnership principle is useful in devising tax-efficient withdrawal strategies in the presence of progressive tax rates. In particular, one tax-efficient withdrawal strategy is to time withdrawals from TDAs for years when those funds would be subject to an unusually low marginal tax rate for that investor. For example, suppose a taxpayer will usually be subject to a 25% marginal rate once required minimum distributions begin. Each year, she could withdraw funds from her TDA up to the top of the 15% tax bracket and then withdraw additional funds from the taxable account. After the taxable account has been exhausted and the TDA and TEA remain, she could withdraw funds from her TDA up to the top of the 15% bracket and then withdraw additional funds from her TEA. The objective is to minimize the average of marginal tax rates on the TDA withdrawals.We also present two tax-efficient withdrawal strategies that use Roth conversions. In the first of these strategies, this same taxpayer converts sufficient funds from the TDA to a Roth IRA to fully use the 15% tax bracket. Then, she withdraws additional funds as needed to meet her spending needs from the taxable account. Once the taxable account has been exhausted, she withdraws sufficient funds each year from the TDA to fully use the 15% bracket and then withdraws additional funds from the TEA. The advantage of this strategy compared with the prior strategy is that the taxpayer has more funds in the TEA growing tax-free but fewer funds in the taxable account growing at an after-tax rate of return.In the second tax-efficient strategy that uses the Roth conversion, the taxpayer makes two separate Roth conversions at the beginning of the first 27 retirement years, with each conversion amount being sufficient to fully use the 15% tax bracket. At the end of the year, she retains the funds in the Roth TEA with the higher returns and recharacterizes the other Roth TEA back to the TDA. This strategy allows her to avoid taxes on the returns earned in the year on the converted funds, and these funds henceforth will grow tax-free in the TEA.In a detailed example using the 2013 federal tax brackets, we demonstrate that the most tax-efficient withdrawal strategy can add more than six years compared with a tax-inefficient strategy. In addition, the most tax-efficient withdrawal strategy can add more than three years compared with the strategy advocated by the conventional wisdom.Sensitivity analyses confirm that the portfolio longevities increase as we progress from Strategy 1 through Strategy 5 even if we change such key assumptions as assets’ rates of return and asset allocation. In short, the ideas in the detailed example also apply to other investors and for other key assumptions.Finally, we show the advantage of holding some funds in TDAs to meet the nontrivial probability of large tax-deductible expenses, such as medical costs, which often occur late in life. Although these TDA withdrawals are subject to taxes, the individual probably will be in a low tax bracket, possibly the 0% bracket, owing to the medical expenses.