TAN Wealth Management
CERTIFIED FINANCIAL PLANNER™ Practitioner in San Francisco Bay Area

Wealth Perspectives

The Most Tax-Efficient Sequence of Withdrawal Strategy Explained

 

You work so hard to save and accumulate wealth during your working years. Now you are in retirement; it’s time to use it. For today's educational video, I am going to share with you the most tax-efficient ways to withdraw money from your accounts in retirement. The industry calls it sequence-of-withdrawals. Of course, there are exceptions to the rules depending on your unique financial position. 

Hi everyone, my name is Tan, and I am an independent CERTIFIED FINANCIAL PLANNER™ practitioner at TAN Wealth Management. When and how to withdraw from various types of accounts make a big difference in retirement because different types of accounts have different tax characteristics.

The goals with sequence of withdrawals strategy are to:

  • Maximize the amount of money investors can spend in retirement.

  • Receive a higher lifetime after-tax income.

  • Enhance the longevity of the portfolio.

  • Reduce the taxes paid over the course of the investor’s retirement.

  • Eliminate or reduce Social Security benefits from being taxed.

  • Reduce Medicare premiums.

Let’s start with the terms:

  • Pre-tax accounts are Traditional IRAs, 401(k) plans, 403(b) plans, 457(b) plans, Tax-Sheltered Annuities (TSA), and other before-tax tax-deferred accounts. All distributions from pre-tax accounts are taxable at ordinary income tax rates.

  • After-tax accounts are Roth IRAs and Roth 401(k) plans. Qualified distributions from after-tax accounts are tax-free.

  • Taxable accounts are savings accounts, checking accounts, and brokerage accounts, also known as retail accounts. The principal is not taxed. The gains are taxed at ordinary income tax rates or capital gains tax rates depending on the holding period and type of investments.  

The sequence of withdrawals strategy for retirement before age 72:

1. Cash: Have one to two years in total spending in cash then refill it annually. If you don’t have the cash, you can move money from your other accounts to have a cash position.

2. Dividends and capital gain distributions from taxable accounts: You are going to get taxed if you spend the money or reinvest it.

3. Combination of accounts: Use a combination of pre-tax accounts, after-tax accounts, and taxable accounts, but try to use more taxable accounts.

Why?

  • Taxable accounts are not as tax-efficient as pre-tax accounts and after-tax accounts. You have to pay tax on dividends and realized capital gains in a taxable account, whether you use the money or reinvest it, while you do not have to in the pre-tax accounts and after-tax accounts because it has a tax benefit called tax-deferral.

  • Do partial annual Roth Conversion from pre-tax accounts to after-tax accounts, such as doing a Roth Conversion from a Traditional IRA to a Roth IRA. 

Why?

  • This will allow the money inside the after-tax accounts to grow and use for later years.

  • Minimize required minimum distributions from pre-tax accounts in the future.

  • Minimize withdrawals from pre-tax accounts to minimize taxes. What I mean by this is, the money will have to be withdrawn someday. It could be the retiree or their beneficiary. Pre-tax accounts are the worst types of accounts for inheritance because all of that money is taxable at withdrawal at ordinary income tax rates. With taxable accounts, the beneficiary gets a step-in-basis. With after-tax accounts, qualified withdrawals are tax-free.

  • We don’t want Social Security benefits to be taxed because of the high required minimum distributions from pre-tax accounts.

  • We don’t want to pay high Medicare Part B monthly premiums because our modified adjusted gross income is high. The higher your modified adjusted gross income (MAGI), the higher your Medicare Part B monthly premium. “The standard Part B premium amount in 2020 is $144.60 or higher depending on your income. Your modified adjusted gross income as reported on your IRS tax return from 2 years ago is above a certain amount.” This shows the importance of having a dynamic withdrawal strategy so you can control how much taxable income you want to recognize annually. By having a plan, you could eliminate or reduce your Medicare Part B monthly premium. [1]

  • Pre-tax accounts could be a tax bomb to beneficiaries because the beneficiaries are forced to take required minimum distributions that are subjected to ordinary income tax rates.

  • Roth conversion because the money in the Roth account can grow tax-deferral and qualified distributions are tax-free. 

  • When investors are in a low tax bracket, and before required minimum distributions begin at age 72, investors can look into withdrawing from pre-tax accounts and/or do Roth conversion. You want to run the numbers because if you don’t withdraw from pre-tax accounts and wait until you are 72 years old to take out the required minimum distributions (RMDs), the RMDs are taxable, and you have income coming in from other sources like Social Security benefits, now you are getting taxed a lot. Up to 85% of Social Security benefits could be taxable. 

  • The goal is to have lower taxes now and lower taxes later. Less money you have to pay in taxes equals more money you get to spend during your lifetime.

  • You have a short window before you have to take out the required minimum distribution from pre-tax accounts, so don’t waste it.

The sequence of withdrawals strategy for retirement after age 72:

1. Required minimum distributions (RMDs) if you retire after age 72: We use the required minimum distributions (RMDs) first because the law requires us to take out the required minimum distributions from the pre-tax accounts, such as the Traditional IRAs, SEP IRAs, Simple IRAs, 401(k) plans, 403(b) plans, 457(b) plans, et cetera. 

If we don’t take out the required minimum distribution by the deadline annually, we have to pay a 50% penalty on the required minimum distribution amount. For example, you have a $1,000,000 portfolio, and you are 72 years old. Based on the IRS Required Minimum Distribution table, the account balance divided by the factor of 27.4 for age 72 is $1,000,000 / 25.6 = $39,063.

$39,063 X 50% penalty = $19,532.

$19,532 is the penalty you owe the IRS if you don’t take out the required minimum distribution for age 72. [2]

2. Dividends and capital gain distributions from taxable accounts: You are going to get taxed if you spend the money or reinvest it.

3. Losses and gains from taxable accounts to offset each other – it’s like a wash: You can use your depreciated assets and appreciated assets so they can offset each other to realize a zero to low net capital gain. For example, you realized a $50,000 capital loss from selling investment A, and you realized a $50,000 capital gain from selling investment B. Now you have $100,000 to spend for retirement, and the net capital gain is zero. 

4. Combination Of Accounts: This is where it can be complicated because you have to calculate individually to see how much to withdraw from taxable accounts, pre-tax accounts, and after-tax accounts to stay in a tax bracket you are comfortable with. 

Taxable Accounts

With taxable assets, start with selling assets with the highest cost basis then move to assets with a lower cost basis so you can pay less in taxes and have more money to spend. For example, you bought a share of investment A in the year 2000 for $1,000, and you bought another share of investment A in the year 2005 at $5,000. In the year 2020, investment A is at $10,000 per share. It’s better to sell the share with the highest cost basis which is the share you bought in 2005 because you only need to pay $5,000 ($10,000 - $5,000) of capital gain compared to the share in 2000 at $9,000 ($10,000 - $1,000) of capital gain.

In addition, with taxable accounts, your beneficiaries can get a step-in basis upon your death. This means you bought investment A at $1,000 per share in 2000, and it’s at $100,000 per share when you passed away in 2050. Your beneficiary inherited investment A share at $100,000 per share, and that will be their new cost basis. They sell investment A at $100,000 per share, equal no tax because the selling price is $100,000 minus their cost basis is $100,000 equal $0 gain. Thus, it’s smart and more tax-efficient to use the investment with the highest cost basis first and save the investment with the lowest cost basis to spend in later years or save it for legacy planning.

If your health is not good and you have large gains in your taxable accounts, it might make sense to not withdraw from the taxable accounts because your beneficiaries can get a step-up in basis. An example of a step-up in basis is, you bought Google at $3 per share, and Google is at $1,000 per share when you are deceased. Your beneficiaries received Google at $1,000 per share, then sold it right away for $1,000 per share. Your beneficiaries won’t have to pay tax on the gain because their cost basis is when they received the share at $1,000 per share minus their selling price at $1,000 equal $0 gain.

Vice Versa, if you are in poor health and have large losses, you can withdraw from the taxable accounts and realize the loss because you don’t want your beneficiaries to get a step-down in basis.

For example, you bought Google at $1,000 per share and Google is at $3 per share when you are deceased, your beneficiaries received Google at $3 per share then sold it right away for $3 per share. They don’t have to pay the taxes, but they cannot realize your loss. Therefore, it makes sense for you to sell the share when you are alive so you can realize the loss to offset your tax liability. 

Pre-Tax Accounts

With pre-tax accounts, distributions are taxed at ordinary income tax rates.

Withdraw funds from pre-tax accounts when a retiree has high medical expenses. Why? “If you itemize your deductions for a taxable year on Schedule A, you may be able to deduct expenses you paid that year for medical and dental care for yourself, your spouse, and your dependents.” [3]

“In 2019, the IRS allows all taxpayers to deduct the total qualified unreimbursed medical care expenses for the year that exceeds 7.5% of their adjusted gross income. For example, if you have an adjusted gross income of $45,000 and $5,475 of medical expenses, you would multiply $45,000 by 0.075 (7.5 percent) to find that only expenses exceeding $3,375 can be deducted. This leaves you with a medical expense deduction of $2,100 ($5,475 - $3,375).” [4]

I am in favor of spending from pre-tax accounts, like a 401(k) plan, when you are in a low marginal tax bracket in retirement because:

  1. The required minimum distributions will be less in the future. This helps you hedge against your Social Security benefits from being taxed, which we call avoiding the tax torpedo. 

  2. Pre-tax accounts, like a 401(k) plan, are the worst inheritance assets. Since that money has never been taxed, it’s 100% taxable to the beneficiaries at ordinary income tax rates. 

  3. No step-in basis like other assets. What does that mean? For example, you bought a share of Amazon for $2 in 1997 in a pre-tax account, like a Traditional IRA. You passed away in 2020 and the Amazon share is at $2,000 per share. Your daughter inherited the share at $2,000 per share then sold it for $2,000. Your daughter will have to pay tax on the full $2,000 at ordinary income tax rates because the money in the pre-tax account has never been taxed. 

If the same Amazon share was held in a taxable account, your daughter would get a step-up in basis. For example, you bought a share of Amazon at $2 per share in 1997. You passed away in 2020, and the Amazon share is at $2,000 per share. Your daughter inherited the Amazon share at $2,000, then sold it for $2,000. Your daughter will pay no tax because her cost basis is $2,000 due to the step-up in basis minus her selling price of $2,000 equal $0 gain. 

Here is a direct quote from the IRS website. “To determine if the sale of inherited property is taxable, you must first determine your basis in the property. The basis of property inherited from a decedent is generally one of the following: The fair market value (FMV) of the property on the date of the decedent's death [or] the FMV of the property on the alternate valuation date if the executor of the estate chooses to use the alternate valuation.”

After-Tax Accounts

Roth 401(k) plans have required minimum distributions (RMDs) if you are no longer employed at the company. Therefore, you can do a direct rollover from the Roth 401(k) plan to a Roth IRA to avoid the required minimum distributions.

With Roth IRAs, you don’t have required minimum distributions, and your spouse does not have required minimum distributions if they rollover your account into theirs. When others inherit the Roth IRAs, they will have required minimum distributions even though it’s not taxable.

Best Practices To Keep In Mind:

  • When you are in a low marginal tax rate, you should withdraw from pre-tax accounts and/or taxable accounts. The concept is to stay in the low marginal tax rate and receive low to zero long-term capital gains tax rates from taxable accounts. Normally, capital gains tax rates are lower than ordinary income tax rates. For the taxpayers that are in the lowest tax bracket, the capital gains tax rate is at 0%. Here is a direct quote from the IRS website, “some or all net capital gain may be taxed at 0% if you're in the 10% or 15% ordinary income tax brackets (4).” Even if you are not at the 0% capital gains tax rate, you are getting taxed at long-term capital gains tax rates, which generally are lower than ordinary income tax rates.

  • Whenever you are in a low marginal tax rate, do the calculations to see if a partial Roth conversion makes sense.

  • When you are in a high marginal tax rate, you should withdraw from after-tax accounts because you want tax-free withdrawals.

  • No one can predict the future. You don’t know what the tax rates and your spending needs are going to be in the future, but you do know how much you can withdraw from each account now to control your marginal tax rate. Therefore, I am an advocate of a dynamic withdrawal approach by withdrawing from different accounts to control the marginal tax rate. This is also called tax bracket management.

  • Asset allocation - the fewer the stocks, the lower the withdrawal rate. For instance, a 70% stocks portfolio can withdraw 4% while a 50% stocks portfolio can withdraw 3.5%.

  • Time horizon - the longer the time horizon, the lower the withdrawal rate if you don’t want to run out of money. For example, a retired 60-year-old can withdraw 3% while a retired 80-year-old can withdraw 6% of their portfolio.

  • Inflation rate. Different investors can have different inflation rates. For example, a single investor has an inflation rate of 2%, while a single investor with 3 kids has an inflation rate of 6% because “on average, tuition tends to increase about 8% per year.” [5]

  • Market conditions - the weaker the market environment, the lower the withdrawal rate.

  • Understand and be aware of the costs, such as your time, taxes, and investment fees when managing a portfolio.

  • The holding period for short-term capital gains is one year or less, and it is taxed at ordinary income tax rates. The holding period for long-term capital gains is more than one year, and it is taxed at long-term capital gains tax rates.

  • Age 55 is the age you can withdraw from your employer sponsored plan, such as a 401(k) plan, without a 10% penalty if you are separated from service when you are 55 years old or older. Here is the direct quote from the IRS website. “Topic No. 558 Additional Tax on Early Distributions from Retirement Plans Other than IRAs.” No Additional 10% Tax for “distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental benefit plan, as defined in section 414(d) if you were a qualified public safety employee (federal state or local government) who separated from service in or after the year you reached age 50.” If you have an old 401(k) plan from a previous employer, you have to wait until age 59 ½ to withdraw from that plan without a 10% penalty, an exception to the rule is no 10% penalty if it’s a qualified distribution. Here are two planning strategies to avoid the 10% penalty. You could do a direct rollover from an old 401(k) plan into the current 401(k) plan or withdraw from the current 401(k) plan then when you reached age 59 ½, withdraw from the old 401(k) plan to avoid the 10% penalty. [6]

  • 59 ½ is the age you can withdraw from your Traditional IRA and old retirement plans, such as 403(b) plan, 401(k) plan, TSA, and et cetera, without a 10% penalty and there are a lot of exceptions to the rule. Here is one exception, and this is a direct quote from the IRS website. “In general, an eligible state or local government section 457 deferred compensation plan isn't a qualified retirement plan, and any distribution from such a plan isn't subject to the additional 10% tax on early distributions. However, any distribution attributable to amounts the section 457 plan received in a direct transfer or rollover from one of the qualified retirement plans listed above would be subject to the additional 10% tax.” [6]

  • 72 is the age you are required to take out required minimum distribution from most retirement plans.

  • From a portfolio construction standpoint, annuities are insurance in case you live longer than expected. Insurance costs money just like your home, auto, and medical insurances. The cost of annuities could be the control of the money and the cost associate with it. Using annuities to hedge longevity risk is very appealing, and some investors like to carve out a portion of their portfolios to invest in annuities for a guaranteed lifetime income.

  • If you want to extend the longevity of your portfolio, you can increase or decrease your spending to match how much money you should withdraw from which accounts.

  • Having multiple types of accounts and funding it throughout your life can give you tax diversification and flexibility in your finances. 

  • Once you are 72 years old and have to take out required minimum distributions, you reduce the flexibility to manage your taxes. Therefore you want to plan early and have money in different types of accounts.

  • There are a lot of moving factors when spending from different accounts in retirement, what income you have coming in, what expenses you have coming out, what type of assets you have, outstanding debts, financial responsibility, et cetera. There is no one size fit all strategy because everyone is different. 

  • Knowing how much to withdraw from each account is an art because it depends on your health, life expectancy, current and future expected tax rate, net worth, and if you wish to leave money to your family or a charity. You want to develop an informed tax-efficient withdrawal strategy to optimize the longevity of your portfolio. 

Preservation of accounts in the following orders

  • Save as much money in after-tax accounts and use it last. Why? With after-tax accounts, the beneficiary can have the ability to mimic a stretch IRA strategy, and withdrawals are tax-free to them. 

  • Follow by taxable accounts. Taxable accounts because of the step-in-basis rule. 

  • Then pre-tax accounts. Pre-tax accounts could be a tax bomb to the beneficiaries because all distributions are taxable income to them. 

  • To summarize, you want to use pre-tax accounts first, followed by taxable accounts, then save after-tax accounts for last. This is just a general rule of thumb, and the order of accounts can change based on your tax liability and goals. 

Some of the ideas I mentioned might not be the most optimal withdrawal strategy for you because it’s in the details, and everyone's financial situation is different. You have to consider:

  • What types of accounts do you have and what is the dollar amount?

  • What is your tax liability now and in the future?

  • What are your estate planning goals?

  • Who is going to inherit your accounts?

Tips:

  1. Ask yourself, how much money do I need annually or monthly?

  2. How much money do I currently have?

  3. What incomes do I have coming in?

  4. Is there a gap from how much I need to how much income I have coming in?

  5. Use the money that will be recognized for tax purposes in that year regardless if you use it or reinvest it, such as Social Security benefits, required minimum distribution, dividends, coupon bonds, and realized capital gains.

  6. What is the amount you will withdraw from which account so you can control your marginal tax bracket?

Conclusion & Disclaimer

This video is for educational use only, and everyone's situations are different.

Tax laws are continuously changing and how we interpret the rules can be different. The recent tax laws changed are the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) and the Coronavirus Aid, Relief, and Economic Security Act of 2020 (CARES Act). 

Everyone's situation is different and taxes are complex, thus don’t do it alone. Talk to your trusted advisors about your plan and what is the best way to execute the plan and why.

I have held over 4,000+ client meetings and have seen clients from low-income tax-bracket to high-income tax-bracket and with all their money in pre-tax accounts to most of their money in taxable accounts. To find the optimal strategy that is customized to you, you can reach out to us at TAN Wealth Management, so that we will build a plan together. 

Thank you for watching. This is Tan, your trusted advisor.

References

1. 2022 Medicare Costs
https://www.medicare.gov/Pubs/pdf/11579-medicare-costs.pdf
2. IRA Required Minimum Distribution Worksheet
https://www.irs.gov/retirement-plans/plan-participant-employee/required-minimum-distribution-worksheets
3. Topic No. 502 Medical and Dental Expenses
https://www.irs.gov/taxtopics/tc502
4. Are Medical Expenses Tax Deductible?
https://turbotax.intuit.com/tax-tips/health-care/can-i-claim-medical-expenses-on-my-taxes/L1htkVqq9
5. Tuition Inflation
https://finaid.org/savings/tuition-inflation
6. Topic No. 558 Additional Tax on Early Distributions From Retirement Plans Other Than IRAs
https://www.irs.gov/taxtopics/tc558

Additional Resources

Medicare Part B premiums and Income Related Monthly Adjustment Amount (IRMAA)
https://www.medicare.gov/your-medicare-costs/part-b-costs

2022 Federal Income Tax Brackets & Rates
https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2022

2021 Federal Income Tax Brackets & Rates
https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2021

Required Minimum Distributions (RMDs):
● “For defined contribution plan participants, or Individual Retirement Account (IRA) owners, who die after December 31, 2019, (with a delayed effective date for certain collectively bargained plans), the SECURE Act requires the entire balance of the participant's account be distributed within ten years. There is an exception for a surviving spouse, a child who has not reached the age of majority, a disabled or chronically ill person or a person not more than ten years younger than the employee or IRA account owner. The new 10-year rule applies regardless of whether the participant dies before, on, or after, the required beginning date, now age 72.
Your required minimum distribution is the minimum amount you must withdraw from your account each year. You generally have to start taking withdrawals from your IRA, SEP IRA, SIMPLE IRA, or retirement plan account when you reach age 72 (70 ½ if you reach 70 ½ before January 1, 2020). Roth IRAs do not require withdrawals until after the death of the owner.”
https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions
● “Date for receiving subsequent required minimum distributions. For each year after your required beginning date, you must withdraw your RMD by December 31.”
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
● When is my required minimum distribution (RMD) due? “If you reached the age of 70½ in 2019 the prior rule applies, and you must take your first RMD by April 1, 2020. If you reach age 70 ½ in 2020 or later you must take your first RMD by April 1 of the year after you reach 72.”
https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions
● Required Minimum Distribution Calculator
https://www.investor.gov/financial-tools-calculators/calculators/required-minimum-distribution-calculator
●“What happens if a person does not take a RMD by the required deadline?  (updated March 14, 2023) If an account owner fails to withdraw the full amount of the RMD by the due date, the amount not withdrawn is subject to a 50% excise tax. SECURE 2.0 Act drops the excise tax rate to 25%; possibly 10% if the RMD is timely corrected within two years. The account owner should file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with their federal tax return for the year in which the full amount of the RMD was required, but not taken.”
https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs


Step-In Basis
● It’s not a step-up in basis because the asset can be a step-down in basis.
● “The basis of property inherited from a decedent is generally one of the following: 
- The fair market value (FMV) of the property on the date of the decedent's death (whether or not the executor of the estate files an estate tax return (Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return)). 
- The FMV of the property on the alternate valuation date, but only if the executor of the estate files an estate tax return (Form 706) and elects to use the alternate valuation on that return. See the Instructions for Form 706.”
https://www.irs.gov/faqs/interest-dividends-other-types-of-income/gifts-inheritances/gifts-inheritances
● “The step-up in basis provision adjusts the value, or “cost basis,” of an inherited asset (stocks, bonds, real estate, etc.) when it is passed on, after death. This often reduces the capital gains tax owed by the recipient.”
https://taxfoundation.org/tax-basics/step-up-in-basis
● No step-in basis from the following assets include but are not limited to 401(k) plan, 403(b) plan, 457(b) plan, “IRAs, pension, annuity, gifts before death, irrevocable trust of decedent.”
https://www.irs.gov/pub/irs-utl/21_-_inherited_assets_-_stepped-up_basis.pdf

Updated information from the IRS

● The annual exclusion for gift per donee is $16,000 for calendar year 2022.
● The annual exclusion for gift per donee is $17,000 for calendar year 2023.
● The annual exclusion for gift per donee is $18,000 for calendar year 2024.
● The lifetime gift tax exemption amount is $12,060,000 for calendar year 2022.
● The lifetime gift tax exemption amount is $12,920,000 for calendar year 2023.
● The lifetime gift tax exemption amount is $13,610,000 for calendar year 2024.
https://www.irs.gov/businesses/small-businesses-self-employed/whats-new-estate-and-gift-tax
https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2024

● For the tax year 2024, the standard deduction for married couples filing jointly is $29,200, single taxpayers and married individuals filing separately is $14,600, and heads of households is $21,900.
https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2024

● The IRA contribution limit for 2023 is “$6,500 ($7,500 if you're age 50 or older), or If less, your taxable compensation for the year.”
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits

● Modified Adjusted Gross Income (AGI) as computed for Roth IRA purposes.
https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2023

● $22,500 is the 401(k) Plans, 403(b) Plans, and 457(b) Plans maximum employee contribution limit for 2023.
● If you are age 50 or older by the end of the year, you can contribute an additional $7,500 for 2023 which is the catch-up contribution.
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-457b-contribution-limits
https://www.irs.gov/retirement-plans/how-much-salary-can-you-defer-if-youre-eligible-for-more-than-one-retirement-plan

 
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