A Guide to
Withdrawing Retirement Assets
A lot is being
written about how much money Americans can withdraw from their investments
to fund their retirement years. Now, a new research institute launched by
Fidelity Investments has outlined the order in which money should be
withdrawn from various tax-deferred and taxable investment accounts.
Described as the ‘withdrawal hierarchy,’ the Fidelity Research
Institute suggests the order, with modifications made courtesy of other
financial planning experts.
1. Take your minimum
required distributions (MRDs) from qualified accounts and IRAs.
If you are age 70½ or older, make sure you know which of your accounts
require such distributions and how large those distributions need to be,
and then meet the requirements and deadlines, avoiding the application of
the 50 percent income tax penalty that will be assessed if you fail to
make timely withdrawals of required distributions.
2. Liquidate loss
positions in taxable accounts.
Some investments in your taxable accounts may be worth less than their tax
basis. In addition to offsetting realized losses against realized gains,
at the federal level you can usually use up to $3,000 ($1,500 for married
couples filing separately) of net losses each year to offset ordinary
income including interest, salaries, and wages. Unused losses can be
carried forward for use in future years.
3. Sell assets in
taxable accounts that will generate neither capital gains nor capital
losses. Such assets
generally include cash and cash-equivalent investments as well as capital
assets which have not increased in value. If your withdrawals from this
tier in the hierarchy largely come from cash-equivalent investments,
sufficient liquid assets holdings should remain intact in order to cover
short-term financial emergencies. And be especially mindful of portfolio
rebalancing issues.
4. Withdraw money
from taxable accounts in relative order of basis,
and then qualified accounts or tax-deferred saving vehicles funded with at
least some nondeductible (or after-tax) contributions, such as variable
annuities and Traditional IRAs that contain non-deductible contributions.
The choice depends on the circumstances, and in some cases it might make
more sense to tap the tax-deferred vehicle first, but for most retirees,
capital gains rates are lower than ordinary income tax rates and generally
liquidating capital assets first would be beneficial.
Assuming there is a
significant difference in the basis-to-value ratio of the assets to be
liquidated in two accounts, the better tactic for choosing between these
two types of withdrawals may be to liquidate the assets with the higher
ratio. That is, the assets that have generated the smallest gain or the
largest loss as a percentage of their basis. If the basis-to-value ratio
of the assets to be liquidated in each account is relatively low due to
significant investment gains, it often will be preferable to liquidate the
assets in the taxable account. Conversely, if the basis-to-value ratio of
the assets to be liquidated in each account is relatively high, it may be
preferable to liquidate assets in the tax-deferred account if portfolio
demands require it. Note that IRAs are generally subject to certain
aggregation requirements when allocating basis. When liquidating gain
positions in taxable accounts, it usually makes sense to sell assets with
long-term capital gains first, since they should be taxed at lower rates
than short-term gains.
5. Withdraw money
from tax-deferred accounts
funded with deductible (or pre-tax) contributions such as 401(k)s and
Traditional IRAs, or tax-exempt accounts such as Roth IRAs. It may not
make much difference which
account you tap first within this category since all withdrawals from any
tax-deferred accounts funded with
fully deductible (or pre-tax) contributions are taxed at the same rate.
When withdrawing money from tax-deferred accounts funded with fully
deductible (or pre-tax) contributions, you may wish to request that taxes
be withheld.
If you believe that
the withdrawals you make may be subject to different tax rates over the
course of your retirement (whether due to changes in tax law or to varying
tax brackets as a result of fluctuations in income) you may be better off
liquidating one type of account within all of these guidelines before
another. For example, it may make more sense to leave your Roth account
intact if you thought your ordinary income tax rate was likely to rise in
later years, increasing the value of the Roth’s tax exemption.
Estate planning
considerations may also significantly impact the entire hierarchy.
Generally, qualified and tax-deferred assets may be given a higher order
within the withdrawal hierarchy in the case of larger estates expected to
hold "excess" assets which will pass to heirs or be subject to
estate taxes. Capital assets receive a step-up in basis at death, while
qualified and tax deferred assets are considered to contain "income
in respect of a decedent" and do not receive a step-up. A number of
other issues may also have an effect on the recommended order of
withdrawal, like if the retiree’s income approaches the threshold of
paying taxes on Social Security income.
October 2006— This column is
produced by the Financial Planning Association, the membership
organization for the financial planning community, and is provided by
McGuire & Co., LLC, a local member of the FPA.
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