Christine Benz: Hi, I’m Christine Benz from Morningstar. Figuring out where to source withdrawals in retirement is perennially a hot topic for individual investors and their advisors. I recently sat down with financial planning expert, Michael Kitces, to get his take on that question.
Michael, thank you so much for being here.
Michael Kitces: Absolutely. My pleasure. Appreciate the opportunity.
Benz: In retirement, you’ve got to figure out where you’re going for your cash on an annual basis. So how does that relate to what you’ve just talked about, about asset location, the sequence with which I should pull from those various accounts? How should I think about that?
Kitces: We actually try to keep these a little bit separate in, I’ll say, what I call the “account sequencing question,” which is, “In what sequence do I want draw down my accounts and where am I holding the dollars across those accounts?” Because the reality is investments are pretty fungible these days, if I need to get money from account A versus account B or move them around, I can move them around quite readily. So one of the discussions often that we heard, even when we had talked about in the past: What does it look like to put bonds in taxable accounts because the yields are relatively low, so there wasn’t a lot of value of asset location IRA and putting stocks in the IRA. And then the question we often get is, “Well, OK, but when interest rates rise, then you’re going to want to switch them.” Well, how do you switch them?
It’s like, well it’s really easy. I sell the bond from the taxable accounts, which if interest rates just rose is actually a harvesting a capital loss. That’s a good deal. I sell the bonds for our capital loss and tax savings in my brokerage account and I buy them in my IRA. I sell the stocks in my IRA, which of course is a tax-free event anyways, and I reinvest the bond proceeds in my brokerage account into my stocks that are now holding the stocks in the taxable account with a very new, very high basis because I just bought into them today. So it’s not as hard as we sometimes make it out to be to move these around, particularly in a realm where a lot of these have zero transaction costs, aside from maybe a penny bid-ask spread to execute a trade in an ETF.
It was a little bit different if I go back a number of years where just ticket charges and transaction charges were a lot higher. I had to be a little bit more careful about the fact that I might have to swap and transmute these across accounts. In today’s environment. I find a lot of investors don’t give as much credit to how amazingly liquid investment accounts and markets actually are today. That even if you don’t have the dollars in the right account, you can move them back and forth quite readily.
The second thing that we find happens in practice around this, so when you get out of the asset location side and you get more directly in this account sequencing issue. In what order do we want to draw down the accounts? This is another one I think has gone through an interesting evolution over the years. First we had investment accounts, then we had IRAs and 401(ks), then we had Roths, we have all these different choices now. The early model of this was pretty simple and straightforward. You spent the brokerage account down first because you wanted your tax-deferred accounts to run, get-tax deferred company growth as long as they could. And then eventually when you ran out of the dollars in the taxable accounts, you would go to the IRAs. The problem, though, and we see this routinely unfortunately with new clients that have come on board that have gone through this, they say, “So the reason I’m hiring you is I’ve built up this pretty sizable IRA, I spent down my other investment accounts early in my retirement. I’m in my mid- to late-70s now. I’ve got a pretty sizable IRA. I’m getting killed on taxes because either the RMDs are just the money I need to live off of when this is my only source of dollars. It’s just a big withdrawal, and it’s blasting me in the top tax brackets.”
They say, “Is there anything you can do about it?” And we say, “Well, absolutely yes. Not now. Now’s too late. But if you had called us 10 or 15 years ago, yes, because what we should have been doing along the way is actually tapping those IRA dollars along the way to fill the low tax brackets.” What we often see for a lot of investors that execute that—I’m going to spend on the taxable account first, I’m going to let the IRA run is like we go through our 60s. We’re like, this is awesome, my tax bill is near zero. I’ve got no IRA distributions. My Social Security hasn’t started yet. I’m being really efficient about the liquidations. I’m liquidating the high basis stuff first. Heck, my bonds were giving me relatively low yield for a lot of the past 10 years. Look at how tax-efficient I am. I’m in this super low tax bracket, and I’m paying basically nothing to Uncle Sam. We do a little victory dance.
And then that bucket runs out and suddenly we’re fully concentrated into an IRA bucket for a really big portion of the dollars. We’re blast into the high tax brackets, and you can’t dodge them. So we get this use it or lose it opportunity with the lower tax buckets to fill them as best we can while we’ve got the opportunity to do so so we don’t cluster all of the dollars in the later years.
Now we get a couple of choices about how we go about doing that in practice. One option is we simply start taking withdrawals from IRAs in the early years where we can fill the low tax brackets before the RMDs and the Social Security and the rest begins. The second option is we can say, “No, I’m still going to draw from my taxable accounts first, but I’m going to do partial Roth conversions every year. Not the whole account, because if I convert the whole account, I go straight into the big tax brackets now.” But just like a small dent every year repeated over three, five, 10-plus years, sometimes, depending on when you retired and when you start your Social Security—gives you an opportunity to keep whittling down the accounts that by the time you run out of taxable account dollars, we’ve got this mixture of IRAs and Roths. And now we can still say, “Well I’m going to draw from the IRA for the low tax brackets, I’m going to top up my retirement spending with the Roth and I can continue this process through the remainder of my retirement.”
Now the significance of all of this is in practice we can do this remarkably independent of our asset location decisions. I can set my account sequencing, which essentially comes down to: What’s the tax bracket that I want to fill? And it varies by investors. For some of us just if I can fill the 12 and not go above the 12, that’s a great deal. For some of us there’s just a little bit too much wealth in the aggregate. Once investors have say a million or few dollars saved up in that big nest egg, it’s pretty hard to stay in the 12% bracket for life. Just there’s enough income that gets generated and kicked off from some combination of interest, dividends. and capital gains that you start creeping in a higher bracket. So we say, great, let’s fill the 22% and 24% brackets, but we’ll avoid jumping into the 32% that follows. When we work with our very affluent clients, anything that’s not the top 37% bracket would be great to fill, and we just go right up to the 37% threshold. What we fill to will vary by investor.
But as I go through the process saying, OK, I want to make sure I fill my low tax brackets so I harvest IRA dollars and either spend them or Roth-convert them while I spend from taxable accounts, I can largely do that independent of where the assets are. I mean, if I’m Roth-converting, I can move the assets in kind. I can sell something out of the IRA and rebuy it in the Roth or vice versa because none of these are taxable transactions and my transaction costs are very low. As you mentioned earlier, sometimes I can even buy and sell out of my IRAs and into my brokerage account. I can’t move the money across the line because that’s a contribution or withdrawal. But I can sell A over here and buy A over here while I sell B over here and buy B over here and just do two transactions that swap them.
Because of that, we find we can often make the asset location decisions quite independently of how we’re drawing down accounts from a sequencing end, which in turn we can often make quite independently of even generating ongoing cash. Because the reality for a lot of us at the end of the day, even if we’re in retirement and taking withdrawals, we might be withdrawing 4% of our portfolio if you follow a 4% rule framework, if you’ve got some Social Security kicking in or pensions or other sources, your portfolio withdrawal might even be less than that. And when I get down the fact I literally need a few percentage points out of my accounts, in practice, you often end out with a lot of choices about how you’re going to generate that. Heck, sometimes this sweeping my bond interest or dividends to cash might do most of it if I’ve got a sizable account or maybe I need to do a small sale transaction, but if they’re bonds, I can harvest losses. If they’re stocks, maybe I’ll harvest losses depending on what it is. Maybe I’ll just go down to the individual lot level and say, “Well, I’ve got a number of stocks in my brokerage account, I need to generate some cash but I only need a few percentage points so I’m just going to find whichever things have the highest cost basis and the smallest capital gains and I’ll sell those down.”
And so what we find in practice is if you do take a few minutes to drill into the accounts and say, OK, I really need my spending but it is only a few percentage points in my overall portfolio, how am I going to generate this cash between the fact that I’m often moving money out of an IRA anyways because I need to fill low tax brackets. So either I can move it to the Roth or if I need some dollars I can just liquidate from the IRA and spend it, or I’m drawing from brokerage account, but I’ve got cash, I’ve got interest, I’ve got dividend sweeps, I’ve got the ability to sell higher-basis investments in the first place. We find in practice it’s really quite manageable to generate cash while optimizing asset location and optimizing account sequencing separately or sort of indirectly what we find—Yes, at some point you will need to sell something from your brokerage account that is up and generates a capital gain. At some point that’s not avoidable, that’s just kind of how it works. I mean, your only alternative at that point is don’t buy things that go up and I can save you all of your capital gains taxes, but that doesn’t actually end out better.
So we can defer, we can delay by being efficient about what we liquidate and how we draw it down and how we handle interest in dividends and other cash flow sources. Yes, at some point you do get to the capital gains, but if you’ve drilled down to everything and all that’s left is capital gains that it probably literally means you already are so far ahead of the game from the years of tax efficiency that you had to get to this point that, yes, it’s a little bit of a comeuppance when the moment of taxes finally comes, but you’re already winning. It’s not bad to get to that moment, it just means you already won.
Benz: Right. Michael, this has been such a helpful discussion. We’ve covered a ton of ground. Thank you so much for being here.
Kitces: Absolutely. My pleasure. Thank you.
Watch “Best Practices for Tax-Efficient Portfolio Management” for more from Christine Benz.
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