Optimizing distributions from accounts can improve outcomes in two situations. The first issue is how to spend down a portfolio in retirement when the portfolio is comprised of Traditional IRA-type assets with little to no basis, Roth IRA-type assets, and assets in a taxable account. The second situation is when an individual is inheriting an IRA and needs to determine under what method to take the RMDs (Required Minimum Distributions). For simplicity throughout, “IRA” means any accounts with Traditional IRA-type tax treatment, “Roth” indicates accounts with tax-free withdrawals, and “Taxable” means, well, taxable accounts.
Optimal Spending Order for Accounts with Different Tax Treatments
What spending order is optimal for a retiree who is older than 59½ having three types of accounts: a taxable account, a Roth IRA, and a traditional IRA with no basis?
The default order is:
- Taxable (preserves tax deferral in the other accounts)
- IRA (no RMDs on the Roth, so this reduces future RMDs by taking the funds now)
In other words, the taxable account should be exhausted before drawing down the IRA which in turn should be exhausted before drawing upon the Roth. There are exceptions to the default order however:
- To the extent the assets in the taxable account have a low basis and/or the owner’s life expectancy is short, it may be prudent to leave the assets untouched for a step-up in basis rather than sell them to live on.If there are state or federal estate taxes spend the IRA first.
- After the taxable account is exhausted, if the tax bracket is abnormally high it may make sense to spend Roth funds ahead of IRA funds (or find some other way to get to next year and a more normal tax bracket (a temporary HELOC draw for example).
Contrary to popular belief, if the tax bracket is abnormally low (or there is “room” in a moderate bracket) it is not optimal to withdraw extra funds. Rather, (partial) Roth conversions to use those low brackets are a superior strategy. (See this post for more on the analysis of Roth vs. IRA in general.)
Optimal RMDs from Inherited Retirement Accounts
The table below shows three categories of heirs (the rows) and the distribution options available when the decedent has passed away either before or after their RBD (Required Beginning Date).
(Technical note: The RBD is generally April 1st of the year following the year in which the owner turns 70½, but there is an exception for someone who is still working, if they own less than 5% of the employer, and if the retirement plan is tax advantaged but not an IRA. In that case, RMDs may be delayed until actual retirement.)
Required Minimum Distributions
|Beneficiary||Before RBD||After RBD|
|Spouse||1, 3, 4, or 6||1, 3, or 5|
|Other Individual||2 or 4||2 or 5|
|1. Rollover to beneficiary’s own IRA|
|2. Take distributions over the non-recalculated life expectancy of beneficiary|
|3. Take distributions over the recalculated life expectancy of beneficiary|
|4. Distribute 100% within 5 years after year of death|
|5. Continue on decedent’s existing payout schedule without recalculation of life expectancy|
|6. Take no distributions until the year the decedent would have attained 70.5|
About 95% of the time (while I made up that statistic, it is approximately correct) the optimal solution is to roll over IRAs to the spouse’s own IRA (option 1) or take distributions over the heir’s life expectancy (option 2). This is so common that many times even financial advisors may not realize there are other options that are more advantageous. The defaults normally work because the heir is usually younger than the decedent and, if a spouse, older than 59½. Here are the exceptions:
- If the decedent at the time of death was younger than the beneficiary spouse and had not yet reached the RBD, do option 6. Then, when the decedent would have been 70½, change to option 1.
- If the beneficiary spouse needs funds from the IRA prior to reaching 59½, do option 3. When the beneficiary spouse turns 59½, switch to option 1.
- If both the decedent and the beneficiary are beyond the RBD, and the beneficiary is older than the decedent, do option 5. The RMD under option 5 will be lower initially than under option 1. However, this will change eventually (the amounts of the RMDs cross at some point because one life expectancy is recalculating and the other is not), and at that crossover point, the beneficiary should switch to option 1.
Option 4 is the emergency bailout option when RMDs were missed the first few years. Given the 50% penalty for not taking RMDs, withdrawing everything prior to the end of the 5th year might make sense.