Financial Architects

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Tax-Efficient Spending from a Portfolio

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:

  1. Taxable (preserves tax deferral in the other accounts)
  2. IRA (no RMDs on the Roth, so this reduces future RMDs by taking the funds now)
  3. Roth

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:

  1. 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.
  1. 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 such as tapping a HELOC temporarily).

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.)

The reason the Roth is last in the list is simply because, under current tax law, there are no RMDs on Roth IRAs (there are on Roth 401(k) accounts).  If all retirement accounts had RMDs (or no RMDs) they would all be equivalent (see this post for caveats though).

The real goal is to preserve tax deferral as long as possible (without triggering higher tax rates), so with that in mind, we can add a little complexity to the simple order above, this is a more complete ordering for a married couple who may also have inherited IRAs:

  1. Taxable
  2. IRA or Roth inherited by older spouse
  3. IRA or Roth inherited by younger spouse
  4. Older Spouse’s IRA
  5. Younger Spouse’s IRA
  6. Roth

This order assumes the spouses have similar ages.  It is possible that given a large enough age disparity options 3 & 4 could swap places temporarily.