How much a retiree withdraws from retirement funds will certainly impact how long those funds last. With that in mind it's important for retirees and their advisors to adopt a tax-efficient plan for withdrawals.
"Implementing an informed withdrawal-order strategy can minimize the total taxes paid over the course of one's retirement, thereby potentially increasing both the amount of spending the portfolio can support and the portfolio's longevity," according to a recent Vanguard report on goals-based retirement spending.
Colleen Jaconetti, senior investment strategist at Vanguard, recently laid out the most tax-efficient way to sequence withdrawals in retirement in a discussion with Morningstar's director of personal finance, Christine Benz.
1. Start With Required Minimum Distributions
This first step is in some ways the most important because anyone over 70 and a half years old with assets in a tax-deferred retirement account must take a required minimum distribution (RMD) or face a 50% penalty on that withdrawal. That's equivalent to paying a 50% tax on that amount.
2. Consider Taxable Accounts
Any interest, dividend or capital gains distributions of assets held in taxable accounts are taxed, whether they're spent or reinvested. If they're reinvested and then withdrawn after being held for one year or less they will be taxed at one's income tax rate, not the lower long-term capital gains rate for anyone whose marginal tax bracket is 25% or higher.
The goal is "to minimize the taxes because every dollar someone pays in taxes is that much less than they have to spend," said Jaconetti.
To keep that money investors need to sort investments by their tax liabilities.
Long-term capital gains – on investments held for more than one year – and qualified dividends are taxed at 15% for most taxpayers but 20% for those whose marginal tax rate is 39.6%.
