Traditionally, financial advisors and retirement experts have recommended to withdraw from non-qualified taxable account first followed by tax-deferred accounts such as 401(k) accounts and Traditional IRAs and lastly ROTH IRAs. This approach is so widely held that many financial planning software default to this withdrawal strategy. The remainder of this article will discuss the merits of a blended withdrawal strategy to enhance tax efficiency.
Tax Rates
The United States has a progressive tax system meaning higher income is taxed at higher rates. Taxpayers’ taxable income is what determines one’s tax bracket, not adjusted gross income. Taxable income is line 15, after the standard or itemized deduction.
A taxpayer’s tax bracket is considered their “marginal rate.” Not all income is taxed at their marginal rate. For example, a married filing joint couple with a $100,000 2024 taxable income is in the 22 percent tax bracket. Their first $23,200 of taxable income is taxed at 10 percent while their last dollar of taxable income is taxed at 22 percent. This results with a taxpayer having a lower “average effective rate” than their marginal rate.
As many know, qualified dividends and long-term capital gains enjoy more favorable rates than ordinary income. In fact, the couple in this example enjoys a zero percent rate on capital gains up to $94,050 of taxable income. Long-term capital gains are taxed at 15 percent if taxable income is greater than $94,050. Assume the couple with a $100,000 taxable income in our example has their taxable income evenly split between capital gains and ordinary income. In other words, $50,000 of their taxable income comes from sources such as pensions and IRA distributions, and the other $50,000 comes from long term capital gains. The difference between their ordinary income of $50,000 and the top of the zero percent capital gains bracket of $94,050, which equals $44,050 is taxed at zero percent. The remaining $5,950 of capital gains is taxed at 15 percent. The importance of this will be discussed later.
Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (TCJA) was passed at the end of 2017 to take effect in 2018. While the TCJA had many provisions, the changes that impacted this topic the most were the increase of the standard deduction, the suspension of personal exemptions, the reduction in a number of tax brackets, and the expansion of some tax brackets.
In 2017, before the TCJA, the same previously mentioned couple with a $100,000 taxable income would have been in the 25 percent tax bracket. Additionally, the bracket in between the lowest and their current marginal rate is three percent lower today than in 2017. This results in a minor tax savings.
The standard deduction for a 65-year-old married filing joint couple in 2017 was $15,200. The 2017 personal exemption was $4,050 per individual leading to a total $8,100 of exemptions for a 65-year-old married filing joint couple. This couple could offset their first $23,300 of income with their standard deduction and personal exemptions in 2017.
On the other hand, the TCJA eliminated personal exemptions and increased the standard deduction for tax years 2018-2025 barring any future legislation. The standard deduction for an age 65 married filing joint couple increased to $32,300 in 2024. In other words, the model couple can offset an additional $9,000 of income in 2024 due to the changes afforded by the TCJA. Keep this in mind for the remainder of the article.
Tax Computation
This is not as hard as one would imagine, especially for a retiree. Obviously, the difficulty depends on each taxpayer’s individual situation, but an attempt to simplify will be made at the risk of oversimplifying.
Retirees total all of their income sources including the taxable portions of their pensions and annuities, IRA distributions, and Social Security benefits. Then, they subtract any “adjustments to income” which would likely be limited for most retirees. Some examples of adjustments to income for retirees could be capital losses and the “above the line” deduction for charitable contributions allowed by the CARES Act. Taxpayers are left with their “adjusted gross income” (AGI) found on line 11. After that, most retirees use the standard deduction to subtract from their AGI to arrive at their taxable income which determines their tax rate.
Readers should be aware of the phrase “taxable portions” because not all Social Security benefits and IRA distributions are taxable, for example. Taxation of Social Security benefits depends on one’s “provisional income.” Provisional income is defined as one-half of Social Security benefits plus all other income including tax free interest. As far as IRA distributions are concerned, one common scenario that leaves some reported distributions with nontaxable amounts is when taxpayers are utilizing “qualified charitable distributions” (QCD). Most IRA custodians will report the entire distribution amount on the 1099-R, and it is the taxpayer’s responsibility to report the QCD. Again, the importance of this will be discussed soon.
Putting it all together
Bob, 65 years old, sold his business this year for $500,000 which he put into an investment portfolio expected to earn five percent per year. He is married and files a joint return. His wife is the same age. She never worked outside of the home. Considering Bob was a business owner and his wife never worked outside of the home, they do not have any pensions. They will only fund their retirement with Social Security benefits and withdrawals from their investments. Bob also has a $500,000 Traditional IRA also expected to earn five percent per year.
Based on his financial advisor’s recommendation, Bob delays claiming Social Security benefits until 70 years old when his benefit will be the highest possible. Bob and his wife need $7,000 per month ($84,000 annually) to meet all of their retirement expenses. Since he will not have any income sources until age 70, he is going to use his portfolio to cover all of his retirement expenses until Social Security benefits kick in. Which account should he withdraw from?
As previously mentioned, the traditional recommendation is to first fund your retirement entirely from taxable accounts first. Given Bob’s retirement expenses of $84,000 per year, this recommendation would essentially leave him with no current tax burden considering the first $32,300 of income is offset by the standard deduction. If he fully funded his retirement expenses with capital gains, – which is unlikely since some of his withdrawals will likely be a return of principal, his taxable income would be $51,700 ($84,000 - $32,300). This taxable income would fall within the zero percent long-term capital gains bracket. This is good, but it neglects the future tax implications.
If Bob implements this withdrawal strategy, his Traditional IRA will continue to grow. This is good, but there is a downside. The downside is that future required minimum distributions (RMD) will be higher than spending down the IRA today. In fact, Bob’s estimated RMD is close to $30,000 when he turns 73 in 2032. Remember earlier when the expiration of certain TCJA provisions was discussed? So, there are several things working against Bob having a larger RMD in 2027: lower standard deduction, higher rates, and he will have another income source in Social Security possibly increasing his taxable income.
Bob could consider two current strategies to minimize future tax impacts. He could utilize a blended withdrawal strategy in which he withdraws a portion of his retirement needs from his tax-deferred retirement accounts, or he could also consider converting a part of his Traditional IRA to a ROTH IRA.
Bob could consider withdrawing the amount of the standard deduction from his Traditional IRA. He would withdraw the rest of his income needs from his taxable account. This would essentially allow him to deduct some of his IRA “tax-free” while reducing the size of his future RMD due to having a lower IRA balance at RMD age.
If Bob were to utilize the ROTH conversion strategy too, he would convert just enough to keep in the bracket to enjoy zero percent capital gains. Using the $51,700 taxable income figure from earlier, he would convert $42,350. This has a similar effect to the blended withdrawal strategy.
Implementing either of these strategies takes advantage of the TCJA’s current benefits of the increased standard deduction and reduced tax rates. These strategies could also reduce the size of future RMDs at an age where Bob would have an additional income source.
Bob is an Elk and is charitably inclined. Thanks to his tax pro and financial advisor’s advice, he has decided to implement the QCD strategy when he turns RMD age. Bob is expected to use the standard deduction for the foreseeable future including at RMD age. As such, he will not be able to deduct his charitable contributions to the Elks. However, he decides he is going to implement the QCD strategy at RMD age to further enhance the tax efficiency of his retirement withdrawals.
Conclusion
While the mechanics of the tax system work the same for everyone, taxpayers’ retirement withdrawal strategy should be unique. Bob’s strategy might differ drastically if the numbers were altered. Taxpayers’ strategies would also likely vary depending on tax laws. Therefore, taxpayers would be well served to revisit their retirement withdrawal strategies regularly with their financial advisor and/or tax professional.
This article was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational article.
This is a hypothetical example and is not representative of any specific investment. Your results may vary.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.