Withdrawal Strategies That Break the Rules

EDITOR'S NOTE: This article was originally published in the January 2010 issue of Kiplinger's Retirement Report. To subscribe, click here.

As a rule of thumb, retirees should withdraw assets from taxable accounts first, tax-deferred accounts such as traditional IRAs next, and tax-free accounts such as Roth IRAs last. Typically, you spend your after-tax money first because you want your retirement assets to compound tax-free for as long as possible.

But rules are made to be broken. There may be times when tapping your tax-advantaged accounts first will help your money last longer, says William Reichenstein, a professor of investment at Baylor University, in Waco, Tex.

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One category of rule breaker may be retirees who are younger than 70 1/2 and not yet subject to taking required minimum distributions from their IRAs, says Reichenstein. These retirees may be in a low tax bracket for several years until it’s time to take RMDs.

Consider a retiree who is in his mid sixties. He has taxable accounts with bonds, stocks and certificates of deposit. When he turns 70 1/2, he'll need to take RMDs of more than $80,000 from his IRA, which will place him in the 25% tax bracket.

For now, he needs about $45,000 a year for expenses. If he takes money from his taxable accounts, such as the CDs or even some stock sales, most of the withdrawals will not be taxable income.

Reichenstein says this retiree should consider withdrawing enough from his traditional IRA to take him to the top of the 10% or 15% bracket. He could use the money to live on or convert it to a Roth IRA. "If he waits a few years, he will be paying $25 in taxes for every $100 he takes out instead of perhaps $15," he says. "If you're in a very low tax rate now, you can minimize what the government gets."

Which IRA Should Go First?

There could also be times when it may make sense to tap a Roth IRA before withdrawing from a traditional IRA. One case could be when an older retiree is in a higher bracket than the heir and does not have many years left to allow the Roth to grow tax-free. A $100,000 in a traditional IRA would be worth $75,000 to a retiree in the 25% bracket, but worth $85,000 to a beneficiary in the 15% bracket, notes Reichenstein.

In some cases, it may be wise to withdraw from a traditional IRA and a Roth simultaneously. Let's say a single retiree has $300,000 in a traditional IRA and $200,000 in a Roth. She needs to withdraw $50,000 after taxes each year.

If she depletes the traditional IRA before withdrawing from the Roth IRA, the portfolio will last 9.1 years, says Reichenstein. According to his calculations, the first year she will withdraw $58,467 from the traditional IRA, which includes money to pay taxes. (The standard deduction, personal exemption, tax brackets and investment assets are assumed to rise with inflation.)

The portfolio will last 9.4 years if she withdraws enough from the traditional IRA to take her income to the top of the 15% tax bracket and the remainder each year from the Roth. In the first year, she will withdraw $43,300 from the traditional IRA and $11,375 from the Roth IRA. "The advantage of this strategy is none of the traditional IRA funds are taxed at the 25% marginal tax bracket," he says. In the traditional-IRA-first strategy, $15,167 is taxed at 25%.

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