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Retirement draw-down priority

From Bogleheads

Investors face a variety of choices on where to withdraw money from in retirement; for example, a taxable account, a 401(k), or an IRA. Knowing which assets to draw down first will maximize return with a minimum of taxes. Retirement draw-down priority indicates the appropriate order in which assets are tapped for supplying retirement income. Take care to ensure that any draw-down priority decision aligns with your Retirement policy statement.

This article provides a rank-order list of which assets to tap first in retirement. This page stands in contrast to Prioritizing investments, which discusses the order for putting money into retirement savings, while this page discusses the order for taking money out.

Retirement draw-down priority

Figure 1 shows the order in which you may want to prioritize your sources of retirement income, and is described in Table 1 below. To use the list, begin at the top and work your way down until you have met your income need for the year. Skip over any items that do not apply. If you have more unavoidable income than you intend to spend, reinvest the excess according to your investment priority. This order is only approximate and will not apply to every case. Some exceptions to the order are discussed in the details of the list.

Also note that assets that generate significant taxes when tapped - especially pre-tax retirement accounts (including 457(b) accounts) and taxable investments with large gains - should usually not be tapped infinitely in one year before moving further down the list. These assets should only be tapped each year up to the point where it still makes sense for your overall tax planning strategy, considering your current and future expected tax situations, and that of any likely heirs. Adjusting income each year to keep your tax rate constant throughout retirement is an excellent approach. There are various ways to do this, and see below for detailed considerations, but this simple strategy is a good way to start, and may in fact be all that is needed.

This list is focused on meeting income requirements for the current year. Once you meet this income need, there may be other tax-planning transactions (such as Roth conversions and tax gain harvesting) that seek to increase spendable income in future years.

Figure 1. Asset draw-down priority in retirement
Priorities for spending retirement assets
Table 1. Asset draw-down priority in retirement - details
Priority Withdrawal priority
1 Required Minimum Distributions (RMDs)
Required Minimum Distributions (RMDs) can come from many types of accounts, including IRAs (other than Roth), 401(k)s, 403(b)s, 457(b)s, and others, including some inherited accounts. The penalty for failing to take a RMD is large: 25% of the amount that should have been withdrawn but was not. Making sure to take RMDs on time is a top financial priority in retirement.
2 Regular income
This category includes Social Security benefits, pension income, annuity income, rental income, royalty income, income from part-time work, and so on.
3 Investment income
Switch off automatic reinvestment of dividends, capital gains, and interest from taxable investments, and spend this money next.
4 Non-governmental 457(b) withdrawals and other deferred compensation
Unlike a 401(k) or 403(b), savings in a non-governmental 457(b) (and other deferred compensation plans or arrangements) is still property of the employer until it is paid out to you.[1] Therefore, it is potentially exposed to the employer's creditors, and employees are lower in priority than general creditors in the event of legal claims against the employer. Preferentially withdraw from a non-governmental 457(b) and any other deferred compensation plan before other assets. Depending on the perceived stability of the employer, it could make sense to move this up or down the priority list.

This does not apply to governmental 457(b)s, for two reasons. First, governmental 457(b) assets are held in trust for the employee, like a 401(k) or 403(b). Second, unlike non-governmental 457(b)s, governmental 457(b)s are allowed to be rolled into an IRA upon separation from the employer.[2] This typically makes sense - it gives you more control over the account and avoids any fees in the 457(b), usually with no downside - so few retirees will need to consider whether to withdraw from a governmental 457(b) for spending. However, governmental 457(b) plans have no early withdrawal penalties,[3] and this feature is lost when assets are rolled into an IRA, so early retirees may be better off keeping the governmental 457(b) until age 59½.

5 Taxable investments with small gains (or losses)
A taxable investment with small gains is one where the cost basis (what you paid for the investment) is close to the current value. Examples include investments you purchased recently, or ones you have had for a while but have not appreciated much. These investments will only generate a small amount of capital gains relative to the proceeds from the sale, and should therefore be tapped before the more valuable assets further down the list.

Cash-like investments, such as savings accounts and money markets, also belong in this category. They can be considered taxable investments with a basis equal to the investment value, and generate no gains when sold. However, do not tap assets for normal spending that are part of an emergency fund.

If you hold taxable investments until death, they receive a step-up in basis, which changes the cost basis to the value at time of death. However, the step-up in basis is more relevant when the investment has large gains; see the discussion for these assets below.

US Savings Bonds (Series EE and Series I) are taxable investments with special characteristics, and also belong in this category. The interest they earn is fully tax-deferred, state income tax-free,[4] and possibly federally tax-free when used for education (subject to income limits). When a savings bond matures, all the interest is taxable, so maturing savings bonds have the same priority as cash. However, they do not receive a step-up in basis upon the death of the owner.[5] Therefore, it would be better to tap savings bonds before other taxable investments if the other characteristics are similar.

If you have investments where the basis is more than the current value (that is, with unrealized losses), in most cases you should sell the investments even if you do not need the income; doing so will generate a tax-deductible loss. See tax loss harvesting for details.

6 Tax-free Health Savings Account (HSA) withdrawals
Money in an HSA can be withdrawn tax-free when used for current or past medical expenses. As there is no time limit for when money must be withdrawn, a common strategy with HSAs is to save receipts for a long time - years or decades - to maximize the time of tax-protected growth, and eventually withdraw the money for past expenses in retirement. If the balance exceeds available medical expenses later in life, withdrawals are taxable but penalty-free after age 65, so a HSA behaves similarly to a traditional IRA.

You should always withdraw tax-free from an HSA before retirement accounts. Withdrawing tax-free from an HSA will always be as good or better (usually better) than from a Roth account, because the foregone future growth on the HSA money may or may not be tax-free depending on medical expenses, but growth on Roth money will always be tax-free. A tax-free HSA withdrawal also eliminates the possibility that the money might later be taxed, if the receipts are lost or the account is left to a non-spouse. Compared to a pre-tax retirement account, the combination of a tax-free HSA withdrawal and a Roth conversion has the same tax impact as a pre-tax withdrawal, but shifts money from a HSA to a Roth account, which is desirable for the same reasons.

In some situations, due to their worse estate planning characteristics it can make sense to take tax-free HSA withdrawals even if you do not need the money for spending; the withdrawal can be reinvested in a taxable account. See HSA tax-free withdrawals for details.

7 Pre-tax retirement accounts up to a specific marginal tax rate
Retirees with pre-tax (or "traditional") retirement assets (such as a traditional IRA, 401(k), or 403(b)) should create a tax-plan for their retirement, and if you expect to leave retirement assets as part of your estate, the predicted tax situation of any likely heirs as well. Based on your and likely heirs' future tax rates, withdraw from pre-tax accounts up to a marginal tax rate threshold that makes sense, and tap assets further down the list for any additional needed income beyond this amount.

Your marginal tax rate may be very different from your tax bracket, due to phase-ins of Social Security and qualified dividend taxation, phase-outs of various tax credits, IRMAA, and other effects. It is usually best to check your actual marginal tax rate curve using your choice of tax estimation software (see: Tax estimation tools), or by consulting a tax professional. Typical thresholds to target include the top of the standard deduction, just under the Social Security taxation bump, just under one of the IRMAA spikes, or just under the 32% bracket. Some of these thresholds also include long-term capital gains and qualified dividends.

For retirees who expect lower marginal tax rates in future years, or plan to leave retirement assets to heirs with lower marginal tax rates, or both, the best choice may be to not withdraw any pre-tax money in the current year. If so, this item should be skipped, and additional income may be generated from assets further down the list. Retirees who expect higher marginal tax rates in future years, or who expect to have heirs with higher marginal tax rates, or both, should prefer withdrawing from pre-tax accounts, and should consider Roth conversions if additional money can be converted at a tax rate less than or similar to future years.

Withdrawals from pre-tax accounts before age 59½ are assessed a 10% early withdrawal penalty, unless an exception applies. Early retirees looking to tap pre-tax accounts without penalty can use a Substantially Equal Periodic Payments (SEPP) program or a Roth conversion ladder.

If you have an inherited pre-tax account, it is usually better to withdraw from the inherited account before an individually owned account. Inherited accounts must be emptied within ten years of the owner's death, or according to RMD tables that are more aggressive than for individually-owned accounts. One possible exception is if you have an inherited account subject to ten-year distribution and do not expect to live until the end of the distribution period. Withdrawing from the individual account will decrease future RMDs, but will not affect distributions from the inherited account.

8 Taxable investments with large gains
A taxable investment with large gains is one where the cost basis is much lower than current value, meaning they have appreciated a lot relative to what you paid for them. If you hold taxable investments until death, they receive a step-up in basis, which changes the basis to the value at time of death. Selling an investment with large gains means incurring tax that neither you nor your heirs would otherwise pay, a clear negative. But, taxable investments grow more slowly than retirement accounts because they are not fully tax-deferred. Investments with large gains are listed in roughly the middle of the withdrawal order, but the optimal order for a given investor might be much higher or lower.

Common investments that can increase in value and have large gains are stocks, mutual funds, exchange traded funds (ETFs), collectables, and real estate. Note that you can exclude up to $250,000 (single) or $500,000 (married) of gains on your primary residence from taxation, if you meet the requirements.[6]

Generally speaking, investments with large gains are preferable to preserve compared to retirement accounts when you do not expect to live much longer, because there is less time for tax-protected growth to overcome the step-up in basis. If you are of advanced age or have health problems, it may make sense to delay selling investments with large gains.

Also preserve investments with large gains when there is a big difference in tax rates between you and likely heirs, because you can realize a tax rate arbitrage by tapping either pre-tax (if your rates are much lower than heirs) or Roth (if your rates are much higher) accounts first. Tapping investments with large gains will be worse in comparison, at least until the preferable retirement assets are exhausted or converted to Roth accounts. See below for some examples of how to maximize the value of your estate for your heirs.

Tapping investments with large gains before retirement accounts makes more sense if you are younger and healthy, have a similar tax rate to likely heirs, have tax-inefficient investments, can realize capital gains at 0%, or if the investments are otherwise not ideal for your investment plan (for example, individual stocks).

9 Roth withdrawals
Roth withdrawals are tax-free, as long as you are over age 59½ and have had a Roth account for at least five years. Once you have withdrawn from pre-tax accounts to the point where it no longer makes sense based on your marginal tax rate, Roth withdrawals can provide additional income. However, tax-free HSA withdrawals (based on past and current medical expenses) should always be taken before Roth withdrawals.

While most heirs would be happy to inherit Roth money, if your current marginal tax rate is higher than theirs, they will receive a larger inheritance after taxes if you withdraw and spend Roth money rather than pre-tax.

Withdrawals from Roth accounts before age 59½ may be subject to income taxes and a 10% early withdrawal penalty, depending on treatment of the distribution and whether an exception applies. Early retirees should plan their income strategy to avoid taxes and penalties on Roth withdrawals if possible, by tapping other assets first.

If you have an inherited Roth account, withdraw from that account before withdrawing from an individually-owned Roth account, because the inherited account must be emptied within 10 years of the owner's death or according to RMD tables, whereas individually-owned accounts have no such requirements.

10 Taxable Health Savings Account (HSA) withdrawals
Taxable withdrawals from an HSA usually do not make sense, because there is the possibility of future medical expenses that would allow future withdrawals to be tax-free. If you have current or past medical expenses for which you have saved receipts, and can therefore take a tax-free withdrawal, it is almost always better to do so rather than take a taxable withdrawal.

However, taxable HSA withdrawals may make sense in some limited situations. When a HSA is inherited by a non-spouse, the entire balance is taxable in a single year. If you expect to not live much longer, have no past or current medical expenses, and do not expect much future medical expenses, and your heirs have higher tax rates than you, taxable HSA withdrawals may make sense. Unlike pre-tax retirement accounts, HSAs do not get a ten-year stretch, so if you are in the above situation and you expect to leave a large HSA balance on a per-heir basis, taxable HSA withdrawals should be a higher priority than retirement accounts.

11 Permanent life insurance
Permanent (or whole) life insurance is better left as part of your estate, but if other funding options are exhausted, you can take a policy loan against the death benefit and use it for living expenses. Policy loans will cost interest, and any policy loans not repaid at death will be subtracted from the death benefit.
12 Home equity
Tapping home equity should usually be a last resort. Home equity can be tapped by downsizing (although downsizing could make sense on its own), with a second mortgage or HELOC (Home Equity Line of Credit), or with a reverse mortgage.

Tapping taxable investments or retirement accounts

Often, retirees face the choice of whether to sell appreciated taxable investments and generate capital gains taxes, or withdraw money from retirement accounts. When optimizing just for your own retirement, selling taxable investments first is usually best, because it leaves more money inside retirement accounts, where it will get tax-protected growth. When planning to leave money to charity, withdrawing Roth money first, then taxable, then pre-tax last is usually best, because charities pay no taxes. However, when planning to leave money to heirs, the step-up in basis for taxable investments and the ten-year stretch for retirement accounts must be considered as well. As a general trend, the longer your life expectancy, the more likely selling taxable investments makes sense compared to withdrawing money from retirement accounts.

The following tables show the which assets to draw from first (and in many cases, which to draw from second) to maximize the value of your assets to your heirs for various combinations of the owner's tax rate and the heir's expected tax rate.[7] The tax rates are 12%, 24%, 32%, 37%, and 50.3% with capital gains tax rates of 0%, 15%, 18.8%, 23.8%, and 37.1% respectively. Investments are assumed to grow at 8% total annual return with a 2% yield, with 90% qualified yield. Heirs are assumed to liquidate Roth and taxable accounts at the end of the tenth year. Heirs in the 12%, 24%, and 32% brackets are assumed to withdraw equal amounts from pre-tax accounts each year and reinvest the proceeds in a taxable account, which is then liquidated at the end of the tenth year. Heirs in the 37% and 50% brackets are assumed to liquidate pre-tax accounts at the end of the tenth year. The three tables are for life expectancies for the owner of 30 years, 15 years, and zero. For life expectancies between these numbers, results are roughly linearly interpolated between the two.

While these tables will maximize the value of your estate to your heirs for a given life expectancy, they may not be optimal for you when your life expectancy is uncertain. If there is a chance you might live much longer than this life expectancy, likely a different strategy will maximize the length of time you can stretch your portfolio for yourself. The decision of whether to optimize your draw-down for your heirs, or for your portfolio's longevity while you are alive, is a complex one that depends on many factors.

Table 2. Which assets should be drawn-down first with a life expectancy of 30 years[7]
Heir Tax Rate
12% 24% 32% 37% 50%
Owner Tax Rate 12% Taxable at any basis, then pre-tax Pre-tax, then taxable at any basis Pre-tax, then taxable at any basis Pre-tax, then taxable at any basis Pre-tax, then taxable at any basis
24% Taxable if basis more than 42%, then Roth Taxable if basis more than 17%, then pre-tax Taxable if basis more than 78%, then pre-tax Taxable if basis more than 67%, then pre-tax Pre-tax, then taxable at any basis
32% Taxable if basis more than 42%, then Roth Taxable at any basis, then Roth Taxable if basis more than 17%, then pre-tax Taxable if basis more than 9%, then pre-tax Taxable if basis more than 79%, then pre-tax
37% Taxable if basis more than 44%, then Roth Taxable if basis more than 12%, then Roth Taxable if basis more than 4%, then Roth Taxable at any basis Taxable if basis more than 43%, then pre-tax
50% Taxable if basis more than 47%, then Roth Taxable if basis more than 28%, then Roth Taxable if basis more than 23%, then Roth Taxable if basis more than 17%, then Roth Taxable at any basis
Table 3. Which assets should be drawn-down first with a life expectancy of 15 years[7]
Heir Tax Rate
12% 24% 32% 37% 50%
Owner Tax Rate 12% Taxable at any basis, then pre-tax Pre-tax, then taxable at any basis Pre-tax, then taxable at any basis Pre-tax, then taxable at any basis Pre-tax, then taxable at any basis
24% Taxable if basis more than 70%, then pre-tax Taxable if basis more than 44%, then pre-tax Pre-tax, then taxable at any basis Taxable if basis more than 95%, then pre-tax Pre-tax, then taxable at any basis
32% Taxable if basis more than 69%, then Roth Taxable if basis more than 26%, then Roth Taxable if basis more than 43%, then pre-tax Taxable if basis more than 35%, then pre-tax Pre-tax, then taxable at any basis
37% Taxable if basis more than 70%, then Roth Taxable if basis more than 37%, then Roth Taxable if basis more than 28%, then Roth Taxable if basis more than 16% Taxable if basis more than 70%, then pre-tax
50% Taxable if basis more than 72%, then Roth Taxable if basis more than 51%, then Roth Taxable if basis more than 45%, then Roth Taxable if basis more than 39%, then Roth Taxable if basis more than 21%
Table 4. Which assets should be drawn-down first with a life expectancy of zero[7]
Heir Tax Rate
12% 24% 32% 37% 50%
Owner Tax Rate 12% Taxable at any basis, then pre-tax Pre-tax, then taxable at any basis Pre-tax, then taxable at any basis Pre-tax, then taxable at any basis Pre-tax, then taxable at any basis
24% Roth, then taxable if basis more than 8% Taxable if basis more than 71%, then pre-tax Pre-tax, then taxable if basis more than 26% Pre-tax, then taxable if basis more than 7% Pre-tax, then taxable at any basis
32% Roth, then taxable at any basis Taxable if basis more than 53%, then Roth Taxable if basis more than 71%, then pre-tax Taxable if basis more than 62%, then pre-tax Pre-tax, then taxable at any basis
37% Roth, then taxable at any basis Taxable if basis more than 63%, then Roth Taxable if basis more than 53%, then Roth Taxable if basis more than 41% Pre-tax, then taxable if basis more than 10%
50% Roth, then taxable at any basis Taxable if basis more than 76%, then Roth Taxable if basis more than 70%, then Roth Taxable if basis more than 62%, then Roth Taxable if basis more than 42%

See also

References

  1. "Non-Governmental 457(b) Deferred Compensation Plans". IRS. Retrieved June 2, 2024.
  2. "Rollover Chart" (PDF). IRS. Retrieved June 6, 2024.
  3. "Retirement topics: Exceptions to tax on early distributions". IRS. Retrieved June 6, 2024.
  4. "Tax information for EE and I bonds". TreasuryDirect. Retrieved June 2, 2024.
  5. "IRS Publication 559: Survivors, Executors, and Administrators" (PDF). IRS. Retrieved June 2, 2024.
  6. "Topic No. 701, Sale of Your Home". IRS. Retrieved June 23, 2023.
  7. 7.0 7.1 7.2 7.3 Source spreadsheet: LowBasisOrRetirement4.xlsm, Google Drive

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