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A Guide to Withdrawing Retirement Assets
A lot is being written about how much money Americans can
withdraw from their investments to fund their retirement years.
Now, a new research institute launched by Fidelity Investments
has outlined the order in which money should be withdrawn from
various tax-deferred and taxable investment accounts. Described
as the "withdrawal hierarchy," the Fidelity Research Institute
suggests the order, with modifications made courtesy of other
financial planning experts.
1. Take your minimum required distributions (MRDs) from
qualified accounts and IRAs. If you are age 70½ or older,
make sure you know which of your accounts require such
distributions and how large those distributions need to be, and
then meet the requirements and deadlines, avoiding the
application of the 50 percent income tax penalty that will be
assessed if you fail to make timely withdrawals of required
distributions.
2. Liquidate loss positions in taxable accounts. Some
investments in your taxable accounts may be worth less than
their tax basis. In addition to offsetting realized losses
against realized gains, at the federal level you can usually use
up to $3,000 ($1,500 for married couples filing separately) of
net losses each year to offset ordinary income including
interest, salaries, and wages. Unused losses can be carried
forward for use in future years.
3. Sell assets in taxable accounts that will generate
neither capital gains nor capital losses. Such assets
generally include cash and cash-equivalent investments as well
as capital assets which have not increased in value. If your
withdrawals from this tier in the hierarchy largely come from
cash-equivalent investments, sufficient liquid assets holdings
should remain intact in order to cover short-term financial
emergencies. And be especially mindful of portfolio rebalancing
issues.
4. Withdraw money from taxable accounts in relative order
of basis, and then qualified accounts or tax-deferred saving
vehicles funded with at least some nondeductible (or after-tax)
contributions, such as variable annuities and Traditional IRAs
that contain non-deductible contributions. The choice depends on
the circumstances, and in some cases it might make more sense to
tap the tax-deferred vehicle first, but for most retirees,
capital gains rates are lower than ordinary income tax rates and
generally liquidating capital assets first would be beneficial.
Assuming there is a significant difference in the
basis-to-value ratio of the assets to be liquidated in two
accounts, the better tactic for choosing between these two types
of withdrawals may be to liquidate the assets with the higher
ratio. That is, the assets that have generated the smallest gain
or the largest loss as a percentage of their basis. If the
basis-to-value ratio of the assets to be liquidated in each
account is relatively low due to significant investment gains,
it often will be preferable to liquidate the assets in the
taxable account. Conversely, if the basis-to-value ratio of the
assets to be liquidated in each account is relatively high, it
may be preferable to liquidate assets in the tax-deferred
account if portfolio demands require it. Note that IRAs are
generally subject to certain aggregation requirements when
allocating basis. When liquidating gain positions in taxable
accounts, it usually makes sense to sell assets with long-term
capital gains first, since they should be taxed at lower rates
than short-term gains.
5. Withdraw money from tax-deferred accounts funded
with deductible (or pre-tax) contributions such as 401(k)s and
Traditional IRAs, or tax-exempt accounts such as Roth IRAs. It
may not make much difference which account you tap first within
this category since all withdrawals from any tax-deferred
accounts funded with fully deductible (or pre-tax) contributions
are taxed at the same rate. When withdrawing money from tax-deferred
accounts funded with fully deductible (or pre-tax) contributions, you
may wish to request that taxes be withheld.
If you believe that the withdrawals you make may be subject
to different tax rates over the course of your retirement
(whether due to changes in tax law or to varying tax brackets as
a result of fluctuations in income) you may be better off
liquidating one type of account within all of these guidelines
before another. For example, it may make more sense to leave
your Roth account intact if you thought your ordinary income tax
rate was likely to rise in later years, increasing the value of
the Roth's tax exemption.
Estate planning considerations may also significantly impact
the entire hierarchy. Generally, qualified and tax-deferred
assets may be given a higher order within the withdrawal
hierarchy in the case of larger estates expected to hold
"excess" assets which will pass to heirs or be subject
to estate taxes. Capital assets receive a step-up in basis at
death, while qualified and tax deferred assets are considered to
contain "income in respect of a decedent" and do not
receive a step-up. A number of other issues may also have an
effect on the recommended order of withdrawal, like if the
retiree's income approaches the threshold of paying taxes on
Social Security income.
October 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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