Sequencing Asset Liquidation - Which Retirement Assets Should You Use First?

As a retirement saver, you may have accumulated tax-deferred money in an IRA, a 401(k) or 403(b), or an annuity. You may have also earmarked certain taxable money for retirement, such as stock you inherited from a deceased uncle. So by the time you actually enter retirement, you may have both taxable and tax-deferred resources. To make the most of your money, does it matter which assets you sell first to create retirement income?

The answer depends on your circumstances and wishes. Let’s consider the problem from two angles: income tax and estate tax.

The Income Tax Perspective
From an income tax perspective, you want to create the most tax-efficient income you can from the various resources you have. For taxable retirement savings (basically any money held outside of a retirement account set aside for retirement purposes), capital gain tax rates are lower than ordinary income tax rates. Capital gain rates apply to assets that have appreciated in value over time. The lowest capital gain rates—long-term capital gains—apply to assets you’ve owned for more than one year. If you’ve owned an asset for less than one year, then short-term capital gain rates apply, and currently these rates are essentially the same as ordinary income tax rates.

Ordinary income is taxed at a higher rate than capital gains, so as a general rule for taxable money, you’d want to sell any long-term capital gain assets first when you need retirement income. Doing so means you pay less tax now, and you allow any other retirement savings you have to keep growing.

Once you’ve used up most of your taxable retirement money, move on to your tax-deferred money, such as IRAs, 401(k)s and annuities. Assuming you are past age 59 ½, you’ll avoid any early withdrawal penalty. But the withdrawals themselves from these accounts are typically taxed as ordinary income. By waiting to withdraw money from these accounts, they’ve enjoyed more tax-deferred growth.

By the way, there’s no major tax advantage or disadvantage to taking withdrawals from a traditional IRA or a 401(k) account first; income tax-wise they are treated the same. You may, however, want to delay withdrawals from an annuity as long as you can, because the older you are when you start your payouts—annuitizing the asset—the greater your payout amount will be, though it too will be at least partially taxable. Finally, if you have Roth money, you may be wise to save that for last, since qualified withdrawals are completely income-tax free. (A qualified withdrawal means you’ve owned the account for at least five years and are past age 59 ½.)

The Estate Tax Perspective
From an estate tax perspective, you need to consider any inheritance plans for your retirement resources. Taxable savings enjoy what’s known as a “step-up in basis” when they are passed to a beneficiary. Essentially that means your beneficiary can potentially sell an inherited asset and owe no income tax on it whatsoever.

For example, assume Uncle Pete owns stock in a taxable account. He originally bought the stock 10 years ago for $5,000, and today it’s worth $12,000. If Uncle Pete sells the stock today, he would owe long-term capital gain tax on the growth—in this case, tax on $7,000. If he wanted to though, Uncle Pete could hold onto that stock and pass it on to you through his estate when he dies. Let’s say Uncle Pete does that, and by the time he dies, that stock is worth $15,000. When you inherit the stock, you get a step-up in basis from Pete’s original $5,000 purchase price to today’s value of $15,000. In other words, it’s as if you bought the stock for $15,000, due to the step-up in basis. If Pete’s estate sells the stock, it would be liable for the $10,000 of growth. If you sell the stock now, let’s say for $15,000, you won’t owe any capital gain or income tax.

Retirement accounts like IRAs and annuities don’t receive any special estate tax treatment, thus estate tax treatment is not much of a concern there. For married couples, when one spouse passes away, the surviving spouse can inherit any amount of taxable or retirement accounts without creating an estate tax event. Married spouses can pass an unlimited amount of property to each other estate tax-free.

So if you have taxable money that is earmarked for retirement, and you hope to pass that on to someone other than a spouse as an inheritance, you may want to tap other retirement resources first, such as your typical retirement accounts like traditional IRAs, 401(k), annuities and then perhaps Roth IRAs last.