As a retirement saver, you may have accumulated tax-deferred money in an IRA, a 401(k) or 403(b), or an annuity. You also may have earmarked certain taxable money for retirement, such as stock you inherited from a deceased relative. 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. Consider the problem from two angles: income tax and estate tax.
Because these decisions can be complex, it is wise to seek qualified tax and legal advice.
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. In other words, you want to have the highest amount of money left over after income taxes are paid. For taxable retirement savings (basically any money held outside of a tax-deferred 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 essentially are 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 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, as well as tax-free accounts such as municipal bonds or muni bond funds, 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 typically are taxed as ordinary income. By waiting to withdraw money from these accounts, you receive more tax-deferred growth.
There’s no major tax advantage or disadvantage to taking withdrawals from a traditional IRA or a 401(k) account first; they are treated the same for income tax purposes. However, investment performance will be a major deciding factor. You may 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, although it too will be at least partially taxable.
Note that higher-asset households with high account balances may want to seek professional advice regarding tax-efficient withdrawals due to high RMDs.
Finally, if you have Roth money, you may be wise to save that for last, since qualified withdrawals are completely free from income tax. (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 is known as a step-up in basis when they are passed to a beneficiary. Essentially that means your beneficiary potentially can sell an inherited asset and owe little or no income tax on it whatsoever.
Retirement accounts like IRAs and annuities don’t receive any special estate tax treatment, so 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 free from estate tax.
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 traditional IRAs, 401(k), annuities and then Roth IRAs last.