Which Account to Spend First?

Many people saving for retirement end up with a variety of savings or investment accounts:  regular personal (non-retirement) accounts; employer pre-tax retirement accounts [such as 401(k)s]; employer post-tax retirement accounts [such as a Roth 401(k)]; traditional Individual Retirement Accounts (IRAs); and Roth IRAs.

When it comes time to begin withdrawing from these plans, how do you decide which account to take money from?

Pre 59 ½

If you are younger than 59 ½, it is better to focus on your personal, non-retirement accounts.  Withdrawing from these accounts may not create any additional taxes since you may simply be withdrawing cash.  If you need to sell an investment in which you have a taxable gain, there would be some tax; but even in that case, you are only owing tax on the profit from the sale, not on the total sales price, and you’re also paying tax at more favorable long-term gain rates (if you owned the investment for at least a year).

Contrast this outcome with paying taxes on every dollar withdrawn from a pre-tax 401(k) or traditional IRA.  In addition, if you are under age 59 ½ you are also subject to, with a few exceptions, a 10% penalty on the amount withdrawn.

From 59 ½ to 70 ½

After age 59 ½ there is no longer a 10% penalty to worry about, but the personal, non-retirement account most likely remains the best place to tap initially.  You are still either avoiding income taxes because you are simply withdrawing cash, or you are incurring less tax because you are just owing it on the profits from investments being sold.

However, there are exceptions to this general rule. Suppose you have a large value in your 401(k) or traditional IRA?  Once you begin taking required distributions, your future tax bracket might be higher than your current tax bracket.  In that scenario, withdrawing some money from a pre-tax source (401(k) or IRA) might be a smarter strategy.

What about your Roth 401(k) or Roth IRA?  Taking money from them would be completely tax-free.  If your personal, non-retirement accounts have already been tapped, and if you expect your future tax bracket to be lower, then withdrawing some money from a Roth 401(k) or Roth IRA during this period could be wise.  However, since a Roth IRA has no required distributions, my default strategy is to let this wonderful, totally tax-free account just continue growing as long as possible.

After 70 ½

Once age 70 ½ is reached, you are now faced with required minimum distributions from a 401(k) and traditional IRAs.  You have no choice but to receive these taxable minimum distributions.  However, if your budget requires more than the minimum distribution, where should the excess come from?

Again, my default choice is a personal, non-retirement account, if that is available.  If not, and the excess has to come from a 401(k) or a traditional IRA vs. a Roth IRA, what then?  Assuming the excess is taxed at the same rate (it doesn’t push you into a higher tax bracket) and assuming your expected future tax bracket is about the same as your current tax bracket, I would opt for taking the excess from the 401(k) or traditional IRA.  I still like the strategy of letting the tax-free Roth keep growing for as long as possible.

If you should have a Roth 401(k), it would be best to roll this to a Roth IRA before age 70 ½. While there are no required distributions for the Roth IRA, the Roth 401(k) does have required distributions after 70 ½.

Keep in mind that these are general guidelines and your actual situation may necessitate a different withdrawal strategy.

Gerald A. Townsend, CPA/PFS/ABV, CFP®, CFA®, CMT is president of Townsend Asset Management Corp., a registered investment advisory firm located in Raleigh, North Carolina.  Email:   Gerald@AssetMgr.com