This story appears in the February 28, 2016 issue of Forbes. Subscribe
Congratulations if you reach retirement holding a diversity of assets: tax-deferred IRA, Roth IRA, pension, Social Security and a taxable brokerage account. Also condolences, because it's hard to know which assets to use first when you need spending money.
Should you withdraw cash from your traditional IRA or sell appreciated stocks in your taxable brokerage first? You're going to have a tax bill either way, since withdrawals from that IRA and capital gains are both taxed. Which is the lesser evil?
Or what if the choice is between cashing in stocks that have gained and dipping into your precious Roth, the retirement account that is totally tax-free? The correct answer here is tricky; it depends on whether you are likely to be leaving money to heirs.
You are playing a card game with the IRS. You have some good cards and some bad cards in your hand. You need to know when to play each card in order to maximize your aftertax wealth.
We're assuming here that you have money in at least three of the five baskets listed above. Without a diversity of retirement accounts you're in a straitjacket. "The problem so many people have is that they save only in their [traditional] 401(k)," says Randy Kurtz, founder of Chicago money manager BetaFrontier. "In that case you can't do much."
Moral: When you are young, build tax diversity. Have some taxable assets—namely, money invested outside retirement plans. Have some tax-deferred assets—namely, money in a traditional IRA or 401(k). Have some tax-free assets—those Roth accounts.
You build up a Roth three ways: by contributing to a Roth IRA, by opting to put some of your 401(k) contributions in a Roth 401(k) and by converting IRA assets. Direct contributions to a Roth IRA are permitted only when your income is below a threshold; the other two options are available to everyone. (Read more on Roth strategies.)
You’ve been saving diligently for retirement. Now make that money last the rest of your life.
If you behaved yourself as a retirement saver you have choices as a retirement spender. In that case follow this 11-step guide to drawing income.
1. DELAY SOCIAL SECURITY. You can start claiming anytime from age 62 and age 70. By delaying eight years you boost the monthly, inflation-adjusted paycheck by 76%. That's a good deal if you are healthy. It's a great deal if you have a younger spouse who stands to claim the survivorship benefit. For a spouse who doesn't have much of a benefit on his or her own earnings, the spousal payout (38% of your amount when you are alive, assuming you have deferred your start date to age 70, and 100% after you are dead) is extremely valuable.
You probably don't realize how large the Social Security asset is. For a married taxpayer who has been paying the maximum tax for 35 years, the present value of a Social Security annuity beginning at age 70 is as high as $1.2 million.
Some people can't afford to wait; they need Social Security to live on at age 62. Some (such as single, sickly retirees) shouldn't wait. For the majority of prosperous retirees who are married to younger, lower-earning spouses, delay pays.
2. DON'T DELAY RMDs. Beginning in the year you turn 70 1/2, you must take out an annual "required minimum distribution" from a traditional IRA. It's figured as an age-related percentage of the previous year's balance. You must also take RMDs from your 401(k) at 70 1/2 (unless you're still working at the company and aren't an owner of it).
The penalty for taking too little is draconian (50% of the shortfall). So this much of your retirement income is foreordained.
Matthew Kenigsberg is in Fidelity Investments' retirement think tank. Fidelity doesn't dispense tax advice, but it does send clients off to their CPAs with pointed questions about how to arrange their tax affairs. For that purpose Kenigsberg has constructed a hierarchy of retirement withdrawals. On it cash-outs from taxable accounts come ahead of everything but those RMDs.
This is counterintuitive. Dividends and long-term gains in the taxable account are taxed at low rates federally (probably 15% for you). IRA withdrawals are taxed at higher rates (let's say 28%). You'd think it would be smart to drain the 28% account first.
But there's a subtlety here. Deferring a withdrawal from the IRA doesn't just defer the tax on future earnings; it defers tax on the principal, too. This is equivalent to paying tax right now on the principal and then getting a complete exemption from tax on future earnings.
You're going to pay high tax on the current IRA balance no matter what. Consider that sum as already belonging to the IRS. On future investment earnings the IRA effectively offers a 0% tax rate, which beats out the rate on the taxable account by 15 points.
The full Kenigsberg hierarchy: Take RMDs from your tax-deferred IRA, then deplete your taxable account, then dip further into your tax-deferred IRA. Finally, play your trump card, the tax-exempt Roth account. Prosperous retirees who are thinking more about heirs than their own needs may need to modify this rule (see No. 10), but the ranking is a good starting point for your withdrawal plan.
4. SET UP A ROTH IRA. You pay income tax on employment earnings before the money goes into the Roth but owe no tax on either principal or earnings on the way out. You can also convert pretax traditional IRA money to a Roth by paying tax.
A Roth account is nirvana. There is no withdrawal mandate while you're alive. It makes a nice bequest. There are penalties for cashing too much of it in too soon, but they are aimed primarily at younger savers. Get some money in a Roth as soon as you have the opportunity. Later on, certain technical withdrawal rules make it useful to have had a Roth IRA, even one with a token amount, for at least five years.
5. SET UP A LINE OF CREDIT. You could use a securities portfolio as collateral. Ted Cruz evidently did.
Arrange the credit line before you need to draw on it, advises money man Randy Kurtz. Credit buys you flexibility. There may come a time when you need a chunk of cash and the alternative sources—stock sold in a depressed market or withdrawals from a tax-deferred IRA—would cause pain.
Using securities for collateral? Don't take the broker's margin loan, which is aimed at traders and may carry a usurious rate (like 8%). Instead get a credit line against a part of your portfolio you don't trade. By pledging a lot of assets at Schwab (like $3 million) you get the bargain rates (like 2.7%) accorded to high rollers, even if the amount you draw down is small.
There are restrictions. Your collateral can't be an IRA or Roth. If it's stocks, the government has cutely arranged to make your interest nondeductible: A securities law forbids using the proceeds to buy more stock, and a tax law forbids the deduction unless that's the purpose of the loan. But interest on a home equity line is deductible on the first $100,000 borrowed, provided you don't pay the alternative minimum tax.
6. DON'T JUMP AT A LUMP SUM. The formula in this story explains why trading in a monthly pension is usually a bad idea.
7. TAKE CAPITAL LOSSES NOW. Got stinkers in your portfolio? Switch into similar stocks or funds for 31 days in order to harvest a tax deduction. There's nothing to be gained by waiting. There is much to be lost. You might really need a loss now or carried forward to some future year when a capital gain is dumped into your lap. Also, unrealized losses evaporate on your death, while the loss carryforward can potentially be used by your widow(er).
8. DON'T TAKE AN IRA DISTRIBUTION YOU DON'T NEED. Let's say you've already taken out the required minimum and you're temporarily in a low tax bracket. You think it would be smart to take out more, to shrink the balance and thus shrink future RMDs. That would be dumb. Instead, convert this supplemental amount into a Roth IRA.
9. MANAGE YOUR BRACKETS. It may make sense to accelerate or defer income in order to keep it from spilling into a higher tax bracket. Find your marginal rate by playing what-if with your tax software. Plug income projections for 2016 into the 2015 program (it's close enough). Now try adding a $10,000 Roth conversion or a $10,000 capital gain. What does that do to the bottom line? How will the picture change in later years?
Surprises lurk in those lines of code. Some retirees are in a 0% capital gain bracket and should take advantage by selling appreciated stock. At higher levels of income the 3.8% ObamaCare tax jumps out of the shadows; an IRA distribution is not supposed to be subject to that tax, yet it can be, indirectly, if the distribution puts dividend income in harm's way by pushing it across a certain income boundary.
Did you know that couples with adjusted gross income between $170,000 and $428,000 are subject to the equivalent of a 3% surtax? It arrives via the additional Medicare premiums charged to higher-income folks.
But also remember that the appreciation on assets you hold until death escapes income tax. This freebie may be more valuable to your family than keeping a tax-favored retirement account going. It could tilt you away from the usual rule that has you burning up taxable accounts before invading IRAs.
11. MANAGE YOUR DONATIONS. Kenigsberg often suggests that a client over 70 send money directly from an IRA to a charity. Up to $100,000 of such donations counts against that year's RMD and also never appears in your adjusted gross income. That spares you from numerous AGI-related gotchas (such as higher Medicare premiums).
But there are times when it pays to play the cards differently. Suppose you want to get rid of a $10,000 block of Amazon stock that you bought for $2,000. And suppose you aren't going to get hit with an AGI surcharge. Then you might be better off donating the stock and simultaneously converting $10,000 of your IRA to a Roth. The charity deduction will be $10,000, with the $8,000 of appreciation never taxed. Your taxable income remains the same. With this finesse you have converted unwanted stock into a tax-exempt account.
