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Which Accounts to Tap First?

When you withdraw money from your investment accounts, the big question is: in what order?  From taxable accounts first?  Tax-deferred?  The answer makes a difference.

When you leave the workforce and rely on your savings for income, you are liberated from many daily tasks.  The 8 a.m. meetings, unfinished projects, and strings of emails all disappear.  Yet, you are left with one major responsibility: paying yourself.

The road to becoming your own HR department – the transition from living on a paycheck to living off your portfolio – requires a major attitude adjustment.  You’ve built your nest egg over a successful career and now your portfolio needs to support you.

Here are some strategies to consider when the time comes to crack it open.

The plan behind retirement savings is simple: you are trying to grow your nest egg as large as possible.  Success is measured by the size of your portfolio at retirement and much less so on how you achieve that growth.  When the time comes to start withdrawing funds, it’s a different story.  Success is measured by your overall happiness, standard of living, and trust that your money is not in danger of running out.

First, know that all those tenets of savings you relied on when growing your portfolio, work against you in retirement.  Dollar cost averaging and compound interest both work in reverse.

Dollar cost averaging – investing a fixed amount at a specified interval, like the first of every month, can help during volatile markets because it lets you buy more when markets are down.  However, when regularly withdrawing funds, temporary dips in the market can do damage because you must sell more shares to provide an equal amount of cash.

With compound interest friend to all investors, you know that early investing provides a larger base to grow and steady investing magnifies returns.  But in reverse, early withdrawal – i.e., a large lump sum taken from the retirement portfolio early on will diminish the positive influence of compounding on remaining assets.

Knowing these retirement challenges lie ahead, the next step is to set up a withdrawal plan.  A great first step is to create a cash bucket of safe, liquid investments that can support near-term expenses.  If you know what your next six months of expenses are, it will make it much easier to tolerate volatility and stick to your long-term plan.

Next, create a plan outlining which investment account to tap first.  Should you draw from your taxable accounts at the onset or dip into your individual retirement accounts?  A basic goal of tax planning is to put off paying taxes as long as possible.  Tax deferred retirement accounts allow you to declare income later in life; if you also have a lower income in retirement, taxed paid may be considerably lower.

Yet there are several scenarios when drawing from your IRAs first might make sense:

Are your IRAs very large, potentially causing your distributions to bump you into a higher tax bracket?  If this is the case, it might make sense to begin spending from your IRAs before you reach age 70½, the time in which you are required to begin taking distributions.  Remember that your required minimum distribution (RMD) is considered taxable income.

If your IRA had grown to $2 million by 70½, your first distribution would be approximately $73,000, potentially bumping you into a higher bracket and forcing you to pay more to the government.  Had you been spending down the IRA during the first years of retirement, your RMD (and subsequent tax payments) would be less.

Investments also matter when deciding how to fund your retirement.  If you have stock with large gains, you may want to hold off selling for as long as possible.  If these securities become part of your estate, your heirs receive a step-up in basis at inheritance, meaning they pay no capital gains tax on the appreciation earned over your lifetime, only on the appreciation since they inherited it.

Last, save your Roth for, well … last.  The strategy for reducing IRA values (and RMDs) doesn’t apply to Roths as they have no distribution requirement.  With a Roth IRA, you invest money that had already been taxed – the opposite from a conventional IRA, where the money gets taxed upon withdrawal.  Since you won’t have to pay tax on your Roth money, keep it growing tax free, perhaps even into the next generations.

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Sean Condon, CFP, is a wealth advisor and financial planner with Windgate Wealth Management in Chicago. Take our brief quiz to find out how much portfolio risk is right for you.

Sean provides financial guidance to people who are building a career and concerned about accumulating wealth for their future. His firm also works with those at or near retirement and in need a strategy for managing the transition from living on a paycheck to living off their portfolio. Additional insights on financial planning and investing can be found on the Reflections blog, here.

If you would like to know more about Sean or have questions about becoming a client of Windgate Wealth Management, send an email to [email protected] or call 844-377-4963.

Perritt Capital Management Inc. is the registered investment advisor for Windgate Wealth Management accounts. Perritt Capital Management Inc. is not responsible for any linked website’s content.

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