Do you remember first learning the order of operations for a math problem such as 3 x (5 + 4) – 12 / 4 = ?
The acceptable way to solve that problem is to add the parenthesis first then multiply by 3 so you get 27 then divide 12 by 4 to get 3 and finally subtract 27 -3 = 24.
Well there’s something similar you need to figure out when you retire. What is the proper order of operations for withdrawing money from your retirement and taxable accounts?
AI Response
I asked AI the question of order of operations and here is the response:
When retiring, the order in which you withdraw funds from different types of accounts (tax-deferred, taxable, and tax-free) can significantly impact your tax burden and help extend the life of your retirement portfolio. Here’s the generally recommended order, but keep in mind individual circumstances vary, and consulting a financial advisor is ideal for personalized guidance:
1. Taxable Accounts First
- Why: Drawing from taxable accounts first allows your tax-advantaged accounts (tax-deferred and tax-free) to continue growing without immediate tax consequences.
- How: Selling assets in taxable accounts may incur capital gains tax. If you’re in a low tax bracket, long-term capital gains rates can be relatively low, sometimes even zero.
- Benefits: This approach may help you manage your tax bracket, potentially allowing you to do Roth conversions at lower tax rates in the early years of retirement before required minimum distributions (RMDs) begin.
2. Tax-Deferred Accounts (like Traditional IRA or 401(k)) Next
- Why: After depleting or reducing taxable accounts, it’s often beneficial to draw from tax-deferred accounts, especially once you reach the age where RMDs are required (currently age 73).
- How: Withdrawals from tax-deferred accounts are taxed as ordinary income, so it’s wise to manage the amount withdrawn to avoid pushing yourself into a higher tax bracket.
- Benefits: Starting withdrawals from tax-deferred accounts after taxable accounts helps defer taxes and allows Roth (tax-free) accounts to continue growing for longer.
3. Tax-Free Accounts (like Roth IRA or Roth 401(k)) Last
- Why: Roth IRAs have no required minimum distributions, meaning you can let this money grow tax-free for as long as possible.
- How: Use Roth funds for later years or for unexpected large expenses to avoid bumping up your taxable income.
- Benefits: Leaving Roth accounts to grow can provide a tax-free inheritance to your heirs if you don’t need to use these funds. Using them last can also give you flexibility in managing taxable income later in retirement.
Considerations and Exceptions
- Bridging Tax Brackets: If you have years in lower tax brackets (e.g., early retirement years), it may be beneficial to take some funds from tax-deferred accounts in those years to “fill up” lower tax brackets.
- Roth Conversions: In years when your taxable income is lower, consider converting a portion of your traditional IRA or 401(k) into a Roth IRA. This strategy can help reduce RMDs later and increase your tax-free savings.
- Healthcare Costs: If you need to stay within a certain income level for healthcare subsidies or Medicare premium brackets, this may influence your withdrawal order, potentially leading to some Roth withdrawals earlier than the traditional approach.
By following this typical withdrawal sequence, retirees can manage their tax exposure and potentially maximize their retirement savings. However, personal factors like spending needs, income sources, tax brackets, and legacy goals should also guide the strategy.
I’d rather be solving math problems than retirement withdrawal buckets calculations but you gotta do what you gotta do.
I checked AI’s answer with Boldin’s recommendation and they were the same although Boldin had this framework:
- Taxable
- Reverse Mortgage Equity
- Tax Deferred
- Roth
- Health Savings Account
I am continuing to play around with Boldin and I really like it, at some point I will write a full review but I have a lot on my plate right now!
Share The Wealth
Does this order of operation make sense to you? Have you done it this way? Let me know in the comments below.