A reader writes in, asking:
“Sometime in one of your posts, would you expound upon the pros and cons of prioritizing your spending from taxable vs. tax-deferred accounts during retirement, factoring in how one’s heirs will fare inheriting whatever is left over from either type of account?”
With regard to general planning about which account(s) to spend from per year, it’s easiest to start with a simplified analysis in which we assume that:
- You’ll be spending all of the money during your lifetime, and
- You have only Roth and tax-deferred accounts.
If all you have are tax-deferred and Roth accounts, the question for each dollar you need to spend is: how does my current marginal tax rate (i.e., the tax rate I would pay on this dollar, if I took it from tax-deferred) compare to the marginal tax rate I expect to face later in retirement?
- If your current marginal tax rate is lower than the one you expect in the future, this dollar should come from tax-deferred.
- If your current marginal tax rate is higher than the marginal tax rate you expect to face in the future, this dollar should come from Roth.
One key point here is that marginal tax rate is not necessarily the same thing as tax bracket. It’s quite common for retirees to have a marginal tax rate that’s higher than their tax bracket, because their income is at a point where additional income not only causes the normal amount of income tax, it also causes their eligibility for some particular tax break to decline. (Most commonly: It causes more of their Social Security benefits to be taxable.)
For many people, this means spending largely from tax-deferred accounts in the early years of retirement before Social Security kicks in, then spending from a mix of Roth and tax-deferred each year after that. (A common exception: Early retirees purchasing insurance on one of the ACA-established exchanges may want to prioritize Roth spending in the early years — to maximize subsidies — until they qualify for Medicare.)
What If You’ll Be Leaving Money to Heirs?
If you’re confident that you won’t be spending all of your money during your lifetime, the question changes. Instead of asking how your current marginal tax rate compares to your future marginal tax rate, we want to look at how your marginal tax rate compares to the marginal tax rate your heirs would have when they are taking the money out of the account (which, in most cases for IRAs, would start as soon as they inherit it, because they’d have to take RMDs over their lifetime).
In many cases, this suggests that prioritizing spending from tax-deferred makes sense, because it’s common for your marginal tax rate while retired to be lower than the marginal tax rate your heirs would have when they inherit the money, which would likely be while they’re in the late (i.e., peak earning) stages of their careers. But, as with anything related to tax planning, this varies from one family to another. Some families may find that the heirs would be better off inheriting a larger tax-deferred account than a smaller Roth account because the heirs have chosen a lower-paying career (thereby making their marginal tax rate lower).
What If You Have Taxable Accounts?
If you have significant assets in taxable accounts, the situation again depends on how much you expect to be leaving to heirs. In the case in which you expect to spend most or all of your assets, spending first from taxable accounts often makes sense in order to preserve your tax-advantaged retirement accounts. If, however, you expect to leave a large portion of the portfolio to heirs, and you have assets with large unrealized capital gains, it often makes sense to avoid liquidating those assets, so that your heirs can inherit them with a stepped-up cost basis — thereby allowing your family to avoid taxation on the gain completely.
Caveat number one: I’m assuming with all of the above that the estate tax is not a concern. If estate taxes are a concern, the analysis changes somewhat, as it becomes relatively more advantageous to spend from tax-deferred accounts to minimize the size of the taxable estate. Of course, with the exemption where it is these days ($5.34 million in 2014 for single taxpayers, twice that for married couples), most people don’t have to worry about this.
Caveat number two: The approach presented above is very generalized. That is, any given person is likely to have factors affecting the decision in addition to the factors mentioned above. So, if you want the best analysis, meeting with a tax professional who can look at your personal situation is the best bet.