Which type of accounts should you draw from first in retirement– taxable, tax deferred, or tax free?

The answer depends on many factors specific to your situation including your estimated life expectancy, what type of investments you own, and the amount you have in each type of account. It also depends on your projected rate of investment return, your income tax bracket, and whether you plan to leave assets to your heirs.

You won’t always have complete flexibility in choosing which accounts to withdraw from first. Complicating your planning are the rules that require you to begin withdrawing at least minimum amounts from traditional IRAs beginning at age 70½, and from 401(k) and other employer-sponsored retirement plans beginning at age 70½ or once you retire. If you fail to comply with these rules you’ll be subject to a stiff 50% penalty on the amount you failed to withdraw.

If you plan to spend most of your money

If you’ll need most of your savings to pay your retirement expenses, the standard advice is to withdraw from your taxable accounts first and your tax-deferred assets second. Spending from your taxable accounts first allows your savings in tax-deferred retirement accounts, including traditional IRAs, 401(k) plans, 403(b) plans, and 457 governmental plans, to continue to accumulate without being taxed for a longer period.

Moreover, taxable distributions from your tax-deferred accounts are treated as ordinary income. And your ordinary income tax rate is probably higher than the capital gains tax rate you pay when you sell taxable assets. Furthermore, you’re already paying taxes on the earnings your taxable assets generate, so withdrawing from those accounts first may make sense.

If you plan to leave money

On the other hand, if you intend to leave a significant sum to your heirs and you own appreciated investments in taxable accounts, you may instead want to consider withdrawing first from your tax-deferred accounts.

Here’s why you may want to leave your taxable accounts intact. When you leave your beneficiaries appreciated investments in a taxable account, the cost basis of those assets is generally increased, or stepped-up, to their fair market value on the date of your death (or if less, the alternate valuation date).

Therefore, when your beneficiaries sell the investments they won’t owe capital gains tax on the appreciation that occurred prior to your death. Your beneficiaries will only owe tax on any appreciation that occurred after your death.

(At least this is the case until 2010, when this step-up basis is scheduled to be limited. However, these limitations are only for the year 2010 since the entire Tax Act of 2001 expires in 2011 -- unless future legislation is enacted before then.)

In contrast to a taxable account, if your heirs inherit a tax-deferred account, such as an IRA or 401(k) plan, they’ll owe ordinary income taxes on the earnings and deductible contributions as they withdraw them.

Tap Roth IRAs last

Whether or not you plan to pass on your savings or spend it, tap into any Roth IRA you own last. You can make qualified withdrawals tax free from Roth IRAs, and minimum distributions aren’t required from Roth IRAs during your lifetime. What’s more, qualified Roth IRA distributions pass to your heirs income-tax-free. 

Article is for educational purposes only and is not intended to provide specific tax or legal advice. For answers to tax questions, please see your tax professional. For legal questions, consult an attorney.

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