Greetings! I trust that this finds you well and enjoying life.
You may have assets in accounts that are taxable (e.g., CDs, mutual funds), tax deferred (e.g., traditional IRAs and 401(k)s), and tax free (e.g., Roth IRAs and Roth 401(k)s). Given a choice, which type of account should you withdraw from first? The answer is-it depends.
For retirees who don’t care about leaving an estate to beneficiaries, the answer is simple in theory: withdraw money from taxable accounts first, then tax-deferred accounts, and lastly tax free accounts. By using your tax-favored accounts last, and avoiding taxes as long as possible, you’ll keep more of your retirement dollars working for you.
For retirees who intend to leave assets to beneficiaries, the analysis is more complicated. You need to coordinate your retirement planning with your estate plan. For example, if you have appreciated or rapidly appreciating assets, it may be more advantageous for you to withdraw from tax-deferred and tax free accounts first. This is because these accounts will not receive a step up in basis at your death.
However, this may not always be the best strategy. For example, if you intend to leave your entire estate to your spouse, it may make sense to withdraw from taxable accounts first. This is because spouses are given preferential tax treatment with regard to retirement plans. A surviving spouse can roll over retirement plan funds to his or her own IRA or retirement plan, or, in some cases, may continue the deceased spouse’s plan as his or her own. The funds in the plan continue to grow tax deferred, and distributions need not begin until the spouse’s own required beginning date.
Another factor to consider is that IRA assets enjoy special protection from creditors under federal and most state laws. Federal law provides protection for up to $1,283,025 of your aggregate Roth and traditional IRA assets if you declare bankruptcy. (SEP IRAs, SIMPLE IRAs, and amounts rolled over to the IRA from an employer qualified plan or 403(b) plan, plus any earnings on the rollover, aren’t subject to this dollar cap and are fully protected if you declare bankruptcy.) The laws of your practical state may provide additional bankruptcy protection, and may provide protection from the claims of your creditors even in cases outside of bankruptcy. IRAs you’ve inherited may be afforded less protection under state and federal law. You should check with an attorney to find out how your state treats IRAs. If asset protection is important to you, this could impact the order in which you take distributions from your various retirement and taxable accounts.
The bottom line is that this decision is a complicated one. A retirement professional can help you determine the best course based on your individual circumstances.
If we can help in any way with this or anything else related to retirement don’t hesitate to contact us.
Jeff Christian CFP, CRPC