WHEN I FIRST LOOKED at the issue of portfolio withdrawals more than two decades ago, many financial experts suggested retirees follow a simple strategy: spend taxable account money first, traditional retirement accounts next and Roth accounts last. That way, you’d squeeze more years of tax-deferred growth out of your traditional retirement accounts, and even more out of your tax-free Roth.
If only things were so simple today.
Why have portfolio withdrawals become more complicated? More than anything, it’s driven by the tax laws. Let’s start by considering four key sources of retirement income.
Taxable accounts. Yes, with a regular taxable account, you have to pay taxes each year on interest, dividends and realized capital gains. But if you need to make a withdrawal from your taxable account, the tax bill may be zero—and, for most folks, the maximum will likely be 15%, and that assumes a zero cost basis. Moreover, if you hold your taxable account investments until death, any embedded capital-gains tax bill disappears.
Traditional retirement accounts. While withdrawals from a taxable account may involve little or no tax, every dollar withdrawn from a traditional retirement account will typically be taxed as ordinary income. Still, each year, you’ll want some income that’s potentially taxable—perhaps as much as $58,575 in 2023 if you’re single and $117,150 if married—so you take advantage of your standard deduction, along with the 10% and 12% federal income-tax brackets. As I see it, exiting an IRA at those tax rates is a bargain.
On top of that, if you have hefty itemized deductions later in retirement thanks to, say, large medical costs, you can set your deductions against your retirement account withdrawals, potentially paying little or no taxes on those withdrawals.
Another consideration: charitable giving. Even if your IRA is on the hefty side, that might not be such a problem if you plan to make qualified charitable distributions once you reach age 70½. You might also opt to bequeath what’s left of your traditional IRA to charity, thus saving your heirs from the embedded income-tax bill and instead leaving them your Roth accounts. The bottom line: Having a healthy balance in a traditional IRA or 401(k) isn’t necessarily a tax nightmare.
Roth accounts. These offer the chance for tax-free growth, don’t necessitate required minimum distributions like traditional retirement accounts, and still make a great inheritance even though most heirs now have to empty retirement accounts within 10 years. But there’s a cost to be paid today: Getting money into a Roth means paying income taxes either on the wages contributed or on money converted from traditional retirement accounts.
Social Security. In addition to the key benefits—lifetime inflation-adjusted income with a possible survivor benefit for your spouse—Social Security has another virtue: At most, just 85% of your benefit will be taxable and it could be far less. Whatever the tax rate, it’ll be lower than that levied on your traditional retirement accounts.
To get the largest possible monthly check, many folks postpone Social Security until as late as age 70, especially if they were the family’s main breadwinner. Problem is, from a tax perspective, delaying Social Security clashes with the notion of delaying traditional retirement account withdrawals.
How so? Once folks start required minimum distributions in their early 70s from their often-bloated traditional retirement accounts, not only are those withdrawals sometimes taxed at a steep rate, but also all that income often means that even more of their Social Security benefit is taxable—a phenomenon known as the tax torpedo. In other words, postponing all retirement account withdrawals until your 70s can trigger a double tax whammy, because it can also mean that up to 85% of your Social Security benefit is also taxed.
What to do? Today, retirees are often advised to start drawing down their traditional IRAs and 401(k)s in their 60s or to convert a portion of their IRA to a Roth. But in this “it’s never simple” tax world, that has two other knock-on effects.
Health insurance premium tax credit. If you retire before age 65, and hence you aren’t yet eligible for Medicare, one of the biggest potential costs is health insurance. But if you purchase coverage through a health-care exchange, and your household modified adjusted gross income is no more than four times the federal poverty level, you should receive a tax subsidy. In 2023, that would usually put the cutoff at $54,360 for single individuals and $73,240 for couples, assuming there are no kids at home. But thanks to 2022 legislation, these thresholds will be substantially higher through 2025. To see whether you might qualify, try this calculator.
The lower your income, the larger the tax credit—potentially more than $9,000 per person per year where I live. Result? If your goal is to get a large tax subsidy, you’d want to avoid, say, converting to a Roth or realizing stock market capital gains.
IRMAA. Limiting your income can also be the key to avoiding the Medicare premium surcharges known as IRMAA, short for income-related monthly adjustment amount. In 2023, these surcharges apply to single individuals with modified adjusted gross incomes of $97,000 and above and couples with incomes of $194,000 and above.
At these income levels, the surcharges for Medicare Part B and Part D are equal to roughly 1% of income—something to be avoided, if possible, but hardly a devastating financial hit. The income that’s assessed is that from two years earlier, which means high-income folks need to start worrying about these surcharges in the year they turn age 63.
How do you navigate your way through this thicket of tax considerations? There’s no one-size-fits-all answer.
My plan is to do hefty annual Roth conversions through at least age 62 and possibly for a few years beyond that, with the goal of avoiding much bigger tax bills in my 70s, when I’ll have to take required minimum withdrawals from my traditional IRA. My earned income is still sufficiently high that it would be tough to qualify for the health insurance tax credit, so I’m not worrying about that.
I’m also not too worried about IRMAA. The Medicare premium surcharges I might trigger look far less punitive than the higher income-tax rates I could face in my 70s if I didn’t undertake some hefty Roth conversions. That said, because IRMAA is a cliff penalty—meaning $1 over the various thresholds triggers the full charge for the year—I’ll keep an eye on those thresholds once I reach age 63 and I’ll look to limit my income if I’m likely to be close to the next threshold.
While the above strategy should work out okay for my situation, I could easily imagine a scenario where folks, instead of deliberately generating extra taxable income in their early 60s, might want to minimize it, so they qualify for the health insurance tax credit. This would be a double tax win—both avoiding income taxes and collecting the credit.
How would you pay for living expenses during this stretch? That’s where a handsome taxable account balance would come in handy. Once you reach 65 and start Medicare, you might then look at drawing down your IRA or converting a portion to a Roth, assuming you fear punishing tax bills from required minimum distributions in your 70s and beyond.
Where does that leave us? At the risk of oversimplifying, here are four suggestions: