Tax-efficient Retirement Withdrawals

Considering taxes, in what order should U.S. retirees consume different sources of retirement savings/income? In their August 2018 paper entitled “Constructing Tax Efficient Withdrawal Strategies for Retirees with Traditional 401(k)/IRAs, Roth 401(k)/IRAs, and Taxable Accounts”, James DiLellio and Daniel Ostrov describe and illustrate an algorithm that computes individualized tax-efficient consumption for U.S. retirees of:

• Tax-deferred retirement accounts [Traditional IRA/401(k)].
• Post-tax retirement accounts [Roth IRA/Roth 401(k)].
• Other taxable retirement accounts.
• Other sources of money subject to income tax, including: earned income, some pensions, annuities bought with pre-tax money, earnings from annuities bought with post-tax money and sometimes Social Security benefits.
• Other sources of money that do not affect tax rates of retirement accounts, such as: tax-free gifts, Health Savings Accounts, some pensions, principal from annuities bought with post-tax money and sometimes Social Security benefits.

Their model adapts to individual retiree circumstances and accommodates typical changes in tax policies (changes in marginal rates and number of brackets). For tractability, they make simplifying assumptions. The principal simplification is that  return on stocks, stock dividend yield, inflation rate, tax brackets and rates, other income sources and consumption rates are known each year (not random variables). When the goal is to optimize a bequest, inputs also include year of retiree death, marginal tax rate of the heir and rate the heir consumes inherited retirement accounts. They do not attempt to determine the optimal mix of  stocks and bonds/cash within retirement accounts (their deterministic model would prefer all stocks). Using illustrations of algorithm outputs based on varying input assumptions, they find that:

• Five guiding rules are:
  1. The order of consuming traditional versus Roth IRAs is irrelevant.
  2. Consume taxable stocks and dividends earlier rather than later.
  3. When consuming taxable stocks, start with those having the highest cost basis.
  4. Always consume dividends before Roth IRAs.
  5. Always take required minimum distributions from tax-deferred accounts.
• The algorithm almost always outperforms strategies advocated by financial institutions and academics, and underperforms only slightly in a few unusual cases.
• A key finding is that dividends can produce large, negative effects in a taxable retirement stock portfolio, such that many retirees should avoid rather than prize dividend-paying stocks.

In summary, results indicate that consumption of retirement portfolios/income in a tax-efficient manner almost always improves outcomes across a wide variety of individual circumstances compared to widely offered advice.

Cautions regarding findings include:

• As always in modeling retirement finances, simplifying assumptions are arguable.
• As noted in the paper, the algorithm assumes no costs in selling stocks from retirement portfolios.
• Also as noted in the paper, the algorithm ignores many complicated tax implications of Social Security income. The algorithm may still accurately treat Social Security income for very wealthy and very poor retirees.