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For most retirees, the tax-efficient liquidation of a retirement portfolio requires coordinating between both taxable brokerage accounts and pre-tax retirement accounts like an IRA or 401(k).
The conventional view is that taxable investment accounts should be liquidated first, while tax-deferred accounts are allowed to continue to compound. In practice, however, it?s possible to be too good at tax deferral, such that the IRA grows so large that future withdrawals ? or even just RMD obligations ? actually drive the retiree into higher tax brackets.
A more tax-efficient liquidation strategy is to tap IRA accounts earlier rather than later: Not so much that the tax bracket is driven up now, but enough to reduce exposure to higher tax brackets in the future.
The optimal approach, though, preserves the tax-preferred value of retirement accounts while filling the tax brackets early on. This is achieved through funding retirement spending from taxable investment accounts ? while also doing systematic partial Roth conversions of the pre-tax IRA to fill tax brackets in the early years.
The result is that the retiree will tap investment accounts for retirement cash flows in the early years and a combination of taxable IRA and tax-free Roth accounts in the later years; a process that avoids ever being pushed into top tax brackets, now or ever.
LETTING THE IRA COMPOUND
The classic approach to liquidating investment accounts in retirement is fairly straightforward: After-tax taxable brokerage accounts should be liquidated first, while retirement accounts like IRAs and 401(k) plans receive preferential (i.e., tax-deferred) treatment and should be liquidated last. This allows the retiree to spend down the least tax-efficient portions of the portfolio first ? the brokerage account with annual taxable interest and dividends, and potential capital gains ? while preserving tax deferral and the benefits of tax-deferred compounding growth as long as possible.
Imagine a retiree who has $750,000 in a brokerage account and $750,000 in an IRA, and plans to withdraw $80,000 per year from the portfolio ? with spending adjusted annually for inflation ? on top of other available income sources such as Social Security.
If the IRA is liquidated first, even at an 8% growth rate, the retiree quickly spends down the account. In fact, at an average tax rate of 20%,...