Quizmaster, Doug Hutchinson, presents his quiz for the month. Here, Doug discusses strategies for tax efficient withdrawals.
Your friend Robert is a retiree who is facing an unexpected expense of $4,000. To meet this unexpected expense, he will need to take a withdrawal from either his taxable investment account or his tax deferred Individual Retirement Account (IRA).
Robert’s taxable account and his IRA are the same size and have the same allocation of investments.
Robert faces an income tax rate of 25%. Assume any capital gains realized in a taxable account are long term gains and are taxed at 15%. Assume his cost basis of holdings in his taxable account is 10% below the potential sale price of the holdings.
Assume Robert is 72 years old and has already fulfilled his Required Minimum Distribution (RMD) for his IRA for the year.
Robert asks you: “Should I take the $4,000 withdrawal from my taxable account or from my IRA? Or should I be indifferent on where the $4,000 is coming from?”
If Robert takes the withdrawal from his IRA – he will actually need to withdraw $4,000 ÷ (1 -0.25) = $5,333.33 gross to get to $4,000 net of taxes. He will owe $1,333.33 ($5,333.33 - $4,000 = $1,333.33) in taxes.
If Robert takes the withdrawal from his taxable account he will only pay taxes on the gain. He will withdraw $4,000 net of taxes. His cost basis is $4,000 x (1 – 0.10) = $3,600 and results in a gain of $400. He will owe $400 x 0.15 = $60 in capital gains taxes.
In this particular scenario it probably makes the most sense for Robert to take the withdrawal from his taxable account. The difference in gross amounts ($5,333.33 - $4,060 = $1,273.33) means more money gets to stay invested and grow if he takes the withdrawal from his taxable account.
While it generally makes the most sense to take withdrawals from taxable accounts first (as in Robert’s scenario), there are certain scenarios where it may make the most sense to take some or all withdrawals from a tax deferred account first. Investors should consider changes in their future tax rates, whether gains realized in a taxable account are long-term or short-term, and whether the investor has already fulfilled their RMD, among other factors when deciding whether to take withdrawals from taxable accounts or tax deferred accounts.
Investors should consider working with a planning professional who can offer a customized planning solution that is tailored to their unique scenario.
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This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.