Financial advisors know there is an art and a science to helping clients determine which accounts to tap into first when they retire. There are a number of factors to consider when we advise a client on a withdrawal strategy, and one of the best ways to address this piece of advice is to put pen to paper and map it out.

Once an advisor has this information in hand, it’s often surprising how little money clients may need from their portfolios after they walk away from a regular paycheck.

The Checklist

The cash flow plans we develop require us to ask several questions. 

After the client’s recurring paycheck ends, will there be a residual (possibly sizable) bonus paying out this year or next year? Will the client be working part time or consulting? 

Another important question to ask is whether the client is really ready to retire or significantly scale back work hours. Once many of my successful clients announce their retirement, the calls from friends, former colleagues, corporate boards or headhunters start to roll in. These people may interpret a client’s “retirement” to mean “She’s now available” rather than “He’s leaving the workforce.” So it’s important to ask clients whether they think they’ll be earning some sort of wage during their early years of “retirement.” 

Once that’s answered, we ask whether the clients will have deferred compensation or pensions that start paying out. Perhaps they can’t control the timing of these payouts—their company plan rules often dictate when and in what manner this income is distributed upon retirement. 

Another important question to ask is, have they been contributing to an annuity and should they plan to annuitize it for another stable source of income (especially if they don’t have a traditional pension)? Do they have stock options expiring that will need to be exercised? If they use a cashless sale exercise strategy, they’ll receive cash to live off of.

Is the client a business owner getting paid out in installments, perhaps over a two- to 10-year period? Will he or she be staying on in a limited consulting role at the new company and therefore have this cash flow coming in?

Looking at all these factors will help determine the optimal time to elect Social Security. If the clients have other cash inflows for the first several years of retirement, it may be best to defer taking Social Security until age 70. Yet early Social Security is still worth considering if it means less in portfolio withdrawals ($25,000 coming in is better than $25,000 going out).

Once I have complete information about the client’s cash flow from all these assets and income sources, I use them to develop a five- to 10-year cash flow plan.  

Next Step

Given all that, you may conclude that the client does not need to take a withdrawal from a portfolio right away. Mapping out a multiyear cash flow plan is one of the best ways to determine this. However, if we assume that clients do need immediate withdrawals, what accounts should they draw from first? 

First, you must evaluate the client’s ratio of taxable account assets to tax-deferred and tax-free account assets. If all of his or her assets are in 401(k) or IRA plans, there is not much need for further withdrawal plan analysis. All of his or her portfolio withdrawals will be subject to ordinary income tax (unless there is some basis in the IRA or after-tax money in the 401(k), for example).

If the clients have a mix of assets, start by looking at their ages and tax brackets. Given other cash inflows, if they’ll be in the top 39.6% federal tax bracket, any portfolio withdrawals should come from more tax-favored accounts. These sources can include cash in the bank (which have no taxes on withdrawals) or their taxable brokerage accounts (which are taxed at lower capital gains rates). 

I advise clients entering retirement who need portfolio withdrawals to have at least one to three years of their estimated withdrawal needs in cash in their local bank. This is not only good for overall withdrawal flexibility, but it can save your clients taxes in retirement since they’ve already paid the tax on this cash.

We generally recommend that the clients don’t tap into their IRAs or qualified plans right away. This is especially true for clients who retire early; if they do, they should wait until they reach at least age 591/2 so they can avoid the 10% early withdrawal penalty. It’s yet another argument for spending down cash or taxable accounts first.

Clients who retire early, before age 591/2,  can take out money from their 401(k) and avoid the 10% early withdrawal penalty if certain conditions are met. First, they must leave their company no earlier than the year they turn age 55, and second, they must leave all or a portion of their 401(k) at that company rather than rolling the 401(k) to an IRA. I sometimes advise clients who meet this criteria to leave a small amount in their 401(k) until age 591/2,  just to provide us with the most cash flow and tax flexibility.

Now, if your client happens to be in a much lower tax bracket, such as the 10% or 15% bracket, and is over age 591/2, he or she should consider withdrawals from pretax 401(k) plans or IRAs to fill up the lower tax brackets. Low-tax-bracket years can be an ideal time to do partial Roth IRA conversions, especially if the anticipated required minimum distributions from the clients’ pretax 401(k) or IRA plans are expected to be significant when the clients turn 701/2. There are no required lifetime minimum distributions from Roth IRAs.

Our firm likes to avoid touching the almighty Roth IRAs or Health Savings Accounts (HSAs) for as long as possible. This strategy allows the clients to grow these tax-free accounts as much as possible as long as certain rules are met.

For example, let’s say your client faces an unexpected $20,000 bill for medical expenses later in retirement. In order to pay this bill out of an IRA, he or she will need to withdraw a pretax amount of $30,000 or more. But if we have a sizable enough tax-free asset—like a Roth IRA or an HSA for qualified medical expenses—the client needs only to tap into $20,000. The more in tax-free assets the clients have, the lower their withdrawal needs will be over time, increasing the likelihood they won’t outlast their portfolio.

Our firm tries to avoid spending down all of a client’s cash or taxable investment accounts too soon. While the client will likely pay less in income taxes in the early years of retirement, leaving only assets subject to ordinary income taxes, such as IRAs, later in life the client could face years of unpleasant tax bills or a faster drawdown rate. This is especially true if the client eventually needs to live in a nursing home and face double or triple the amount of his or her anticipated cash outflows. 

(I often recommend long-term care insurance as one way to help mitigate this risk; I like to refer to it as Bubble Wrap around a retired client’s portfolio.) 

If you’re starting to see the proportion of the client’s tax-deferred assets become significantly larger than taxable assets, it may make sense to start withdrawals from the IRAs sooner than age 701/2. If you keep a good balance between tax-favored assets and non-tax-favored ones, you give the client more flexibility to pay for the unknown expenses that may come along.

If the client is elderly or has health problems, the withdrawal plan may need to shift as you start thinking about passing assets to the next generation or making charitable contributions. A person could spend down the pretax 401(k) or IRAs more while leaving the taxable accounts to get a stepped up cost basis at death to benefit heirs. This is a good strategy when your clients are in a lower income tax bracket than their heirs. Also, your elderly clients may want to consider making annual gifts to family or charity should estate taxes be a potential issue. They could take up to $100,000 out of their IRA to take advantage of the qualified charitable distribution rules, or perhaps gift low-cost-basis stock in the taxable accounts to charity.

Finally, while your clients are accumulating assets, make sure they are saving and investing their money in a variety of accounts (IRAs, taxable accounts and Roth IRAs). This strategy can set up the client and the advisor for the most flexibility to cover the client’s expected and unexpected expenses in retirement. The CPA may become your best friend in developing the art and science behind the withdrawal plan.

 

Lisa Brown, CFP®, CIMA is a partner and wealth advisor at Brightworth.