Fidelity recently released a new report in its “Viewpoints” series, called “Tax-Savvy Withdrawals In Retirement.” Here the firm discussed the ways retirees can boost their after-tax income. The good news, said the firm, is that there are several ways, especially when the retirees are using multiple account types, including traditional retirement accounts, Roth accounts and taxable accounts.

But then there’s some not-so-good news as well, says the firm: Choosing those accounts is complicated.

“There are several approaches you can take,” Fidelity says. “Traditionally, tax professionals suggest withdrawing first from taxable accounts, then tax-deferred accounts and finally Roth accounts where withdrawals are tax-free. The goal is to allow tax-deferred assets the opportunity to grow over more time.”

Fidelity recommends that single retirees draw proportionally off each of their multiple account types during retirement, but the firm adds this caveat: “If an investor anticipates having a relatively large amount of long-term capital gains from their investments—enough to reach the 15% long-term capital gain bracket threshold—there may be a more beneficial strategy.”

Specifically, the firm says retirees “may want to consider using their taxable accounts first to meet expenses. Once the taxable accounts are exhausted, the proportional approach can then be applied.” In the context of the entire article, it appears Fidelity is not actually recommending the exhaustion of the taxable account itself before applying the proportional approach, but instead only that retirees exhaust the recognized long-term capital gains inside the account during the year.  

But there’s another issue Fidelity doesn’t address that I want to take up here: Though the firm’s conclusions may be appropriate for many retired single individuals, they don’t address the unique tax needs of retired married couples—or their kids.

Why Couples Are Unique
Let’s assume, for example, that two recently retired spouses, both age 64, have a $2 million IRA, a $500,000 Roth IRA and $500,000 in other taxable accounts. They receive $60,000 annually in Social Security benefits (or approximately $51,000 after 18% in taxes are cut out, which include a 12% federal tax and an assumed 6% state income tax rate on the 85% taxable amount of Social Security). With their Social Security included, the couple need $120,000 a year to retire on (or $10,000 a month) after federal and state income tax, meaning they have to make up $69,000 in after-tax money from their own accounts.  

So which source or sources of retirement savings should the couple draw from first to reach that $69,000?

Under the proportional withdrawal system espoused by Fidelity, $13,000 would come from taxable accounts (for simplicity, we’re assuming that $13,000, all in long-term capital gains and qualified dividends, represents the total income generated by the couple’s taxable accounts during the year). Another $13,000 comes from the tax-free Roth IRA. Finally, $52,000 comes from the couple’s taxable IRA, which after the 18% in combined federal and state taxes becomes $43,000.  

But remember that the couple (including the surviving spouse) must begin taking required minimum distributions from their taxable IRA when they turn 75. If we assume that there is just 5% growth inside the IRA over the next 11 years, these distributions would push the couple’s marginal federal income tax bracket from 12% to 22% or higher (when we use 2023 tax brackets, adjusted for inflation). After the first spouse dies, these RMDs and the so-called “single filer penalty” (a quirk in the federal tax law math that disadvantages the survivor) would likely throw the surviving spouse into the higher tax bracket of 24% or even into a higher one, an increase of 100% or more over the couple’s current federal marginal income tax bracket of 12%.

Bearing all that in mind, will the proportional withdrawal system advocated by Fidelity produce the optimal long-term after-tax results in this situation? Why would the couple not instead primarily use proceeds from their taxable IRA for those 11 years? As long as these proceeds don’t trigger taxes on the couple’s qualified dividends and long-term capital gains, this step would both significantly minimize the total income taxes on the couple’s taxable IRA in the long run and fully preserve the couple’s tax-free Roth IRA until a later date—when the Roth’s tax-free benefit can be better leveraged.

The $69,000 shortfall in the couple’s annual after-tax retirement needs in this example could thus be satisfied each year first with the total of their long-term capital gains and other income generated by their taxable account for the year, second with taxable IRA receipts (to the extent these do not push the couple into the 22% federal income tax bracket or cause the couple’s long-term capital gains and qualified dividends to be subject to tax), and third with additional cash or other proceeds from the couple’s taxable account.   

For example, if their taxable account generated a total of $10,000 of long-term capital gains and qualified dividends and no other taxable income during the year, they can put that toward their needs and then make up the $59,000 remaining shortfall with $56,000 of IRA proceeds ($46,000 after taxes) and $13,000 of additional cash from their taxable account.

By paying attention to tax brackets, the couple in this example see better after-tax income tax results. Over the long run, their IRA will get hit with a significantly lower average federal income tax. They also preserve their tax-free long-term capital gain and qualified dividend treatment for at least 11 years. And they can maximize the benefit of their tax-free Roth IRA by letting it grow for a later day, when either the couple or the surviving spouse is likely to be in a much higher marginal federal income tax bracket.

The couple’s children will see tax benefits from this approach as well. The kids must withdraw from their parents’ taxable IRAs over the 10 years after the parents pass on. Those are years in which the kids are likely to be in their peak income tax brackets. That means the kids will benefit if the value of their parents’ taxable IRA is smaller while the value of their parents’ tax-free Roth IRA is larger. Under current tax law future income taxes on the taxable accounts the children inherit from their parents are also minimized using this approach, since any taxable appreciation inherent in the underlying value of the taxable accounts as of the parents’ death is eliminated when the mother and father pass on, through the tax concept known as “income tax basis step-up.”

It’s All About Income Tax Brackets
In short, when it comes to retirement account withdrawals for a married couple, it’s all about tax brackets—the couple’s, the surviving spouse’s and the children’s. Although the circumstances are going to be different for every client, advisors must recognize a few facts for the best results:   

1. A retired married couple is going to be in a higher income tax bracket once they are forced to take required minimum distributions.

2. The surviving spouse is likely going to be taxed at a higher federal income tax rate than the couple was while they were both living.

3. The couple’s children, over the 10 years after their parents’ passing, on average are likely to be in higher federal income tax brackets than their parents were while they were retired and still living.

The best retirement savings withdrawal plan for retired married couples must therefore be sensitive not only to the tax bracket of the married couple today, but also to the couple’s potential tax bracket in the future, after their required minimum distributions begin, as well as to the likely higher future tax brackets of the surviving spouse and the couple’s children.

James G. Blase, CPA, JD, LLM, has more than 40 years of experience as an estate planning attorney. He practices in St. Louis. He is also a professor of estate planning at the UCLA Extension’s Accelerated Personal Financial Planning Program.