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Which Funds To Tap In Retirement?

Unless you’re independently wealthy, eventually you’ll have to start using some of the money you’ve saved for retirement. After all, that’s what it’s there for, so there’s nothing wrong with using those assets. But it could create problems if you spend the “wrong” funds first.

For purposes of deciding what to spend when, let’s divide your retirement assets into three baskets: personal accounts, such as stock and bond holdings that are currently taxable; traditional IRAs and qualified retirement plans, such as a 401(k), income from which is typically taxed only when withdrawn during retirement; and non-taxable accounts, such as Roth IRAs.

The rule of thumb is to withdraw funds from your personal accounts first, your traditional IRAs and qualified plans second, and your Roth IRAs third. This spending order is likely to produce the lowest possible tax bill, promote more tax-deferred growth, and allow you to milk your assets for as long as possible. If you were to spend your money in the reverse order, you would pay more in taxes each year, thereby siphoning off funds that could have been reinvested and reducing your overall nest egg—and maybe even exhausting all your funds during your lifetime.

The preferred “spending order” in retirement is only reinforced by tax law changes that look effect in 2013. Under the American Taxpayer Relief Act (ATRA),  a new top tax bracket of 39.6% was added on top of the previous top tax rate of 35%. Furthermore, ATRA increases the maximum 15% tax rate on long-term capital gains and qualified dividends that applies for most investors (0% for low-income investors) to 20% for those in the top 39.6% bracket.

To add insult to injury for high-income investors, a 3.8% Medicare surtax debuted in 2013. Under this special tax law provision, an investor must pay the 3.8% surtax on the lesser of “net investment income” or the amount by which modified adjusted gross income (MAGI) exceeds a threshold of $200,000 for single filers or $250,000 for joint filers. “Net investment income” includes most forms of taxable income, such as capital gains and dividends, but not distributions from qualified retirement plans and IRAs or tax-exempt income. Still, some of those items may increase your MAGI for this calculation.

Despite these tax-based incentives, remember that you generally have to begin taking “required minimum distributions” (RMDs) from qualified retirement plans and IRAs—but not from Roth IRAs—after age 70½. If you’ve reached that point, you may as well take the RMD amounts first before the regular sequence.

Last but not least: Everyone is different, so you may have valid reasons for changing the usual order. If you have any questions about your situation, please let us know.