Three steps for tax-savvy portfolio withdrawals

When it comes to decumulation, where should you pull assets from first?

The shift from asset accumulation to asset decumulation

The time is finally here. You have been building up your portfolio balances for years and are finally ready to start deploying this wealth to help fund a new chapter in your life. Whether you’ll be turning to your investment portfolio as your main source of income or using it to supplement other funding sources, understanding how to prioritize which accounts from which to draw assets first can be critical from a tax perspective. This article explores a three-step approach to asset decumulation (the process of deploying accumulated wealth to fund your lifestyle) with a tax-efficient mindset.

Step 1. Develop a spending plan

Consider your intent for your wealth: Where do you want your portfolio assets to end up over the long term? Do you want or need to increase your wealth, even if it means scaling back spending? Do you want to preserve principal? Are you comfortable with a partial or even total drawdown of your wealth? Establishing your primary intent can help empower your financial decision making about spending and lifestyle goals. Learn more about the power of intent.

Understand your spending needs: First, think through the areas of your life that you will need to fund. Major categories can include lifestyle, health care, travel, education costs or gifts for family members and charitable giving. Also consider how these expenses may change over time. Learn more about building a lifestyle bucket to help fund your lifestyle needs and wants over your lifetime.

Have a plan in case of disruptions: Consider how market events might affect your short-term spending approach in any given year. This could be from a steep decline in asset prices or some other major economic disruption. Learn more about how a liquidity bucket may help avoid disruptions.

Step 2. Determine your funding sources

Non-portfolio income: Now that you have a spending target, calculate how much you can expect in annual non-portfolio income. This can include “guaranteed income” streams, such as Social Security, pensions and annuities. Are there ways to optimize these sources? For example, does it make sense to delay starting to take Social Security to maximize your benefits? Other sources of non-portfolio income may include deferred compensation, consulting income, real estate income, trust distributions and more.

Your annual withdrawal target: Your total non-portfolio income may not cover your entire spending target, and you will need to supplement it with withdrawals from your portfolio. Subtract your total annual non-portfolio income from your annual spending target. This is your annual withdrawal target.

Step 3. Set a tax-smart withdrawal strategy

Now that you know how much you need to withdraw, you will need to decide where to withdraw it from. Many investors enter the decumulation phase with multiple accounts that tend to fall into three broad groups from an income tax perspective: taxable, tax-deferred and tax-free. Optimizing withdrawal sequencing from these accounts for tax efficiency usually depends on your tax status. Other factors to consider are your age, whether you expect to pay lower taxes in the future, the types of assets you own and your main objectives (e.g., minimizing current income taxes, funding charitable goals, minimizing income taxes or maximizing benefits for heirs or a combination of objectives).

If you are in the top tax bracket: Conventional wisdom holds that your withdrawals should start with required minimum distributions (RMDs) from tax-deferred retirement accounts. You are generally required to take RMDs from company-sponsored retirement plans and IRAs (not Roth IRAs) if you are older than age 72.

Any additional withdrawals should come from taxable accounts. These withdrawals are generally subject to capital gains tax on realized appreciation, with long-term capital gains tax rates ranging from 0% to 20%, depending on income level (3.8% Medicare surtax may also apply for high-income earners). That is considerably lower than the ordinary income tax rates that tax-deferred account withdrawals are generally subject to and offers two major benefits: 1) a lower current tax bill and 2) more time for tax-advantaged growth and compounding for tax-deferred and tax-free assets.

Next comes other tax-deferred accounts, followed by tax-free accounts. Drawing from tax-deferred accounts first allows you to keep tax-free accounts, such as Roth IRAs—which can be great to leave to heirs—for last. Learn more if a Roth IRA conversion may make sense.

If you are not in the top tax bracket: Ideal withdrawal sequencing is generally similar, but it may make sense to move up the priority of tax-free accounts, since drawing from tax-deferred assets may place you in a higher tax bracket.

Through general guidelines, this chart shows that ideal withdrawal sequence depends on tax status. If you are in the top tax bracket: 1) take RMDs, 2) taxable accounts, 3) tax-deferred accounts, then 4) tax-free accounts. If you are not in the top tax bracket: 1) Take RMDs, 2) taxable accounts, 3) tax-free accounts, then 4) tax-deferred accounts.

Potential exceptions: There are circumstances when modifications to this general withdrawal sequencing may make sense.

This table shows potential exceptions when modifications to the general withdrawal sequencing (Chart 1) make sense. If you’re still working, you may want to delay RMDs. If you hold low-basis assets in taxable accounts, you may want to consider leaving these assets alone to take advantage of stepped-up basis or use for charitable gifting. If you have an unusually low-income or high-deduction year, you may want to withdraw from tax-deferred accounts earlier. If you have an unusually high-income or low-deduction year, you may want to withdraw from tax-free accounts earlier. If you expect to be subject to lower tax rates later in life, or your heirs are subject to lower tax rates, you may want to withdraw from tax-free accounts earlier.

We can help

Determining the right sequencing for your unique situation can be complex. Your J.P. Morgan team can help you think through each of these steps more fully to develop a practical, personalized withdrawal strategy designed for your specific needs and goals.

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