What retirement funds to tap first

How you break open your nest egg can be just as important as how you grow it.

By the time most people retire, they've probably accumulated a portfolio that could include 401(k) plans, individual retirement accounts, mutual funds, and individual securities. Knowing what accounts to tap first, how much to take out, and anticipating the tax implications can be a daunting task.

Still, financial planners say there are some general guidelines that can help retirees craft a smart withdrawal plan.

"A place to start would be to maximize [tax] deferrals," says Frank Armstrong, a certified financial planner in Miami and author of "The Informed Investor."

Generally, experts say it's a good idea to hit your taxable accounts first. That way your tax-deferred assets, including your 401(k) and IRAs, can continue to grow tax-free.

T. Rowe Price Associates Inc. ran three withdrawal scenarios to illustrate the impact that a withdrawal strategy can have on retirement wealth. Each of the three examples started out with the same balances across the following accounts: a taxable mutual fund, a brokerage account with individual stocks, a traditional IRA, and a Roth IRA.

After making various assumptions for inflation, projected growth in the portfolio's accounts, withdrawal rates, and the individual's income tax bracket, the results showed that a hypothetical 65-year-old who withdrew funds over a 20-year period in a tax-efficient manner resulted in after-tax balances that were 26 percent higher than if the assets had been withdrawn in the reverse order. Account balances were also 17 percent more than the balance in the third scenario, where an equal amount was withdrawn from each account every year.

Taxable mutual-fund accounts should be tapped first, because they represent savings that aren't sheltered from taxes, recommend T. Rowe Price's financial planners. Savings from appreciated stock portfolios are next. You will still owe capital-gains taxes when you sell the shares, but you won't be subject to involuntary capital-gain distributions, as you would be when a fund manager sells stocks within a mutual fund.

Of the tax-deferred vehicles, look to traditional IRAs or company-sponsored retirement plans before a Roth IRA. Because taxes have already been paid on contributions to Roth IRAs, any withdrawals are income-tax free (if the account has been held at least five years and the owner is at least age 59-1/2). Moreover, these vehicles can be passed on to heirs, who may continue the assets' tax-deferred growth for decades.

When developing your withdrawal strategy, make sure to consider your tax bracket each year. If your income drops significantly after you retire, it may make sense to pull some money out of your tax-deferred accounts since withdrawals are subject to ordinary income-tax rates. Remember that required minimum distributions from your IRA, which begin after age 70-1/2, could be large enough to push you into a higher tax bracket, experts say.

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