Friends of ours are starting to think about retirement, they've been saving, the context is the mechanics for which order of types of accounts to take from. My approach may differ from other people in the industry but there is I believe a very basic or standard process for the decumulation phase. Once you understand the basics, you can then tweak to your circumstance when the time comes.
This list will start with the basic order and then a tweak that might serve as an example of how nuanced this can be. One thing that doesn't get talked about much on this front is that it is very plausible that the best strategy is to deplete one type of account entirely before moving on to the next one.
Go learn more and it can be complicated are really the only two takeaways from this list.
1. Taxable accounts
Typically it makes the most sense to take from joint, individual or trust accounts first. These are all taxable accounts. The idea is to let whatever types of IRA accounts you might have continue to grow tax deferred or tax free. Depleting your taxable investment account assuming there are IRA accounts of some kind is not a bad thing. It maximizes the the advantages of your IRA accounts. Yes you probably would still have a checking account and hopefully some sort of account for emergencies but in terms of taxable, investment accounts I would say the willingness to deplete it makes sense more often than not.
If you have to sell something to take money out, there will be a capital gains tax if you sold at a profit. Usually, long term capital gains are lower than income tax rates. Short term gains are usually taxed at your income rate.
2. Traditional/Rollover IRA
If you saved in a 401k at work, you'd typically roll it over into a Rollover IRA when you retire.. This number 2 on the list refers to any sort of retirement account where you got the tax benefit on the way in with your contributions. Money in this type of account can grow on a tax deferred basis. You got a deduction when you made your contributions and you will owe income tax when you take distributions but in between, there is no tax on the growth that occurs within the account.
If you have taxable accounts, then this would be the second type to draw from, starting once you've depleted the taxable account. If don't have taxable accounts then start with this type. Distributions from traditional/rollover IRAs are taxed as income. If you start taking money out of this type of account before you turn 59 1/2 you will have to pay a 10% penalty in addition to the income tax owed. There are a couple of exceptions to explore if your hand is forced.
Paying long term capital gains tax as mentioned in item number 1 on this list is usually preferable to paying income tax that you'd pay on an IRA distribution because it is usually lower.
It will frequently make sense to take from this type of account until it is depleted before moving on to a Roth account if you have one.
3. Roth IRA
When you contribute to a Roth IRA, there is no tax benefit on the contribution like the types of accounts mentioned in item number 2 on this list but there is no tax on withdrawals. As opposed to growth being tax deferred, the growth in your Roth is tax free. Having a Roth be the last of the accounts you take from maximizes the opportunity for tax free growth.
Money that was contributed to a Roth can be taken out without penalty before 59 1/2 in case of emergency unless it had been in there less than five years.
4. What about an HSA?
Health Savings Accounts (HSA) are kind of a hybrid. You get the same tax benefit on contributions as you do with 401ks/IRAs. You don't have to wait to take money out for qualified medical expenses, there is no tax/penalty for qualified medical expenses. The list of what is "qualified" is long and pretty liberal. Once you are 65 you can start to take money out for any reason. If, after 65, you take money out for a qualified medical expense there is no tax owed. If, after 65, you take money for something besides a qualified medical expense, you would pay tax on the withdrawal is if it was income, same as a traditional IRA.
One other huge benefit is you can take money out of your HSA and offset it against a qualified medical expense incurred many years ago. A couple of years ago I had my first colonoscopy. Having crappy insurance, I had to pay for it out of pocket. I believe it cost $1500 but either way, I have that receipt in a folder. At any point in the future, I can take $1500 out of our HSA to essentially reimburse myself for the $1500 I paid for my colonoscopy from January 2021.
My preference would be to take from an HSA as late as possible. Maybe, you have no health issues, no big expenses beyond your ability to pay out of pocket and then God forbid something happens when you're 85. The HSA money has been growing all that time and you can pay for whatever happens at 85 without having to pay taxes on the withdrawals versus the scenario of regular spending from the HSA early on, paying taxes on those withdrawals and then paying for your medical expense at 85 from your IRA and paying tax on that money too. There are hardship IRA withdrawals for medical expenses but the limits there are pretty low versus having a well funded HSA.
5. Inherited IRA
The law recently changed on these. The short version is that once you inherit an IRA you have to take a minimal amount out every year starting right away after inheriting it regardless of your age. Fortunately, there is no penalty if you are younger than 59 1/2, but you do pay income tax on the withdrawals. When you get to year 10 you have to empty out whatever is left in the account and pay tax on that balance if you haven't already done so.
Generically, it makes sense to just take out the minimum required from years 1-9 to max out the tax deferred growth opportunity.
An inherited IRA can be used as a bridge between retiring and starting withdrawals from your own IRA or Social Security. The money has to come out over a relatively short time frame.
Traditional/rollover IRAs are subject to required minimum distributions (RMD). Right now, RMDs start at age 72 but legislation has been passed that slowly pushes it up to 75 by 2033. Currently, year one of your RMD calls for withdrawing 3.65% of your IRA balance, going up slightly every year. Right now, the percentage for a 75 year old is 4.06% but that could be a different number by the time 2033 rolls around. You can obviously take more than the minimum but the penalty for taking less is severe.
The reason RMDs exist is so the government can tax your retirement savings.
There are many strategies around RMDs, the above is just the basics of how they work.
7. Lack of options
Not everyone will have all types of accounts of course and maybe their retirement situation will be a stretch, statistically, that describes most people. If you only have one type of account, then you gotta do what you gotta do.
8. A tweak
Here is one scenario where it might make sense to withdraw from a traditional/rollover IRA before you are required to. You stop working at some relatively young age, like maybe 60, you have large account balances that you can live on without any earned income or passive income. Traditional/rollover IRA distributions are taxed as income. The standard deduction in 2023 for married filing jointly is $27,700. If the only income might be an IRA distribution then the first $27,700 is tax free. If you took $50,000 out of your IRA at age 60 and that was your only income, then your effective federal tax rate would be 4.96% which is obviously very low. This could be repeated every year until age 70.
Waiting until 75 when you have to take from your IRA and you're getting Social Security could easily result in a higher tax rate. Assess your own numbers, the point here is just to create awareness that a retired person's effective tax rate could be lower for a time before going up.
Someone starting this at age 60 could repeat until age 70 which is the longest you can wait to take Social Security. The right combination of events combined with a thoughtful strategy could result in a lot less tax paid over the course of a retirement.
A tweak on this tweak could be to just withdraw an amount equal to the standard deduction and taking the rest of what you need from a taxable account. This tweak on a tweak might make more sense for a large IRA balance as opposed to a huge one.
Even if this scenario doesn't fit for you (it won't for me) it makes the point about spending time to understand how all of these variables work to find a scenario that might make sense for you.
9. Roth IRA conversions
I am not a fan of these.
You can convert some or all of a traditional/rollover IRA into a Roth. You'd pay the tax now, making a bet that your tax rate would actually be higher in the future. That is possible as outlined above but no common in my experience.
Similar to number 8 though, if you were really going to have zero income, instead of withdrawing up to $27,700 you could convert that much without paying tax or convert something like $50,000 and having that low effective tax rate.
A little more broadly, there are countless strategies for Roth conversions, probably entire books on the subject. Beyond the basics, it quickly gets into being a tool for estate planning.
This is all very generic. It is not advice, you should not take non-specific advice from a post you saw on the internet. This could be thought of as a prompt to go learn more to draw your own conclusions about what is best for you and maybe see if I got anything thing wrong here which could be the case. Go learn more and it can be complicated are really the only two takeaways from this list.