The Sequence of Investment Withdrawals

Where Do I Get Investing Topic Ideas for this Blog?

Most of my investing newsletter ideas come from a review of my own portfolio and events that happen with a position. Those can be dividend announcements, large increases in the value of an asset, a high-level overview of the progress towards a goal (like dividend growth), or a new stock or ETF idea from another author on Seeking Alpha.

I am sometimes comparing multiple similar investments. Seeking Alpha is a great tool for this type of research and often causes me to look at an investment I never heard of before.

I’m always on the lookout for what I call “easy income” and for investments that can deliver dividend growth. Because I trade options, I also look for opportunities to gain additional income from covered call options trades or by selling a cash covered put option to get income and potentially acquire shares of an investment I want to own.

Sometimes, however, my best ideas come from discussions with my readers or from questions they ask. That is today’s focus.

Unfortunately, I forgot to note who asked the question and I could not find the email that came. If you are the one who asked the question, thank you!

The Question Asked By A Reader

“I read almost all your newsletters, and I enjoy them. I shared one with a friend who is now also subscribing. One idea for a future topic might be in which order one should take distributions based on not only a tax perspective but from an inheritance perspective. After quick read up, I believe it is taxable IRAs first since they don’t receive step-up cost basis.”

The Types of Accounts We Own

Cindie and I have a total of eight accounts at Fidelity Investments. I also have a very small experimental account at Robinhood. (I don’t recommend Robinhood, as it is a very weak platform.) The eight accounts at Fidelity include three brokerage accounts, one checking/savings account, two traditional IRAs, and two ROTH accounts.

To say it another way, four of the accounts are taxable, two are tax-deferred, and two are tax-free. As a result, some decisions are made based on the type of account. This includes what I do with REIT investments, what my tax strategy will be, and what types of investments I will avoid.

Investments I Avoid for Income Tax Simplicity

When it comes to taxable accounts, it is generally wise to avoid REIT investments if you are trying to keep your income taxes to a minimum. “One of the core principles of income investing is minimizing taxes. For this reason, allocating high-dividend REITs to tax-advantaged accounts (like ROTH and traditional IRAs) is a prudent step in ensuring you don’t pay more than you have to.” SOURCE: Dividend.com

Another investment I tend to avoid (but used to own) is called a Master Limited Partnership. This is primarily because they are a nightmare for tax filing and are often slow to send out their yearend K-1 tax forms.

Investopedia shares some helpful reminders about MLPs: “Ordinary dividends are required to be filed on Form 1099-DIV, but distributions from an MLP must be filed via Form K-1. This is much more complicated. That being the case, your accountant will charge you more for the work they have to do. This may just be a few hundred dollars, but depending on the size of your investment in an MLP, this can add up, since it must be done on an annual basis.” “Another negative here is that many MLPs operate in more than one state. This means you will have to file in those different states. Fortunately, the state where you will find a lot of MLP opportunities does not have a state income tax: Texas.” I want easy income that doesn’t require a complicated tax return.

The Size of the Account Can Drive Tax Perspectives

Our three largest accounts, from largest to smallest are my traditional “rollover” IRA, my ROTH IRA, and my wife’s ROTH IRA. My traditional IRA is more than twice the size of my ROTH IRA. My ROTH IRA is about four times the size of my wife’s ROTH IRA. The other accounts are only about eight percent of the total $3.5M in retirement assets.

As a reminder, most of the income is not for our needs or wants. The goal is to increase in generosity rather than to build bigger barns. When we receive our blessings from the Father’s gracious hand, we want to send them on to others to bless their lives. This includes a ministry that serves homeless men and women, overseas missionaries and pastors, a local pregnancy care center, our state’s camp for youth and families, and, of course, our local church. This helps minimize taxes and keeps our focus on treasures in heaven. (Matthew 6:19-21; see The Treasure Principle by Randy Alcorn.)

Withdrawal Principles for Taxable and Tax-Free Accounts

So, having said all that, “in which order one should take distributions based on not only a tax perspective but from an inheritance perspective?”

Each person’s approach might differ slightly, but here are my thoughts.

For taxable accounts, I prefer to keep the balances to a minimum, so the income taxes are just a minor consideration. I would be inclined to withdraw from those accounts first, but only the cash portions.

For ROTH accounts, I don’t generally take distributions. I view these accounts as both our “long-term care” accounts and our “emergency backup fund.” They also become a great base for our estate plan. I want to avoid adding to the tax burden of our heirs. It should be noted that my wife is the primary beneficiary of my ROTH and IRA accounts. We also have a “Winquist Revocable Trust” which is the secondary beneficiary. Our children are the successor trustees of the trust.

The Difference Between a Spouse and Non-Spouse Beneficiary

“Roth IRA account holders should name a beneficiary so that the money they saved to the person they select. If you inherit a Roth IRA as a spouse, you can treat the account as your own. Most non-spousal beneficiaries must make distributions and deplete the account within 10 years.” SOURCE: Investopedia

Withdrawal Principles for Tax-Deferred Accounts

There are a couple of pieces of the puzzle for these accounts. They include more acronyms like QCDs and RMDs.

• RMDs are a Federal and State withdrawal requirement. As we withdraw funds from our traditional IRA accounts, we have to pay income taxes. The goal is to reduce income taxes by giving all of the RMD and then even more as a Qualified Charitable Distribution up to the IRS QCD limit for each year. (The 2024 QCD limit is $105,000. Prior to that, the QCD limit was $100,000 since 2006.)
• ROTH Conversions: After the RMD requirement is met by charitable giving, the next step is to look for ways to move specific ETF, stock, BDC, and REIT investments to my ROTH IRA. This accomplishes two things. It increases the tax-free income base and decreases the IRA account value to minimize future RMD dollars. This increases the amount our estate will leave to our heirs in a way that lessens the tax burdens they might face.

Final Analysis

In the end, the best strategy is one that maximizes income, increases our charitable giving, reduces income tax complexity, and shows generosity to our children and grandchildren. Therefore, it seems prudent to me to take the largest withdrawals from my traditional IRA via QCDs and by moving assets to my ROTH IRA.

I tend to agree with the author of the question. Start with the taxable IRAs first.

Investopedia has a helpful article for parents to read regarding passing on ROTH assets to children. Here is the LINK.