Q: I just retired. What’s the smartest way to draw income from my portfolio?

You have a half dozen or so accounts ranging from your 401(k) to your IRA, to your Roth IRA, to your brokerage accounts, each with different rules and regulations. Each also holds a variety of investments, from individual stocks and bonds to mutual funds and ETFs. So, yes—it can be very confusing to know what to take from where.

Thankfully, my colleagues at the Schwab Center for Financial Research have created a priority system. Their goal is to help you make decisions that minimize your taxes while also protecting your portfolio for the future. In Question 22, #7, on page 195, I gave you the CliffsNotes version. Now I’ll go into some more depth.

Before I get started, though, I want to reiterate a few essentials for managing your portfolio at this point in your life:

Give very careful thought to your asset allocation. You probably shouldn’t be taking on as much risk as you did when you were younger, but I caution you not to avoid stocks, either.
Figure out how much money you need to withdraw to supplement your income from Social Security, a pension, real estate investments, or any other source. If you want your portfolio to last for thirty years, it’s prudent to cap withdrawals at roughly 4 percent.
Keep your most tax-efficient investments in your taxable accounts and your least tax-efficient investments in your tax-deferred accounts. See Question 5, page 69.

Caution: Stocks are the best protection against inflation—so unless you have a very large portfolio, and are certain that you can live on fixed income alone, don’t avoid stocks.

1. First, Draw Down Principal from Maturing Bonds and CDs

In Question 22 I talked about creating a short-term ladder of bonds or CDs. If you’ve done this, your first step can be to tap the principal of each bond as it matures. If this is enough to supplement your other income, congratulations—you’re done. Chances are, though, that you’ll need to press on.

2. If You’re 70½ or Older, Take Your RMDs

Once you reach 70½, the IRS requires you to take a yearly required minimum distribution (RMD) from all of your retirement accounts except a Roth IRA (a Roth 401(k) and a Roth 403(b) have RMDs that kick in once you turn 70½—unless you’re still working). Whether you need this money or not, you’ve still got to take it.

The Skinny on RMDs

Starting at age 70½ you are required to begin withdrawing money from most of your retirement accounts—traditional, SEP and SIMPLE IRAs, and 401(k)s. (However, you can delay taking an RMD from your 401(k) if you’re still employed.) If you have a Roth IRA, you’re in the clear. There is no RMD for a Roth IRA.

While the concept of an RMD is simple, there are rules you need to abide by to avoid substantial penalties. Here are a few things to keep in mind.

Don’t be late: Technically, you have until the year after you turn 70½ to take your first RMD. The IRS gives you the choice of taking it either by the end of the year you turn 70½ or by April 1 of the year following. For instance, if your 70th birthday is on December 1, 2013, you turn 70½ on June 1, 2014, so you could delay taking your first RMD until April 1, 2015. All subsequent RMDs must be taken by December 31 of each year.

This timing is no casual matter. The penalty for failure to take your RMD on time is 50 percent of the amount that should have been withdrawn.

Factor in taxes: While delaying your first RMD may seem to make sense if you don’t need the money, there’s another consideration. Even if you wait until the April 1 deadline, you still have to take your second RMD by December 31 of that same year—two distributions in one year. Distributions are taxed as ordinary income, so taking two in one year could bump you into a higher tax bracket.

Calculate correctly: You must calculate an RMD for each of your retirement accounts, not just one. Your RMD is based on the value of your account on December 31 of the previous year, so start by listing the fair market value of your IRAs as of that date. Next, determine your life expectancy using appropriate Life Expectancy Tables from the IRS. You can find them in Publication 590, available at IRS.gov. The basic formula: Fair market value divided by life expectancy equals RMD.

Caution: Your RMD will change every year, so don’t just use last year’s figures. Given the size of the penalty, you want to get it right!

Example: Say your IRA is valued at $100,000. Using the Uniform Lifetime Table, the first year you would divide that by 27.4 years. Your first RMD would be $3,649.64.

To make it easy, the financial institution where you keep your IRA may calculate your RMD for you (Schwab does!), but it’s good to know the formula yourself.

Decide how to take your distribution: While you calculate an RMD for each retirement account, you don’t have to take the distribution specifically from each. You can take the sum total of your RMDs from any one account, making it a much simpler process. In fact, you can simply add up the value of all of your accounts and do just one calculation.

There’s an exception, however, for 401(k)s and most other types of employer-sponsored retirement accounts. If you have more than one, you have to calculate and take a withdrawal from each individual account.

Consider consolidating: If you have just one retirement account with one financial institution, taking your yearly RMD can be a pretty simple process. But if you have several accounts at various banks or brokerages, you might want to consolidate everything in one place. You could also consider rolling any 401(k)s still at a former employer into an IRA. This would make it easier to calculate your total RMD as well as to determine which account to tap for the distribution.

Your strategy should be to sell the lowest-rated securities in your overweighted asset classes. If your RMD satisfies your income needs, you won’t have to tap into your taxable accounts. Nonetheless, your decision on what to sell should be made in the context of all of your accounts. In other words, before you decide what to sell from your IRA, look to where you’re under- or overweighted in your entire portfolio.

Smart Move: Schwab Equity Ratings, which range from a letter grade of A to F, are one way to quickly evaluate stocks. This can be a great starting point for your deeper research.

Example: Let’s say that your RMD is $25,000, which covers all the additional income you need. After reviewing the breakdown of all of your accounts, you see that you are overweighted in large-cap domestic stocks and international stocks and underweighted in bonds. By selling your lowest-rated large-cap and international stocks from your IRA, you get your entire portfolio back to your target allocation.

See “Withdrawing Income and Rebalancing Your Portfolio” on pages 203–204 for an example of how the numbers can work in your overall portfolio.

Smart Move: Just because you have to withdraw an RMD doesn’t mean that you have to spend it. If you don’t need the money now, you can deposit it into your brokerage or savings account for future use.

3. Sell Overweighted and Lower-Rated Investments from Your Taxable Accounts

If you need to withdraw more than your RMD, look to your taxable accounts next. Withdrawals from taxable accounts are taxed as capital gains rather than as ordinary income, with a preferential rate for gains on investments you’ve owned for more than a year. Of course, if you’ve lost confidence in any of your other investments, they are also good sell candidates.

Smart Move: Try to postpone selling appreciated investments that you’ve owned for less than a year. You need to have owned the security for one year and one day to get the long-term capital gains tax rate.

If you have to sell high-rated securities, you can minimize your tax bill by starting with those that will generate a loss, before you sell those that will generate a gain. Also, whenever you’re considering selling an investment in a taxable account, think about matching gains to losses as a way to control your taxes. See Question 25, pages 220–221, for more about this process, known as tax-loss harvesting.

Withdrawing Income and Rebalancing Your Portfolio, All in One

It’s smart to plan your withdrawals at the same time that you rebalance your portfolio. Once you’ve decided which asset class or classes need trimming, look at your lowest-rated holdings for potential sales.

As a simplified example, let’s say that you’re a new retiree with the following moderate portfolio. You intend to withdraw 4 percent, or $40,000, at the end of the year.

Investment	Taxable Account	IRA	Total Portfolio	Allocation
Large-cap stocks	$350,000	0	$350,000	35%
Mid/small-cap stocks	$100,000	0	$100,000	10%
International stocks	$150,000	0	$150,000	15%
Taxable bonds	0	$350,000	$350,000	35%
Money market funds	$50,000	0	$50,000	5%
Total	$650,000	$350,000	$1,000,000	100%

At the end of the year, your portfolio looks like this:

Investment	Taxable Account	IRA	Total Portfolio	Allocation
Large-cap stocks	$410,000	0	$410,000	37.3%
Mid/small-cap stocks	$120,000	0	$120,000	10.9%
International stocks	$178,000	0	$178,000	16.2%
Taxable bonds	0	$340,000	$340,000	30.9%
Money market funds	$52,000	0	$52,000	4.7%
Total	$760,000	$340,000	$1,100,000	100%

As you can see, your domestic and international stocks had a good year, but your bonds were down. By selling some stocks and adding to your bonds, you can rebalance (getting back to your target allocation) and generate your $40,000 at the same time.

Investment	Taxable Account	IRA	Cash Out (or In)	Total Portfolio	Allocation
Large-cap stocks	$410,000	0	$39,000	$371,000	35%
Mid/small-cap stocks	$120,000	0	$14,000	$106,000	10%
International stocks	$178,000	0	$19,000	$159,000	15%
Taxable bonds	0	$340,000	($31,000)	$371,000	35%
Money market funds	$52,000	0	($1,000)	$53,000	5%
Total	$760,000	$340,000	$40,000	$1,060,000	100%

For more on rebalancing, see Question 5, pages 71–73.

Talk to an Expert: You may become quite adept at rebalancing your portfolio once you’ve been through it a few times. As a new retiree, however, it can make sense to enlist the help of a trusted advisor.

4. Sell Overweighted and Lower-Rated Assets from Your Tax-Deferred Accounts

Generally, your tax-deferred accounts will be your last place to look for income, starting with outsized asset classes and lower-rated securities. If you’re 70½ or older, you know that at a minimum you have to withdraw your RMD. But you can take more if you need it. Or, if you’re younger than 70½, you may still want to tap your tax-deferred account despite the fact that you will be paying taxes at your ordinary income tax rate.

It’s often smart to tap into your Roth IRA last. Not only can it continue to grow without taxes, but you’ll be able to withdraw that money tax-free at a later date. Roth IRAs are also a great way to pass on money tax-free to your heirs. In fact, some retirees may want to convert all or a portion of their IRA to a Roth IRA.

Does a Roth Conversion Make Sense?

Converting your traditional IRA to a Roth IRA means coughing up taxes now in order to avoid taxes later. Usually we think of this as a strategy better suited for younger investors, but it may make sense for you as well.

Recapping a few basics (for more details, see Question 4, page 32):

Money put into a traditional IRA is generally tax-deductible, but you pay ordinary income tax rates on withdrawals.
Money put into a Roth IRA is not tax-deductible, but you can withdraw earnings tax-free if you’re at least 59½ and have held the account for at least five years. You don’t have to take an RMD.

As a result:

Roth IRAs generally make the most sense for those with a long time horizon who believe that they will be in a higher tax bracket when they withdraw funds.
Traditional IRAs generally make the most sense for those with a shorter time horizon who believe that they will be in a lower tax bracket when they withdraw funds.

As a retiree, you have less time for tax-deferred growth and probably a lower likelihood for a higher tax bracket in the future. Still, a conversion may make sense. Let’s take a closer look at some potential pros and the one big con.

Pros

If you’re planning to leave your IRA assets to your heirs, it’s a real plus for them. In effect, you’d be prepaying the income taxes on their behalf without it being a taxable gift. Your heirs can then take income-tax-free withdrawals during their lifetimes.
The tax you pay up front on the conversion reduces your gross taxable estate, especially when you pay from assets other than your IRA.
There is no RMD for a Roth IRA. If your current RMD is more than you need or want, converting to a Roth will allow you to take less—preserving more for your heirs.
If you pay the tax now, you can make future withdrawals tax-free.

Con

The biggest deterrent to converting to a Roth is that you have to pay income taxes up front. Note in particular:

The assets you convert are added to your gross income in the year you make the conversion, so you could be bumped into a higher tax bracket.
Ideally you should have the cash on hand to pay the income tax. If you have to sell appreciated assets to pay the tax, you’ll also have to pay capital gains tax. If you have to pay the tax from your IRA, you lose the potential benefit of tax-free growth on the amount.

Also realize that a Roth conversion isn’t an all-or-nothing proposition. You can choose to convert just a portion of your IRA, and you can also convert portions over a number of years.

Caution: If you decide to convert to a Roth, be sure to take your RMD for the year before completing the conversion. RMDs are calculated based on your traditional IRA balance at the end of the previous year and cannot be part of a Roth conversion.

Important Disclosure
Schwab Equity Ratings and the general buy/hold/sell guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment, or other objectives or needs of, and may not be suitable for, any particular investor or client. Investors and clients should consider Schwab Equity Ratings as only a single factor in making their investment decision while taking into account the current market environment.

Part III: Life in Retirement, Question 23