Spending from a portfolio in retirement can get complicated quickly. In addition Structuring investments to support cash flows And calibrate safe spending rateRetirees must also consider the tax consequences of their spending decisions. In this quote from my new book, How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement, I asked author and tax and Social Security expert Mike Piper to discuss tax-efficient withdrawal ordering, as well as considerations when converting tax-deferred accounts to Roth.

Christine Benz: Let’s talk about the tax consequences of withdrawing money in retirement. For many households, early retirement years are low-tax years. Can you talk about why this is?

Mike Piper: Work income is gone, Social Security hasn’t started yet, and RMDs haven’t started yet. Unless you have a defined benefit pension, the only automatic income you will receive will usually be interest or dividends from your taxable assets. Your income is generally quite low in those years, except for amounts you receive from deferred tax accounts.

Christine: Okay, so if I’m just starting to retire and need to spend money, how do I know which accounts to get into first? What makes the most sense from a tax perspective?

-Mike: In tax planning you almost always have to say “it depends.” But not in this case. The first dollar you spend each year in retirement is your checking account dollar: everything in the checking account and everything that automatically comes into the checking account. This could be interest from your taxable assets, dividends from your taxable assets, earned income (if you still have any), required minimum distributions, Social Security, retirement income, and all of the above.

We want to spend these dollars first because spending does not create any additional tax costs. And since these are taxable account dollars, they’re not very tax efficient from an investment standpoint.

When we spend by checking the dollars in the account, it does not create taxable income. That’s the whole idea. So sometimes this leaves you with a low taxable income for that year. The best way to take advantage of this is to do Roth conversions.

Christine: Okay, so put the checking account dollars at the top of the line. Assuming I need additional funds for my living expenses, where should I turn next?

-Mike: The next dollars you have access to after the checking account are taxable dollars where you have an unrealized loss on an investment. There is no tax cost to selling the position.

It gets harder from here on out because we have three options. We can spend from tax-deferred accounts, we can spend from a Roth, or we can spend taxable dollars on which we can earn taxable income.

The question of whether Roth or tax deferred depends on the current tax rate versus the future tax rate. This seems simple, but there are a few “gotcha” provisions that can cause your tax rate to differ from your tax bracket.

The other thing to remember is that the future tax rate may not be what you expect for a few reasons. First, if we are talking about a married couple, there will often be years when only one of them is alive. This is important because it means the surviving spouse only has half as much room in each tax bracket and half the standard deduction that a married couple filing jointly has, but generally they will have more than half the income because the portfolio is still the same. there, doing what he does, etc. This generally means they will have a higher tax rate in those years.

Another point about the future tax rate is this; When we make the “pay tax now, pay tax later” assessment, it might be someone else’s tax rate. Your heirs may be taxed if they inherit traditional IRA assets from you. This tax rate will generally be high because any beneficiary other than your spouse will typically have to distribute the account over ten years. So they will only owe taxes on the deferred tax balance for ten years, plus any earnings they have. Statistically speaking, this inheritance is most likely to occur in years when earnings are highest. So there will usually be a fairly high tax rate.

Christine: So, because of all these additional considerations, it’s not easy to decide whether to spend traditional tax-deferred assets or Roth assets. How about the third option, which is to spend taxable assets that you have earned and will owe taxes on when you sell them?

-Mike: The main things you need to consider when deciding whether it makes sense to sell assets from a taxable account to meet spending needs are the amount of capital gain you will realize by doing so and whether the gain will be long-term or short-term. If it’s short-term, you probably don’t want to sell these assets. Leave them alone until you realize a long-term capital gain.

Assuming you can make a long-term gain, how large is the gain relative to the current value of the asset? If it’s only up a few percent since you bought it, that’s a pretty modest gain. You can sell it and the tax cost won’t be that much. It’s almost like checking the dollars in the account. You’ll lose some on taxes, but that’s not a big deal.

If a position has risen too high, it is more difficult to decide. Such assets can be valuable for heirs or charities to inherit because they can completely avoid tax on appreciated taxable assets.

So the question is: Do you have a chance of giving these assets away later? If so, you probably shouldn’t sell them. You should probably go ahead and spend retirement account dollars instead.

Christine: You mentioned earlier that early retirement years are generally low tax years, and this seems like a good time to convert traditional IRA balances to a Roth because you may owe less in taxes. How should people decide whether to convert and how much to convert?

-Mike: There are a few things going on with Roth conversions.

The first takes up the whole debate because it is easy to understand and is the only thing that will always apply. When you convert, instead of paying tax later, you pay tax now at the current tax rate on your conversion. This could be good, it could be bad. This depends on the current tax rate and the future tax rate, and this is more complicated than it seems. This is definitely a case-by-case thing, as it largely depends on how many of these “gotcha” provisions apply to you. For example, if you have children studying at university, conversion may not be recommended. That’s because the American Opportunity Tax Credit phases out if your income is above certain levels, and it phases out over a relatively short period of time. Before you convert, ask how many things like this apply to you and what the actual tax rate will be. You need to remember all these various caveats and complicating factors. A transformation can be good or bad.

The second thing that happens when you do a Roth conversion is that you have to pay taxes. If you have taxable account dollars that you can use to pay the conversion tax, that’s by definition a good thing. This includes interest etc. It is money that grows slower because you have to pay taxes on it.

The third thing that happens when you do a Roth conversion has to do with required minimum distributions. If you’re in a household that won’t have to spend your entire RMD each year, you can reinvest some of that money outside of a retirement account.

And because you’re in a future taxable account, that money will potentially be subject to a tax cost every year for the rest of your life. How effective this will be depends on your life expectancy: what kind of health you are in and how old you are now. If you’re doing a Roth conversion, one good thing that happens is you shrink the RMD. Essentially, your money stays in a Roth account instead of a taxable account where it will be subject to a tax burden.

The fourth thing applies to fewer people. When you do a conversion and pay the taxes due, you reduce the total dollar amount, and that’s important from a property tax perspective. Of course, the federal estate tax applies to a very small percentage of people these days. However, there are some states that impose property taxes, and their thresholds are generally much lower. Given the choice between $100,000 in a traditional IRA or $80,000 in a Roth IRA, $80,000 is less than $100,000, meaning a smaller gross estate. Estate taxes don’t care whether it’s Roth or traditional.

Reproduced with permission from the publisher, Harriman House Ltd. How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement By Christine Benz. Copyright (c) MMXXIV Morningstar, Inc.