A Cash Flow Dilemma – Should I take distributions from my IRA or from my taxable account?

I know, long title… but I wanted to fully describe the content of this article, which is to answer the following dilemma:

I have a sizable IRA and a sizable taxable account that holds appreciated stocks.  I am in need of additional funds (above any RMD required from the IRA) – so which account should I draw the additional funds from?

Taxable account!

There is one school of thought that says you should take the additional funds from the taxable account, because at today’s capital gains rates you will save a bundle in taxes.

The capital gains on your appreciated stock will at most be taxed at 15% (through the end of 2010) or 20% under present law (beginning in 2011).  When you compare this tax rate to the ordinary income tax rates, which top out at 36% for 2010 and will rise to at least 39.6% in 2011, this is a bargain.  This also assumes that you’ve held the stock for at least 12 months, otherwise your gains would be taxed at your ordinary income tax rate.

It’s a no-brainer, you should always take this extra money from the taxable account, right?  No, not always…

IRA account!

There is another school of thought that says, since appreciated stock receives a step-up in basis, you should leave those funds alone and plan to leave them to your heirs at your death.  This way the appreciated portion is never taxed.

Note – this particular school of thought loses its value at present due to the estate tax being currently eliminated, which effectively eliminates step-up provisions for 2010 (unless legislation is passed to change the law for 2010).  In 2011 the law (as presently written) brings back the step-up provision.

So when you consider the concept of paying ordinary tax on your IRA distribution and zero tax on the taxable account (assuming you never need to use those funds) versus paying capital gains on the taxable account and potentially leaving your heirs with a fully-taxable IRA (because IRA funds never receive a step-up in basis), this method seems to make a lot of sense.

Conclusion

In the circumstance where you know you’re going to need funds from both accounts, it probably doesn’t make much difference in the long run, but you would likely come out better using the taxable funds at today’s low capital gains rates first.  This will hold true until changes are made the the capital gains tax rates that might make this method less desirable.

But if your holdings are large enough in either account to cover your needs for the long term, with some planning of your distributions you might come out better with the second method.  Or rather, your heirs will come out better in the long run, since some sort of step-up rule is likely to be in place once Congress gets their act together and passes new estate tax legislation.

Photo by Môsieur J. [version 3.0b]

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Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry.  . Read more from this author