The message that you need to save for retirement is loud and clear. It's hard to escape, in fact. The message that retirees with 401(k)s will have to make a decision about how to structure their assets in retirement to avoid running out of money is also loud, if a bit less clear.

The message of how to optimally sequence a withdrawal strategy in retirement in terms of tax efficiency, choosing from among taxable and tax-deferred accounts, is neither loud nor clear. Many of the best practices are little known or even counterintuitive. And planners aren't necessarily compensated for the hard work involved. But solving this retirement spend-down problem is a great opportunity for advisors. After all, these problems are too complex for most clients to solve without expert advice:

Some are calling this the next wave of retirement planning. "The science of financial planning is shifting in this direction," says Brian Nygaard, managing director of Pershing in San Francisco. "I don't think we are very far along yet as an industry, particularly in providing technical support, though individual advisors are working very hard to maximize results."

The good news is that there is a vast amount of activity among academics and practitioners on solving this problem. Whereas a few years ago, clients and planners might have sequenced withdrawals from 401(k)s, IRAs, Roth IRAs and other accounts without worrying about the tax implications, there is now agreement that where you draw from makes a difference. And new software tools are coming to market that will aid advisors in their efforts to provide the next generation of retirement spend-down planning.

The challenge of how to optimally structure this spend-down is that any financial plan is dependent upon a huge number of assumptions. Is the client's tax rate going up or down after retirement? Do the clients have beneficiaries? Are the beneficiaries' future tax rates higher or lower than the retiree's? Where does the client plan to retire and what are that state's income, sales and property taxes? Will future governments honor current commitments to the unique features of Roth IRAs?

"You don't have much idea what tax rates will be in the future and it doesn't just depend on the next election," says Anthony Webb, research economist at the Center for Retirement Research at Boston College. Webb's concern is that models of optimal withdrawal strategies throw off misleading feelings of accuracy about the future. Warns Webb: "When trying to optimize, it's important to think about how you will fare if your model's parameters turn out to be incorrect."

Rules of Thumb

To address these concerns and hammer out optimal withdrawal strategies, researchers and practitioners met at New York University this summer at a conference organized by Robert Gordon, president of Twenty-First Securities in New York City. The key insight from the conference was that retirement payouts can be extended by choosing the right sequence of withdrawals. "I want people to understand there is some juice in doing it right," Gordon says.

Doing it right means understanding a few rules of thumb that can help planners conceptualize the best withdrawal strategy for their clients, even if it also means acknowledging that these rules won't work in every case. Says Gordon, "The average person should consider these rules of thumb—but of course, no one is average."

The most basic rule is to tap taxable accounts first (in addition to any required minimum distributions), letting assets grow in tax-free accounts. This way, income taxes are minimized and clients are subject primarily to capital gains. Taxable-first is the default position of most thinking, and of most software that addresses retirement withdrawals.

Here, however, is one of the many complications inherent in draw-downs: This could be bad advice for, say, clients planning to leave an inheritance. For example, a very elderly client facing capital gains on a highly appreciated position might be better off not touching the taxable account, so the beneficiary can take advantage of the step-up in basis.

After-Tax Values

The starting point for planning a withdrawal strategy, then, is to understand the after-tax values of various accounts to your client. "You have to look through assets to your after-tax dollars," advises Robert Fishbein, vice president at Prudential Financial. After all, as he points out, "we pay for housing and food and travel in after-tax dollars." Adjusting pretax to likely after-tax dollars makes comparisons between account types clearer and puts the various asset buckets on an "apples-to-apples" basis. It also yields additional insights about how best to sequence a drawdown.

One method of making this adjustment has been developed and formalized by William Reichenstein, professor of investments at Baylor University. Reichenstein's insight is that for a tax-deferred account like a 401(k), the government essentially owns a portion of the account—the part that will be paid in taxes. Take, for example, a client with a traditional IRA worth $100,000 and a Roth IRA worth $75,000, and an expected tax rate of 25%. According to Reichenstein, the two accounts share the same real value: $75,000 after taxes. This equivalency is valid even if the accounts both double in value. The IRA would now be worth $200,000 pretax, or $150,000 (that is, less 25%) after tax. Doubling the Roth also results in a value of $150,000 after taxes. Once advisors and clients understand how much money they have on an after-tax basis, they can more easily make drawdown conclusions.

This gives rise to a second, alternative rule of thumb: "Look for opportunities to take money out of a tax-deferred account when the tax rate is low," Reichenstein says. The intuition behind this alternative rule is simple: In years with exceptionally low tax rates, the retiree should withdraw sufficient funds to fully exploit the low tax bracket. Reichenstein has identified three likely situations when this might be the case: years with large deductible medical expenses; years with large charitable contributions; and years before required minimum distributions. "The government owns a certain percentage of your tax-deferred accounts," Reichenstein says. "Look to take out money in low tax years when this share is at a minimum."

Roth Vs. Traditional IRA

What is the optimal withdrawal strategy for a Roth IRA versus a traditional one? The standard rule is to tap the traditional IRA first. The Roth can keep growing tax-free, whereas the retiree will eventually be taxed on withdrawals from the traditional IRA. But the decision really needs to be predicated on assumptions about future tax rates. Joel Dickson, principal at Vanguard, says, "if you expect to be in a higher tax bracket in the future, you want to draw down your taxable IRA first."

The more interesting—and complex—situation occurs when the retiree expects to be in a lower tax bracket in the future. Congress is not going to lower tax rates, but the retiree may have so little wealth that he or she is in a very low bracket. In this case, Reichenstein advises, "the retiree should withdraw the free amount from tax-deferred accounts each year, where the free amount consists of standard deduction and personal exemption(s), plus $1,000 each for being over 65. Additional funds could come from a Roth IRA and/or taxable accounts." A blended approach allows the retiree to stay in a lower tax bracket by using the Roth for some income rather than completely preserving the Roth.

Precisely determining the optimal balance between Roth and traditional IRAs requires some talent for prophecy, since you must weigh after-tax values. In an election year and hard economic times-including a series of government bailouts and a war that are not yet paid for-it's hard to know where tax brackets will be in a couple years, let alone the 30, 40 or more that constitute a modern retirement. The good news is, strategies are adjustable.

Reasons to Convert

In general, high-net-worth advisors may not have much experience with Roth IRAs because of previous income caps on conversions. This is about to change, big time, in 2010, when the conversion limit vanishes. "Roths are going to become much more important to HNW advisors and their clients," says Bruce Steiner, a tax attorney at Kleinberg, Kaplan, Wolff & Cohen in New York City.

Steiner explains why Roths might become very popular: Once a client completes the conversion process, he or she never needs to pay any more income tax on the account. This is true not only for the client and spouse, but also the beneficiaries. In contrast, beneficiaries who inherit stock may still face capital gains beyond any initial step-up in basis. And unlike traditional IRAs, Roths require no minimum distributions, which Steiner terms "meaningful."

Because of Roths' unique attributes for beneficiaries, planners also need to keep an eye on beneficiaries' likely tax rates. "If the retiree faces low taxes but the beneficiary is in a higher tax bracket, preserving the Roth makes sense" says Steiner. If the retiree is in a high tax bracket and the beneficiary is in a low one, though, tapping the Roth as opposed to the traditional IRA is a strategy to consider.

What Planners Are Doing

Because of the complexity involved in spend-down planning, many advisors use a basic algorithm for sequencing withdrawals, and make adjustments as necessary for each individual situation. Usually this plan is arrived at following a determination of the retiree's income needs and predictable post-retirement healthcare costs. Dan Keady, director of financial planning at TIAA-CREF, explains how he generally sequences withdrawals once these bigger questions have been answered: "Minimum distributions come out first, followed by dividends, nonqualified withdrawals, after-tax annuities, qualified retirement plans and finally Roths."

Rather than saying, here is the optimal tax-efficient plan for 20 years, Keady argues, planners must be ready to make changes and revise their inputs. This is also true for any software based solutions. Says Keady: "It's hard to look out 20 years in terms of sequencing." Instead, one of his core suggestions is to create a relationship with a client over a period of time, and review and update tax-efficient withdrawal strategies as the client ages.

Next Steps in Modeling

As planners get more focused on drawdown, optimizing the sequence of withdrawals could become more standardized. Advances in software will aid planners in this effort. Traditionally, tax has not been factored into spend-down computer modeling, so there are currently few tools at planners' disposal. And academic theoretical models still have limitations. Most ignore certain asset classes all together, such as real estate. (This is not just a modeling problem. Reverse mortgages, which have many tax advantages, tend to be overlooked as a tax-efficient source of retirement funds.)

Going forward, Scivantage, a Jersey City financial services software provider, expects to launch software early next year which incorporates a holisttic view of taxable and tax-deferred accounts. Retirement Benchmark, a Kansas-based advisory firm focused on providing services to baby boomers and retirees, has developed several core services related to optimal drawdown strategies to extend wealth. Its drawdown software tool will be available to consumers as soon as this month; the RIA and Institutional version will be launched in early 2009. According to company founder Bill Meyer, a former Schwab executive, "The software fuses three important factors when considering retirement income: Social Security, Roth conversions and withdrawal sequencing that minimize taxes."

A Rebalancing Moment

A holistic issue facing planners is not only which accounts should be liquidated first, but also which assets should be tapped first. Timothy Noonan, managing director at Russell Investments, suggests that a planner can tackle both problems at once. At the beginning of spend-down, Noonan argues, most portfolios are far from perfectly balanced and may have been haphazardly constructed. Most frequently the 'nest egg' is a collection of portfolios, each imperfect.

During the consolidation of these portfolios that normally precedes spend-down, advisors have a great opportunity to rebalance. This can be accomplished in a tax-aware manner in terms of asset sales. These asset allocation changes are in addition to optimal withdrawal sequencing. The key, he argues, "is to keep an eye toward the end goal, including the best glide- path for the client."

Noonan adds, "The big win for the best advisors is to be the one with the retirement spending plan that reaches across accounts and brings them into alignment in terms of diversification and sequencing rules."

This may appear daunting. But the best advice to planners and clients is simple: "The main point is, don't be afraid," says Fishbein of Prudential. "You don't have to solve this at once. You can come back to it each year. It has to be a dynamic process."

David E. Adler is a frequent contributor to Financial Planning.