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."