Not All Retirement Dollars Are Created Equal

You can prolong the life of your retirement portfolio--in some cases significantly--if you are smart about how you draw your income.

Extensive research by Dr. Bill Reichenstein, professor at Baylor University and partner in the firm Retiree Income found that in general, the key is to spend down assets in taxable accounts first and then withdraw from a combination of tax-deferred accounts such as your 401(k), 403(b), traditional IRA, and tax-free Roth accounts.

Note: “conventional wisdom” would have you leave Roth accounts untouched as long as possible. (These would be the very last assets you would withdraw.)

Fortunately, it doesn’t require a PhD to understand the reasoning behind Reichenstein’s elaborate mathematical modeling: Taxes take a bigger bite out of the return you get in taxable accounts.

Say you have XYZ corporate bond with a 4% coupon in both your Roth IRA and your brokerage account. If you’re a retiree in the 25% income tax bracket, Uncle Sam gets one-fourth of the interest that XYZ bond pays to your brokerage account each year, reducing your after-tax return to 3%. However, there is no tax (ever) on the income that hits your Roth account; you keep the full 4%.

“By withdrawing funds from the taxable account before the Roth, the investor will receive a higher return and thus be able to extend the longevity of the portfolio,” explains Reichenstein.

So far, so good. But if tax free is so smart, why not leave assets in your Roth account(s) as long as possible? Because prolonging the life of your retirement portfolio means you can’t ignore the short term. In the short term, the taxes you pay each year also matter. By strategically dipping into your Roth account (example below), you can reduce your average annual tax rate and still end up with the total income you need.

Reichenstein’s second principle is that “the best way to think about funds in a tax-deferred account is that the government effectively owns [a percentage].” That percentage, which we’ll call “t,” is your marginal tax rate when you take money out of the account.

For instance, writes Reichenstein, “If t is 25%, then the retiree should look for opportunities to withdraw funds from his tax-deferred account when the withdrawals would be subject to a lower-than-25% tax rate.”

He points out two potential occasions: 1) before required withdrawals (RMDs) begin at age 70½, and 2) when the retiree ends up with unusually large itemized deductions, from things like high medical expenses or a generous charitable contribution.

As explained in my previous column , the official income tax rates for this year and next range from 10% to 35%. But in the table below I add a 0% tax bracket because you don’t pay income tax on every single dollar of income you receive thanks to a variety of tax deductions, the personal exemption, and certain income that is, by law, tax-free.(1)

Again, as a retiree, your annual goal is to draw your annual income from the various accounts you have in such a way that you minimize your total income tax bill by taking  full advantage of the lowest tax brackets.

For example, let’s assume you are married, file jointly and are both age 66. You need $100,000 in pre-tax income, including the $22,000 you get from Social Security. As you can see from the above table, it looks as if you’ll be paying 25% tax on some of your income. However, keep in mind that right off the bat, without itemizing, your “standard deduction” and “personal exemptions” allow you $21,300 in tax-free income this year. (2)

You’ll pay 10% on the next $17,000 in income and 15% on an additional $52,000. Following Reichenstein’s strategy, assuming you have any, the first thing you would do is cash in some of the investments you have in your brokerage account.  If these are taxable bonds or bank account assets, there is likely to be little capital gain; you will mostly be getting a return of principal. So there would be little, of any, tax on this amount.  If you liquidate stocks, you’ll pay a maximum capital gains tax rate of 15%.

Next, you probably want to tap your retirement accounts- your 401(k) and/or traditional IRA, etc.- in order to fill up the 10% and 15% brackets.

The point is, if you find yourself getting close to crossing over the threshold into the 25% bracket, you should take the remainder of the income you need from your Roth account.

Of course, a further complication is how Social Security benefits interact with your other sources of income. If your income exceeds certain thresholds, up to 85% of your Social Security benefits might be subject to income tax. (Another plus for Roth accounts: income withdrawn from these accounts does not affect the taxation of Social Security.)

1. Such as most municipal bond interest and qualified Roth withdrawals.

2. 2011 standard deduction for married, filing joint = $11,600.  Deduction for age 65 or older = $1,150/person.  Personal exemption = $3,700/person.

Ms. Buckner is a Retirement and Financial Planning Specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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