How to Make Retirement Accounts Last

Retirees have a tough time finding advice on the best ways to spend the money in retirement accounts. In this month’s visit we will consider the best order to withdraw retirement money.

Most people have more than one type of retirement account. There usually is at least one tax-deferred account, such as an IRA, plus a taxable account.

The standard advice is to draw down the taxable accounts and leave money in a tax-deferred account as long as possible to let the tax-deferred compounding work.

My research shows that in many cases that traditional advice is correct. The retiree’s wealth will last longer if the tax-deferred compounding is allowed to work for as long as possible. The table nearby shows the advantages of tapping taxable accounts first at different rates of return. My conclusions are supported by other research.

The results, however, depend on the assumptions made. The assumptions do not apply to everyone. For some people, retirement savings will last longer if the tax-deferred accounts are tapped first.

The model assumed that the taxable accounts and the IRA had the same annualized rates of return. Suppose that is not the case. Remember in last month’s visit we concluded wealth will accumulate to a greater amount if care is taken to put the right investments in the right accounts. Some assets are best held in taxable accounts and others in tax-advantaged accounts.

High return assets that are not traded frequently, such as stocks and equity mutual funds, should be held in taxable accounts where they qualify for the long-term capital gains rate. Bonds, real estate investment trusts, and other income instruments are best in tax-deferred accounts.

When those rules are followed, the taxable account is likely to earn higher returns than the deferred account. Adjusting the spending model for this difference in returns results in different recommendations. When the annual returns in the taxable account are four percentage points or more higher than the returns of the deferred accounts, then it is better to withdraw money from the deferred account first.

The wealth can be made to last even longer if the taxable account is managed to minimize taxes. There are some time-honored strategies for minimizing taxes on taxable accounts.

Investments with paper losses should be sold first. The realized losses offset any gains for the year, including distributions from mutual funds. Losses that exceed gains offset other income up to $3,000 per year. Any additional losses are carried forward to future years to be used in the same way until exhausted.

Next sold should be assets with the lowest taxes as a percentage of their value. Divide the taxes that would be due on the sale by the value of the asset to be sold.

In the taxable account, minimize trades each year. Be a longer-term investor and make trades only when the prospects for the investment seem dim, the investment has become high risk, or there would be low taxes on the trade.

Another situation in which it is not best to tap taxable accounts first is when it is wise to empty deferred accounts early. This has been covered extensively in past visits and in my book The New Rules of Retirement.

Briefly, there are people with sufficient assets outside of their IRAs that they are not likely to need the IRAs during their lifetimes, or at least not need the bulk of the IRAs. Yet, the tax law requires them to begin distributions after age 70½. These distributions are taxable as ordinary income and will increase as the individual ages. When children or other heirs inherit the IRA, they will owe income taxes on distributions from the IRA.

In these situations, the investor could be better off taking money out of the IRA early, paying the taxes at the current value, and letting the after-tax amount compound in a tax-deferred account. This is discussed more fully in the Archive on the web site and in my book.

What about other types of accounts, such as Roth IRAs or IRAs with nondeductible contributions? Tax-exempt accounts, such as Roth IRAs, should be spent last. The combination of tax-exempt compounding and distributions maximizes wealth when the compounding is allowed to work for a long as possible. As a general rule, the IRAs with nondeductible contributions should be allowed to compound longer than fully taxable IRAs, since distributions will be only partly taxable.

Whichever distribution order you select, do not forget your asset allocation. The distributions will change the asset allocation, and adjustments might have to be made in the different accounts to restore the appropriate to what is appropriate. The adjustments might incur taxes and trading costs. These potential costs should be considered before taking a distribution.

Most retirees are not planning their retirement distributions. They are letting the tax law plan for them by deferring IRA distributions until after age 70½, then taking what the tax law requires. Wealth might last longer if the retiree reviews the alternatives and adjusts the schedule for his or her situation.