Stretching Retirement Accounts to Last

A major fear of retirees and those nearing retirement is running out of money. You can stretch your retirement funds by planning the order in which to spend your different investment accounts. Paying attention to the drawdown order increases after-tax wealth and makes your money last longer.

Most people have more than one type of retirement account. You might have tax-deferred accounts (IRAs and 401(k)s, taxable accounts, a Roth IRA, and perhaps other accounts.

Here’s the basic rule to follow: Draw down the taxable accounts first and leave money in tax-deferred accounts as long as possible to let the tax-deferred compounding work. The table on page four shows the advantages of tapping taxable accounts first and how the advantage change with the rate of return.

The basic rule, however, is based on some assumptions, and the assumptions do not apply to everyone. For some people, retirement savings will last longer when the basic rule is modified.

The model I used to derive the table assumed the taxable accounts and the IRA had the same annualized rates of return. Suppose that is not the case, and for many people it probably is not. We’ve advised in the past that 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 held in tax-deferred accounts. When those rules are followed, the taxable account is likely to earn higher returns than the deferred account over the long term.

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 from taxable accounts should be assets for which taxes will be the lowest percentage of their value. Divide the taxes that would be due on the sale by the value of the asset to be sold to determine the taxes as a percentage of value.

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 too high a risk, or there would be low taxes on the trade.

Another exception to the basic rule is that sometimes it makes sense to empty deferred accounts early. I’ve covered these situations in some detail in past visits and in my book The New Rules of Retirement. Briefly, there are people who have enough income sources outside 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 minimum annual distributions after age 70½. These RMDs are taxable as ordinary income and will increase as the individual ages. So, the RMDs will increase gross income and taxes by forcing distributions of money that isn’t needed. When children or other heirs inherit what’s left of the IRA, they will owe income taxes on distributions.

People in these situations could be better off taking all or some of the money out of the IRA, paying the taxes at the current value, and letting the after-tax amount compound in a taxable account.

Tax-exempt accounts, such as Roth IRAs, should be spent last. The combination of tax-exempt compounding and tax-free distributions maximizes wealth when the compounding is allowed to work for a long as possible. As a general rule, IRAs with nondeductible contributions should be allowed to compound longer than fully taxable IRAs. The distributions from these IRAs will be partly tax free, and they should be spent before Roth IRAs and after fully taxable IRAs.

Whichever distribution order you select, don’t forget to monitor your asset allocation. The distributions are likely to change the asset allocation. Make adjustments in the remaining accounts to restore the target allocation, though the adjustments might incur taxes and trading costs. It’s important not to let tax issues change your investment strategy.

RW January 2011.