You’ve probably been saving money to fund your retirement for most of your life. As retirement gets closer, there are a host of questions to consider, most of them having to do with “soft” issues:
- How will you spend your time?
- How will you maintain your sense of identity and self-worth?
- How will you get the social interaction that you desire?
- Will your spouse retire at the same time?
- How will you make the mental switch from saving to “dis-saving?”
I’m a numbers-centric guy myself. Ann is the member of this dynamic duo who is more attuned to the psychological issues facing our clients. Now that she is full-time with Sapient, she is planning to launch a blog of her own. I’ll assume that she will eventually cover some of the issues that I blithely ignore.
Ann and I have great planning software (Right Capital) to help us and our clients figure out when to stop working, how much they can spend each year, and how they can best fund their spending with the right mix of investments and a tax-smart strategy for drawing on their various types of accounts.
This article will focus on that final topic: structuring tax-optimal strategies for funding retirement. The first question and most obvious question our clients often ask concerns the order in which to withdraw from the three types of investment accounts available to most retirees:
- Taxable accounts
- Traditional IRA accounts
- Roth IRA accounts
Withdraw Money from Your Accounts in This Order
Virtually all financial planning authorities agree with the following excerpt from Vanguard:
"If your taxable distributions and RMDs (if any) aren't enough to cover your spending, withdraw additional money from your savings in a way that will allow you to pay the majority of your taxes while you're in a lower tax bracket.
That's sometimes easier said than done, but for many people, the order below will make the most sense.
- Withdraw from your taxable accounts first. This will allow your accounts with tax benefits to keep growing as long as possible. Remember that as you sell assets in these accounts, offsetting your capital gains with losses will help keep your taxes down.
- When you've spent all the money in your taxable accounts, begin withdrawing from your tax-deferred accounts, like traditional 401(k)s and IRAs.
- Finally, withdraw from your tax-free accounts like Roth 401(k)s and Roth IRAs. If you don't use all your Roth money, you can include it in your estate plan, since Roth accounts keep many of their tax advantages even after being passed down."
From “How to set up your withdrawals”, Vanguard
Tax-Sheltered Buildup is Key
Why do the simple 1-2-3 rules of “conventional wisdom” make sense most of the time? Because of the value of tax-sheltered buildup. A dollar invested in a tax-sheltered account (such as an IRA or Roth IRA) is going to provide a lot more spendable money after taxes than a dollar invested in a taxable brokerage or bank account. I will show that with an example.
Let’s assume that you have $10,000 in your IRA. Let’s also assume that you are in the 22% tax bracket, which if you are married filing jointly in 2024 means your taxable income is between $94,300 and $201,050. (If filing as a single, income would be between $47,150 and $100,525.) Furthermore, let’s assume that you do not expect your tax bracket to change going forward.
Regarding investment returns, let’s make the following assumptions:
- A 60/40 stocks/bonds portfolio mix, which will be stable through time.
- Stock dividend yield of 1.5% taxed at a preferential rate of 15%.
- Growth rate for stock dividends of 6% per year.
- Total return for stocks of 7.5% (1.5% + 6%).
- Bond yield of 4% taxed at your 22% federal income tax rate.
- Total return for bonds of 4% (equal to the yield).
- Index-like low portfolio turnover of 5% per year, with a long-term capital gains tax rate of 15%.
- Total portfolio return of 6.1% (60% x 7.5% + 40% x 4.0% = 6.1%).
- That return is compounded through the end of the 30th year.
Option #1: Leave $10K in IRA Account
If you keep the $10,000 tucked inside your IRA account, you will not have to pay any tax on the growth in value unless and until you make distributions out of your IRA. The table below assumes that the $10,000 will stay invested for 31 years, which is about the duration of a typical retirement these days. The initial investment of $10,000 compounded at 6.1% per year results in an ending value of $62,687. A final disbursement takes place at the end of the 30th year, with 22% in income taxes paid on the distribution ($13,791). The ending after-tax value is $48,896, and the after-tax return is 5.25%. This return rate is 86% of the 6.10% gross return. Because of the tax-sheltered buildup, the after-tax return is not reduced by the full tax rate of 22%, but rather by only 14%.
Option #2: Move $10K to Taxable Account
Another option would be to distribute the $10,000 out of the IRA immediately and invest it within a taxable account. The problem with this strategy is that it exposes the $10,000 investment to immediate and ongoing taxes. First, a federal income tax of 22% of the initial $10,000 distribution is immediately due, leaving a balance of only $7,800 to invest. The taxes on the 60% stock portion aren’t too severe, since stock dividend yield is only 1.5% and dividends are taxed at a preferential rate of 15%. The 4% yield on the 40% bond portion, on the other hand, is subject to taxation on the interest income at the 22% rate for ordinary income. In addition, even index funds have some level of turnover, generating realized capital gains. Although these gains are reinvested in the account, capital gains taxes are due along the way. We are assuming a 15% preferential rate on long-term capital gains. Short-term capital gains tax would be due on any assets owned for less than twelve months (we assume none), with the gains taxed at ordinary income tax rates.
Applying our assumptions to the taxable account results in in an ending value of $34,236. A final disbursement takes place at the end of the 30th year, with 15% in long-term capital gains taxes paid on the distribution ($5,135). The ending after-tax value is $29,100, and the after-tax return is 3.51%. This return rate is only 58% of the 6.10% gross return. Because of the tax burden born by the taxable account each and every year, the after-tax return is reduced by a whopping 42%!
Option #3: Convert $10K to Roth IRA
Distributions from a traditional IRA into a Roth IRA are known as “Roth distributions.” If only part of an IRA is distributed out, it is called a “partial Roth distribution.” In this case, as with the distribution to the taxable account, a 22% income tax must be paid on the initial $10,000 distribution, leaving a balance of only $7,800 to invest. However, unlike with the distribution into the taxable account, no further taxes will ever be owed on that Roth IRA money. It is “tax-free.”
Note that the ending after-tax value for the Roth IRA is $48,896, and the after-tax return is 5.25%. These are exactly the same figures as for the traditional IRA. Because all of the particulars were held constant, the only difference was when the 22% income tax rate was applied: the Roth IRA was taxed at the beginning and the traditional IRA was taxed at the end. In math, there is something known as “the transitive property” of multiplication. The order of the multiplication factors doesn’t matter—the end result will be the same:
T x A x B x C = A x B x C x T
The comparison between the traditional IRA and the Roth IRA illustrates the single most important criteria for determining whether a partial Roth conversion makes economic sense. A partial Roth conversion is attractive if and only if your future tax rate will be lower than your current tax rate. Your after-tax return will be higher only if your tax rate on future traditional IRA distributions will be higher than what you would pay now to distribute some of your IRA to a Roth IRA. It is entirely a matter of tax rate arbitrage.
Is Tax Planning Right for You?
If you are willing to believe what the authorities say you may not need to read any further; just follow the 1-2-3 conventional wisdom described above. However, you should first note that the Vanguard excerpt above indicated that the point is to “pay the majority of your taxes while you're in a lower tax bracket.” Historically, it used to be the case that when people turned 65, they went from receiving a monthly paycheck to receiving a monthly pension check and/or a monthly Social Security benefit check with no gap in between. The conventional wisdom worked fine for them. However, for most of us, our transition to retirement may require more planning and analysis.
Under the old system, monthly income for a lot of people did not change dramatically from when they were working to when they retired. Thus, their tax bracket did not typically change. They didn’t need sophisticated tax planning. Following the above “conventional wisdom” about the order in which to tap the different types of accounts was good enough.
However, especially if your future tax bracket is likely to be higher than your current tax bracket, your situation may require further analysis. For example, if you will have some “gap years” in which your income will be unusually low because you have stopped working, haven’t yet started collecting Social Security, and haven’t yet started having “required minimum distributions” (RMDs) taken out of your IRA accounts, then you are a prime candidate for in-depth tax planning. Because so many of our clients are in that situation, Ann and I recently launched Sapient Tax Services to provide tax planning.
A Partial Roth Conversion Example
Making opportunistic partial Roth conversions can make a huge difference in your expected lifetime tax obligations. Our example is for a newly retired couple, John and Jane Smith. He is 66 and she is 64. To be conservative, the retirement projections illustrated below carry through until Jane turns 100. The Smiths expect to spend about $120,000 per year after taxes in retirement (in real, inflation-adjusted dollars). His Social Security benefit is $50,000 per year and hers is $25,000 per year. Neither of them has a defined-benefit pension plan. That leaves $45,000 per year ($120,00 - $50,000 - $25,000) that will have to be provided by their investments.
Their advisor (me) has persuaded them to delay Social Security until age 70. That means that there will be several years that their investments will have to provide 100% of their living expenses. They have sufficient retirement savings to make this feasible:
$ 400,000 Taxable account
$1,500,000 His traditional IRA
$ 200,000 Her traditional IRA
All three of their accounts are identically invested in a portfolio of 60% stocks and 40% bonds. The stocks have a 1.5% dividend yield and a dividend growth rate of 6.0%, for a total return of 7.5%. The bonds have a yield of 4%. Therefore, the portfolio expected return is 6.10% (60% x 7.5% + 40% x 4.0%). A 2.5% inflation rate leaves an expected real return of 3.60%. (All calculations illustrated below are based on “current dollars” after inflation.) An extremely low index fund-like turnover rate of 5% is assumed, with all realized capital gains taxed at 15%.
Their beginning effective federal income tax rate is 12%. The “effective” tax rate is the blended average rate paid on all taxable income. They are expected to be in the 22% tax bracket for most of their retirement, but not until John starts collecting Social Security benefits. The “tax bracket” is the tax rate paid on the last dollar of income, and it is also known as the "marginal tax rate." The calculations used to generate the graphs below update their federal income tax rate each year by using their tax rate from the previous calendar year.
No Roth Conversions
The graph below shows the expected sources of taxable income for the Smiths throughout their retirement, which begins in 2024. John does not start collecting Social Security until 2028, and Jane starts in 2030. They need $120,000 per year in living expenses. They can fully fund the gap from their taxable account for the first three years. In the graph below, those years are blank because selling assets from their taxable account generates capital gains but not ordinary taxable income. By the fourth year (2027), there is not much left in the taxable account, and they must withdraw about $115,000 from John’s IRA (first orange bar). John’s Social Security starts to contribute $45,000 per year in 2028 (first blue bar), but the rest continues to be funded from John’s IRA. Jane’s Social Security commences in 2030, which reduces but does not eliminate the distributions from John’s IRA.
Because he was born before 1960, John’s RMDs start when he is 73, which is in 2031. This increases the distributions from John’s IRA enough to slightly exceed the $120,000 needed, so the small excess gets put into their taxable account. The taxable account, which had been completely depleted in 2027, now starts to grow again. Jane was born after 1960, so her RMDs do not start until she is 75, which is in 2035. That bump in their combined RMDs accounts for the modest increase in the orange bar starting in that year.
There is a noticeable hump in the IRA distributions during the middle years of their retirement. Between their Social Security benefits and their RMDs, the Smith’s taxable income stays solidly in the 22% tax bracket (married filing jointly taxable income between $94,300 and $201,050) throughout their retirement. The exception is those first three years of retirement (2024 to 2026) which were funded from their taxable account and which generated no taxable income at all. During those years, their tax rate was zero!
The graph below shows the year-ending balances of their three accounts. Their taxable account is quickly depleted to fund the early years of their retirement. As shown above, taxable accounts are by far less tax-efficient than tax-sheltered accounts, so it makes sense to spend them down first. John’s IRA is the bulk of their retirement savings and is the source of most of their retirement income. Both of their IRA accounts are slowly depleted through RMDs. The RMD amounts are more than they need for their $120,000 spending level, so the remainder is deposited into their taxable account, which grows significantly in their later retirement years.
With Roth Conversions
Next we will examine the impact of using those early years of zero income, and zero income tax, to make a few significant Roth conversions.
We know that the Smiths will spend their retirement years in the 22% tax bracket. There are two tax brackets below the 22% bracket: 10% and 12%. The optimal strategy for taking advantage of the Smith’s low taxable income during 2024 to 2026 would be to “fill up” the 12% bracket with Roth conversions. This means that they would be paying a tax rate of up to only 12% on amounts converted, whereas if they stayed in the IRA, the tax rate would be up to 22% on their future RMDs.
The graph below is mostly similar to the one above with no Roth conversions. However, in each of the first three years, $94,300 is converted from traditional IRA to Roth IRA. This amount “fills up” the 12% tax bracket.
John had no Roth IRA to start, but these three Roth conversions of $94,300 provide a good base from which his Roth account can growth. There were no more deposits into the Roth after those first three years, but without any RMDs or taxes, John’s Roth is able to grow so that it eventually becomes the Smith’s largest retirement account.
Compared to the “No Roth Conversions” account balances above, where most of their retirement assets ended up on their taxable account, now most of it is in John’s Roth IRA. This is a much more tax-efficient outcome. Also, having a mix of taxable, IRA, and Roth IRA assets increases their tax-planning flexibility.
Comparisons: Total Assets and Taxes Paid
The first graph below may be a bit disconcerting. Because of the three large distributions out of John’s IRA for the Roth conversions, the Smith’s total assets are depleted more quickly because of the income taxes paid during those first three years if they do the Roth conversions. It takes time for the Roth conversion strategy (blue line) to end up above the no Roth conversion strategy (orange line).
Remember the transitive property of multiplication covered above. It doesn’t matter when the tax rate is applied along the chain of returns, what matters is the tax rate. A lower tax rate will end up beating a higher tax rate assuming that assets are held for the same time period and that a final withdrawal tax rate is applied to the amounts left in both the taxable accounts and the traditional IRA accounts. (The graphs below do not assume a final tax rate. Including one would strongly favor the Roth conversions strategy.)
All of the graphs assume that both John and Jane will live until Jane’s 100th birthday. However, there is one very important event that is highly likely to increase the Smith’s future tax bracket: the passing of one of them and the surviving spouse’s transition from married filing jointly to filing as a single taxpayer. The income tax break points will be cut in half. After that event, the surviving Smith will almost certainly be in the 24% tax bracket. This will make having paid income taxes in the 12% bracket even more compelling.
There is another looming event that is likely to result in tax rates increasing: The Tax Cuts and Jobs Act of 2017 is due to sunset at the end of 2025. With that change in the law, the old 25% tax bracket became a 22% tax bracket. Unless Congress acts, the old tax brackets will go back into effect in 2026. In addition, Congress could also change the income levels or the tax rates to increase income taxes at any time.
Finally, what will happen after both John and Jane are gone? If they have IRA beneficiaries, those beneficiaries will inherit their IRAs. IRA assets must now be distributed within 10 years. It is likely that if John and Jane have adult children, the distributions from their inherited traditional IRAs will be made during what are likely to be their children's peak earning years when their income tax rates will be the highest. Although inherited Roth IRAs must also be distributed within 10 years, there will be no taxes due. Inheriting a Roth IRA is much better than inheriting a traditional IRA for this reason.
Amounts held in taxable accounts have an additional consideration: the “step up in basis.” Under current law, the “tax basis” of the decedent’s assets is changed to equal the market value on the date of death. Thus, assets held in taxable accounts would have no associated tax liability, since on the day of death (of the second to die) the market value would be equal to the tax basis. This would make the tax-efficiency of a Roth and the tax-efficiency of a taxable account the same initially. However, the Roth IRA still provides a vastly superior way for the beneficiary to compound returns sheltered from taxation for a period of up to 10 years.
The final graph below compares the taxes paid between the two strategies. Instead of having no income tax at all for three years (2024 to 2026), the Roth conversion strategy involves paying about $11,000 per year in income taxes. However, once both John and Jane are facing RMDs (2035), the spread between the two taxes paid lines is about $5,000 per year. This difference in tax payments continues for many years. And the graph does not include even higher levels of tax savings that will occur if tax rates increase (such as will occur if the old brackets come back in 2026 or if one of the Smith passes). Paying income taxes for Roth conversions to fill up the 12% tax bracket is likely to prove even more compelling than the comparison depicted in the graph below.
Summary and Conclusions
- The goal in tax planning is to minimize expected lifetime taxes and maximize spendable funds.
- Usually the “conventional wisdom” applies:
- Spend down taxable accounts first
- Spend from tax-deferred accounts (IRAs) next
- Hang on to money in tax-free accounts as long as possible
- The reason the above makes sense is to maximize the power of tax-sheltered buildup.
- If held for a long period, the reduction in return on IRA assets (14% in the example above) will be less than the ordinary income tax rate (22% in the example above).
- But for assets in a taxable account, the tax penalty (42% in the example above) will be more than the ordinary income tax rate (22% in the example above).
- Moving money from a traditional IRA to a Roth IRA (a “Roth conversion”) is attractive if and only if your future tax bracket will be higher than your current tax bracket.
- If your tax bracket is likely to increase later, detailed tax planning is in order.
- Partial Roth conversions to “fill up” the tax bracket below your future one is likely to be optimal.
- Reasons why your future tax bracket may increase include:
- RMDs from your IRAs will push you into a higher bracket
- The TCJA of 2017 will “sunset” in 2025
- You or your spouse may find you are filing as a single taxpayer
- Congress may raise tax rates
- Having more of your retirement assets in Roth IRAs increases your tax-planning flexibility.
- Your beneficiaries will appreciate not having to pay income taxes on inherited Roth IRAs.