Drawing down assets in retirement
I got a mailing from T. Rowe Price the other day and an article in it discussed strategies for drawing down retirement assets. Basically, it recommended using taxable accounts, tax-deferred accounts, and tax-free accounts in that order to fund your retirement. This is actually a pretty complicated subject (and one that I won’t have to actually worry about for a long time). Having read the article, I’m not sure I agree and I have lots of questions about their reasoning.
They wrote you should use taxable accounts first because they are not sheltered from taxes. So what? Ok, it’s possible that if you use an actively managed fund, you’re going to have a lot of capital gains you have to pay taxes on. But assuming you use index funds and reinvest dividends and gains, these should be negligible. Besides, if you have substantial taxable investments, some of the shares of the funds you own could have a capital loss associated with them. With detailed and careful tax planning, you could reduce your taxable income by selling them while still providing you with actual cash to live on.
Next they recommend cashing out tax-deferred accounts. I understand with these that there are rules that dictate when you start drawing these down. For example, you have to start taking required minimum distributions from traditional IRAs by the time you are 70 1/2. I guess it makes sense you’d save these because the earnings keep compounding tax-deferred.
Finally, the say to use tax-free accounts. Again I’m not really sure why except that the earnings are tax-deferred (and tax-free) and you don’t ever hit a required minimum distribution for Roth IRAs (you do for Roth 401(k)s).
On balance, I’d think a combination of tax-free and taxable accounts might make more sense. This would assume you don’t plan on leaving a large estate to posterity that you’re keeping in Roths. With this strategy, you could mitigate the tax bite but still have plenty of cash to live on. I’m sure I’m not seeing something here, but like I said, I won’t be worrying about this for a long time.
April 8th, 2007 at 11:07 am
I think T-Rowe is pretty much correct, at least in a general sense. If you believe that the time value of money is at the root of all sound investment practice, then you understand that ‘tax-deferral’ isn’t just putting off paying the piper. It allows you to keep more money in your possession and working for you.
Let’s take, for instance, a semi-elderly couple that owns their home and whose car has just crapped out. They need a new one, so they are wondering how to pay for it…
If they have money in taxable accounts, they can take that money out and buy the car with no tax implications (because in a taxable account, even with reinvested dividends, they’ve been paying tax on some of the gain all along via 1099-DIVs although they’ll still get a -B). Plus, if they are heading for death (as we all are), there aren’t a ton of great ways to ensure your heirs get the piles of cash you have lying around in regular accounts.
If they take money out of a tax-deferred investment, they will have to pay tax on the entire amount that they take out. They’ll get a 1099-R stating that 100% of that was income. For me, I inherited a traditional IRA and I have to take out 1/(83-my age) of it every year. Let’s just say that I won’t be touching the principal amount for at least another decade. Clearly, in this case, selling a mortgaged property and getting this IRA inherited was better than paying off the house and paying tax in one fell swoop on all that income.
With a Roth, to be honest, I don’t plan to ever touch mine. I plan to leave it (although the kids hopefully won’t need it either). But there is no tax on anything in it (forever at this point), but as soon as I take it out, unless I spend it, wherever I store it, I’m paying tax on what it’s earning.
Of course, there is always some luck that the tax code doesn’t change to benefit the lowest common denominator while screwing the people that found the best way to work the older system.