Retirement withdrawal planning can be very complex

I read a fascinating article recently about retirement withdrawal planning in the November/December 2006 issue of the Financial Analysts Journal (Withdrawal Location with Progressive Tax Rates, Stephen M. Horan, CFA). Let me warn you, the Financial Analysts Journal is not light reading. However, the issues of the article and some of it’s conclusions are important to consider.

Planning withdrawals in retirement can be complex because it’s possible to have so many different kinds of retirement accounts to withdraw from: Roth IRA, traditional IRA, taxable accounts, etc. Which account you withdraw from and when can have huge implications on your standard of living and the length of time your money may last.

The reason is simple, each type of account is taxed differently when you withdraw the money. Roth accounts have no tax consequences at withdrawal. Tax deferred accounts (like traditional IRAs, 401(k)s, Thrift Savings Plans, etc.) are taxed at income tax rates, where the tax increases as you withdraw more money. Taxable accounts are currently taxed at a maximum of 15% for capital gains and dividends or at your marginal income tax rate for interest or non-qualified dividends (dividends that haven’t been taxed at the corporate level like Real Estate Investment Trusts and Business Development Companies).

Which account you withdraw from may have significant tax consequences, and withdrawing from different accounts at different times could also significantly impact the amount of money you can pull from your retirement accounts and the length of time your money lasts. Added to this, tax deferred accounts like traditional IRAs require mandatory withdrawals, even further increasing the difficulty of figuring out how to withdraw your money.

The article mentioned above attempts to find the optimal strategy for withdrawing money. To simplify the problem, the author only looks at Roth and traditional IRAs to find the best strategy. He starts with the simple strategy of withdrawing from the traditional IRA for income needs first, and then withdrawing from the Roth IRA once the traditional runs out. Then, he tries the reverse strategy, Roth first then traditional. It turns out withdrawing from the traditional first leads to significantly higher withdrawal levels and longer lasting withdrawals.

He also tests mixes of withdrawals from Roth and traditional IRAs. What he finds is that withdrawing up to the 15% tax bracket level from the traditional and then pulling from the Roth next to meet spending needs is the optimal strategy. Of course, this depends on how much money you have saved, too. And it doesn’t include taxable accounts, or pension distributions, or social security, etc.

I hope you’re getting the picture: this is complex stuff. The article’s math is very complicated, and as soon as tax rates change, his conclusions need to be retested. This is one difficult problem to solve, and it can have huge impacts on how much money you live off in retirement and the amount of time your money will last.

I hope some genius designs a computer program that will solve this problem for people. You know, just plug in the amount you have from each source and what you’re getting from a pension and social security, and it tells you to pull out X dollars from A account, etc., so you optimize your income and its longevity. But, in the meantime, this will be one difficult problem to solve.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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