See That All Things Are Done in Wisdom and Order
Many head into retirement with multiple types of investment accounts—each with their own taxable implications. Examples of these accounts are: (1) taxable – non-retirement account; (2) tax-deferred – traditional IRA, SEP IRA, 401k, 403b, etc.; and (3) tax-free – Roth and Roth 401k.
A person may reasonably infer that in retirement you should take distributions from all three of the above simultaneously. However, only if you want to spend much less in retirement; and not just a little less—potentially hundreds of thousands, or even millions of dollars less.
Wait, What? How could that be?
It comes down to two factors: taxes and compound growth. At this point, it would be helpful to first understand the differences between the three types of accounts and their respective advantages and disadvantages.
Below is a breakdown of each:
Taxable accounts: These types of accounts are taxed thrice! Yes, that is three times! In these accounts you invest after-tax money, which you earned that was subject to income taxation (First taxation). While your money is invested and you receive dividends (from company stock), and/or interest (from bonds), each year these are taxed as well (second taxation). Finally, when you sell these investments for a gain, they are taxed a final time (third taxation). How much you are taxed on that last taxation depends entirely on whether you held the investments for greater or less than a year. The difference can be significant. If you’ve held it for longer than a year, you are taxed at long-term capital gains rates which are: 0%, 15% or 20% depending upon your income. If you sell prior to holding the investment for a year, the gain is taxed at your ordinary income rate which is often much higher. If you need to sell a stock and you are very close to the year mark, it would be wise to hold for a little while longer to pay that lower rate.
These accounts clearly have tax disadvantages, but a huge advantage of these accounts is, unlike retirement accounts, you have liquidity—access to the money whenever you want it. With most retirement accounts you can’t access it until you’re age 59.5 (for some 401k plans, you can access the funds at 55).
Tax-deferred Accounts: these are the retirement accounts most people are familiar with. They are: IRA, 401k, 403b, 457, etc. Contributions to these accounts are not taxed (you receive a tax deduction on the contributions). Any time you sell an investment for a gain or receive dividends or interest, these are not taxed but are tax-deferred. However, when you withdraw the money from these accounts, the money is taxed at the ordinary income tax rates (taxed once)*. This tax-deferral can be an advantage over a taxable account that is taxed three different times.
Tax Free Account: established in 1997, these are the newest entrant into investment account options. These are retirement accounts for which you contribute after-tax dollars, also known as Roth IRA (after the Senator that sponsored legislation that created them). There is now a 401k version as well, that doesn’t have the income limitations that their IRA counterpart have**.
Akin to their IRA/401k cousin, these accounts have the potential to only be taxed once—prior to your contributions. If your income is lower (i.e. first job out of college, part-time work in the years prior to retirement etc.), you will want to consider making contributions to a Roth.
Proper Order
Now that we’ve introduced the various investment accounts, here is why I think you will want to take distributions in the following order: (1) taxable; (2) tax-deferred; and (3) tax-free. The reason is fairly obvious: the taxable account is taxed three different times, whereas the retirement accounts are only taxed once. Not having to pay taxes on dividends, interest, or capital gains can be a benefit over the long term; and the longer these accounts grow the greater the benefit will be because of compound growth. This is also the reason why I suggest you take distributions from your Roth IRA last—to allow it to compound and grow the longest. Taking a more aggressive approach with the investments you plan to utilize later could prove to be beneficial in the long run. Another advantage I see to a Roth IRA is the ability to tap it for extra income without additional tax implications if certain requirements are met.
Do not just take my word for it, see this piece from Alliance Bernstein***
The financial planning software I use with clients shows something similar. See below an example. For some clients there are potentially millions of reasons why it makes sense to distribute in this order, as opposed to taking a sum out of their taxable, tax-deferred, and tax-free each year (pro-rata). In this hypothetical example, it is a cool $1.477M more they would have to spend in retirement.
This is a hypothetical example and is not representative of any specific investment. Your results may vary.
The only adjustment made to the portfolio example above was how the funds were distributed. Instead of distributing from each account (taxable, tax-deferred, and tax-free) each year in retirement, instead they first take distributions from the taxable account until it is exhausted. Next, they take distributions from the tax-deferred account until it is exhausted. Finally, they take distributions out of the Roth Account in their last years of retirement. This simple strategy would give the hypothetical client an additional $1.477 million to spend.
How Could That Be?
A big reason why this is made possible is because of a Roth. Time is one of the most critical workings of compound growth, and by using the Roth last, it will compound the longest tax free. This could be a significant advantage. This is why I believe people should pursue Roth’s through contributions via an IRA or 401k and especially through conversions (I have an upcoming blog, which will provide more details.).
Bear in mind Roth IRAs, Roth 401ks, back door Roths, or Roth conversions do not make financial sense for everyone. If you have further questions, please reach out to me.
Thank you for taking the time to read my blog and I hope you found it helpful. If you have any questions, feel free to contact me directly. If you don’t currently work with an adviser, click below to schedule a free introductory meeting using this link: https://go.oncehub.com/bookjonny
Note: If your tax rates are lower in retirement than they were when you made the tax-deductible contributions, it is to your advantage. If they are higher in retirement, then you unfortunately pay more in tax. The trouble is you just don’t know what taxes will be in retirement because congress determines these, and they are subject to change.
*Single filers with AGI under $125,000 can donate with a phase out to $140,000. Married filing Jointly with AGI under $198,000 can donate with phase out up to $208,000.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
