11/16/2012 2:45 PM ET|
When should you tap your IRAs?
A hypothetical couple lost out on more than $400,000 in retirement income by following the rule of withdrawing from IRAs last.
When it comes to tapping your retirement savings, a basic rule of thumb calls for withdrawing from taxable accounts first and allowing tax-deferred traditional IRAs and tax-free Roth IRAs to grow as long as you can. But a growing body of research shows that you may be better off with a little more juggling.
In a recent study, researchers found that for some retirees, tapping part of a traditional IRA in the early years of retirement could pay unexpected dividends by reducing the size of required minimum distributions when they turn 70 1/2. Shrinking those taxable payouts could keep you in a lower tax bracket and actually boost your wealth over the long term.
For this strategy to be effective, the authors say, part or all of your early IRA withdrawals must be sheltered by tax deductions and exemptions. Consider a married couple in which each spouse is 65 or older and knows that at least $21,800 of otherwise taxable income in 2012 will be tax-free thanks to the pair's standard deduction and personal exemptions. If the couple's taxable income before any IRA distribution would fall below that level, the couple could use "withdrawals from the tax-deferred IRAs to create tax-free income," Alan Sumutka, an associate professor of accounting at Rider University, in Lawrenceville, N.J., and one of the researchers involved in the study, said in an interview.
Sumutka and his colleagues sought to determine which of 15 possible withdrawal strategies would produce equal payouts but leave a retired couple with the largest account balance after 30 years. They considered a 65-year-old married couple who retired in 2013 with $2 million, split 70% in traditional IRAs, 20% in taxable accounts and 10% in Roth IRAs. The annual rate of return was 6%. The couple's expenses the first year were $80,000 offset by $30,000 in Social Security. The study assumed that Bush-era tax cuts would be extended.
The most tax efficiency occurred when, in the years before required distributions began, the couple tapped their traditional IRAs up to the amount of their deductions and exemptions. They took the balance for the year's expenses from their taxable accounts, paying up to 15% on any long-term capital gains. Once they began taking required minimum distributions, they continued to withdraw from their taxable accounts until those were depleted and then began tapping their tax-free Roth IRAs. The hypothetical pair saved the remainder of their traditional IRAs to last. After 30 years, the couple still had $1.61 million.
The conventional taxable-accounts-first strategy ended in sixth place. The thinking behind this strategy is that your tax-advantaged retirement assets should be left to compound as long as possible. But that strategy left the couple with just $1.17 million.
Keeping income on an even keel
A key to tax efficiency over a 30-year retirement horizon is to keep adjusted gross income and taxable income steady, the authors say. They were able to stabilize income in part by shrinking the IRA -- and, thus, the size of taxable required minimum distributions. "If you leave too much money in the account, eventually you may be forced into a higher bracket," says Lewis Coopersmith, an associate professor of management sciences and fellow researcher at Rider.
The study found that following the conventional strategy led to more volatility in income over the years and resulted in the couple spending 23 years in the 25% tax bracket, with just seven years in the 0% or 15% brackets. With the optimal strategy, the couple spent 14 years in the 25% bracket and 16 years in the 15% bracket.
Tapping the Roth before withdrawing from the balance in their traditional IRAs also helped the couple even out taxable income. "If I took the tax-deferred money before the tax-free money, I would have to pay taxes, so I would be reducing the total ending balance," says Coopersmith.
There are times that the common rule does work, the authors say -- as when initial portfolios are large, at $8 million or more, or contain 45% to 55% in taxable assets.
Further, couples with large taxable pensions would not likely benefit from tapping the IRA first.
More from Kiplinger's Personal Finance magazine:
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What world are you living in. You mention a couple retired at 65 with $2million in retirement savings.
I bet most folks would love have that problem. What % of retired couples are actually lucky enough
to have that kind of money. My guess is that you are speaking to a very small sample.
My parents in the 60's decided to provide for their children by opening a whole life insurance policy with a final payout equal to the value of a house. They figured that the value of a house would be more than enough in case the future went sour and we would not be homeless.
The value of that policy was 15,000 dollars.
Inflation's relentless march making the 5 cent candy bar into the dollar candy bar is the one factor that one cannot adequately prepare for.
Many prior retirees have seen their once "comfortable" retirement turn into a financial nightmare with things like gasoline going from $2 to $4 within a couple of years and the ever increasing taxes and increases in utility costs.
Retirees are projected to be about 1/4 of the total population within the next 20 years and the costs of providing services to those who can no longer take care of themselves will possibly create an exponential rise in costs to meet those needs.
Failure to plan sufficiently could cause you to see poverty in your twilight years.
We made the mistake of taking Social Security at 62. Now we have to have minimum withdrawals that cause us to have to pay tax on our Social Security. We should have withdrawn the amount we get from Social Security from our IRAs instead & waited until the maximum date for Social Security.
Our IRAs would have been drawn way down & our Social Security payments would be much larger.
The total we receive would probably be similar but our taxes would be much less.
How can you amass 2 million dollars and only get 30,000 from SS???? My wife and I have never
made over 110,000 combined and we will get over 45,000 from SS when we retire in 3 yrs.
We will NOT have saved 2 million dollars for our retirement from what we made over the years.
That is really what I would like to know is how they did that??????????? Oh it hypothetical
then you can put any numbers in play cause it's all Crap///////////
If they have $2 million in retirement funds why do they need social security? Means test these people and cut off or reduce the amount of SS they get! Also, if they have that much I'll bet they were over the $108K cap also. Time to raise the SS income tax cap limit to $250K! These people are a drain on the system.
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