Jim'sMoneyBlog

Financial Opinion and Insights

Preserving Retirement Plan Assets

Jim Lorenzen, CFP®, AIF®

Jim Lorenzen, CFP®, AIF®

Help Preserve Your Retirement Assets by Taking Smaller Distributions

But, watch out for the order of returns…. More on that later.

Let’s imagine you own two pots of money: The money that has already been taxed (let’s call it “regular money”) and the money that has not been taxed (let’s call this “retirement money” such as IRA, 401k, 403b, etc.). When you spend a dollar of regular money, the cost to you is exactly $1. When you spend $1 of retirement money, the cost to you could be as much as $1.54[1] (1/.65) because you may have to pay off federal income tax on the amount you withdraw. Therefore, if you want to reduce your taxes, consider not taking more than the required distribution from your retirement money.

Some people think they should never spend their principal, but this can be a mistake if you want to save taxes. It could be better to spend some of your regular assets first, so that you can take advantage of the tax-deferral benefits associated with IRAs and qualified retirement plans. You could be better off financially from an income tax standpoint. Your lifetime tax bill can be less or you will at least defer taxes for many years.

Consider the following hypothetical example that assumes you have a taxable regular money account and a tax-deferred retirement account with a $100,000 balance each. Let’s assume the money in each account earns a return of 6% per year. Let’s further assume that annual distributions of $6,000 per year are being taken for a 20-year period.

Under one scenario, the $6,000 will be taken first from the taxable money and the other scenario considers what would happen if the money was taken first from the qualified money. Under this example, you would have $150,000 more at the end of 20 years by spending your regular money first. The upside is that you could potentially hold onto more money while you are alive.

Of course, the down side is that your beneficiaries will eventually have to pay income taxes on the money when you are gone. As the information provided by this example is hypothetical, actual results will vary depending upon the performance of your investments.[2]

 

Today

In 20 Years

Spend Regular Money First
Regular Money

$100,000

$40,916

IRA Money

$100,000

$320,713

TOTAL

$200,000

$361,629

Spend IRA Money First
IRA Money

$100,000

$0

Regular Money

$100,000

$211,247

TOTAL

$200,000

$211,247

 

Spend Regular Money First

Assumptions: All money is assumed to earn 6%. This assumed rate is used for tax illustration purposes only and does not reflect any particular investment. Federal income taxes are assumed to be 35% in this example, and your income tax rate could be lower based upon your annual income. This illustration covers a 20-year duration, with distributions of $6,000 occurring each year. The income taxes on withdrawals are also deducted from the IRA account.

Now that I’ve told you all this, you should beware of easy answers.  Few investors earn a constant rate in their retirement plans throughout retirement simply because they’re in mutual funds, not long-term fixed income instruments; and the ‘order’ of returns can have a huge impact on outcomes during the withdrawal phase of your retirement. 

Average annual return is just what it means:  It’s an average.  

Here’s a `pitch’ you will sometimes hear:  If you achieve, for example, an 11.6% (purely hypothetical percentage) average annual return over ten years, you can withdraw the same percentage, 11.6% in our example, annually and still have your principal intact!  Is it true?  Unlikely.    Only problem:  Returns don’t come at 11.6% every single year.  Investments have fluctuations!

You can take any fluctuating series of returns that comes out to an average annual compounded 11.6% return over ten years while withdrawing 11.6% each year and then reverse the order and you’ll get two entirely different outcomes! One may have made money and the other very well might reveal the investor went broke! 

So, while withdrawal principles like the one I talked about at the beginning of this post are interesting, what they really are is worth discussing with your advisor who, hopefully, is a CERTIFIED FINANCIAL PLANNER® professional.

Jim

 

Jim Lorenzen is a Certified Financial Planner® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here.  IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.


[1] Federal income tax rates range between 10% to 35% under the 2010 federal tax code, and are based upon the taxpayer’s level of annual income. State income taxes could also apply, which vary from state to state. Please note that federal and state tax laws are subject to frequent changes.

[2] The fact that the beneficiaries are going to pay income taxes at a later date could be an advantage if they are in a lower tax bracket. As previously explained, estate taxes could also apply if the decedent’s estate exceeds $1 million after 2012.

Written by Jim Lorenzen, CFP®, AIF®

February 14, 2012 at 8:00 am