What To Spend First In Retirement



What To Spend First In Retirement

There are three basic phases of a financial life: growth, income and gifting. People tend to focus most of their attention on building wealth, not necessarily how they're going to tap into it or preserve it once they die.

IRAs, 401(k)s and annuities were created for the first two phases. To encourage you to set aside money for retirement, the government allowed for tax-deferral. When this tax privilege was created, it was assumed that when you took income from these instruments, you would be in a lower tax bracket. Fast forward to today, and investors are confronted with three problems they hadn't counted on:

• 1. We've been programmed over the years to defer taxes; so when it comes time to tap into our retirement funds, we get queasy just thinking about stopping the deferral.

• 2. The lower tax bracket we were promised has, for many of us, evaporated.

• 3. The new tax changes now let you defer taxes even longer than before, enticing you to leave even more money to compound tax-deferred.

You may be operating under the assumption that your retirement accounts should be last resorts for income; but when you take into account your current tax bracket, other assets and the tax code, you may need to tap the retirement accounts sooner rather than never.

Tax deferral is not tax avoidance. The Treasury Department is not a charitable organization. The longer your qualified accounts compound, the greater the tax bite ' if not for you, then for your heirs. After educating myself about all of the issues, I now believe it may be better to tap those tax-deferred accounts first and leave other accounts ' which have a better chance of passing to your heirs income-tax free ' for last. Let's look at an example. Mr. Smith, age 66, has a retirement portfolio worth $1,009,000. He needs a total monthly income of $6,100. He gets $2,530 per month via Social Security and rental property, leaving him with a shortfall of $3,570. Here's a withdrawal strategy for him based on the most tax-effective order:

Variable Annuity ($93,000): Mr. Smith withdraws $1,500 each month for approximately 5 years before it reaches a zero balance. He taps into this account first because his heirs will pay income tax (at their rate) and estate taxes (if his assets are large enough) on any growth upon his death.

IRA ($326,000): Not only will this account generate $3,570 each month for an indefinite period, but at 15% compounded growth over the long-term, this account will continue to gain value even as withdrawals are taken.

Roth IRA ($532,000): This account is the last qualified account to be touched because it is funded with after-tax money. If, unlike Mr. Smith, you want to take income prior to retirement, but after age 59 1/2, the Roth IRA is a great tool. Not only can you continue to contribute beyond age 70 1/2 for as long as you have earned income, you can withdraw earnings income tax-free and without penalty (as long as it is more than 5 years old.) Sitting down with your CPA may be the wisest way to determine your best course of action. Realize that the tax laws are continuing to change and so does your net worth. Building a plan that will meet your goals and minimize taxes is what financial freedom is all about.

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