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Balancing Distributions Across Retirement Vehicles Can Add 5-8 Years Or More To Your Retirement Dollars

Apr 21, 2008
The greatest retirement fear today is outliving your savings. Maximizing the number of years your retirement savings will last may be as simple as apportioning distributions among tax free and tax deferred retirement savings. Balancing tax rates on distributions against retirement savings growth rates can add 5 to 8 years or more to your retirement, when you have both tax deferred (e.g., 401K) and tax free (e.g., ROTH IRA) retirement savings.

First we assume that both tax deferred and tax free accounts are growing at the same rate. If not, then the asset allocation of the accounts should probably be adjusted. Given that the tax deferred account is taxed upon distribution, we can effectively say that it grows at a slower rate than the tax free account. It would make sense then to take all distributions from the tax deferred account first, until there is nothing left, so as to let the tax free growth continue unmolested as long as possible.

However, under our current tax laws, tax deferred retirement savings are taxed upon distribution, using the same income tax brackets as any other earned income. This is a graduated scale, such that the marginal tax rate increases with income. E.g., the 10,000th dollar earned is taxed at 10% while the 20,000th dollar earned is taxed at 15% and the 70,000th dollar earned is taxed at 20% (married filing joint).

Considering a 3% inflation rate, a static tax table (using federal taxes only), and the desire to take the same net distributions annually, then taking all distributions first from the tax deferred accounts will result in paying higher and higher taxes over time. Paying the higher tax cuts into how long the money will last. The challenge then is to balance the taxes paid on distributions from tax deferred accounts against the growth of the tax free accounts. Selecting the correct amounts can easily make 5 to 8 years of difference in how long the savings can be played out, as will be shown in the charts below.

In the following scenario, we take nine couples who have each accumulated $1,000,000, spread across tax deferred accounts (e.g., 401K or IRA) and tax free accounts (e.g., ROTH IRA). They need $60,000 per year, in after taxes in distributions, in today's dollars.

Should the tax deferred money be used up to a specific tax bracket and tax free money used to round out the desired distribution? Does the apportionment of distributions differ depending on the allocation of tax deferred and tax free retirement savings?

The answer depends on the allocation of funds across tax deferred and tax free retirement savings. It also depends on the actual amounts (not covered in this article). The chart below compares these nine couples, showing the significant difference the selection of distribution source makes.

Tax Def Tax Free Distrib Timespan Distrib Timespan
$100,000 $900,000 $0 26.39 years $ 8,500 27.46
$200,000 $800,000 $0 24.89 years $16,500 26.93
$300,000 $700,000 $0 23.53 years $24,500 26.16
$400,000 $600,000 $0 22.23 years $33,000 25.43
$500,000 $500,000 $0 20.96 years $42,000 24.71
$600,000 $400,000 $0 19.79 years $51,000 24.02
$700,000 $300,000 $0 18.68 years $60,000 23.33
$800,000 $200,000 $0 17.61 years $69,000 22.58
$900,000 $100,000 $0 16.59 years $82,000 21.71

With $900,000 in tax deferred accounts and only $100,000 in tax free accounts, a 5-year difference exists depending from which accounts distributions are taken. Limiting distributions from the tax deferred account to only be $82,000 in any given year achieves a 21.71 year lifespan for their retirement dollars, whereas using tax free distributions first only achieves a 16.59 year lifespan - a 5.12 year difference. If the couple only needed $50,000 after tax distributions, the chart would show an 8 year difference (not shown).

If the couple used only tax deferred income until it was exhausted, they would have had 21.54 years for their retirement money - a loss of only 0.17 years against their maximum. The lesson here is to err on the side of taking distributions from tax deferred accounts first. This is also significant as it is far easier to accumulate tax deferred savings. There are more stringent contribution limits to ROTH IRAs and not all companies support ROTH 401Ks. And you have to pay taxes at the very beginning in order to grow your money tax free. Different needs with respect to the available savings can result in over 1-year of difference; it still pays to pay attention. The greater the retirement savings and distribution requirements, the more important the balancing act.

Due to our tax code's graduated tax brackets, properly apportioning distributions among tax free and tax deferred retirement savings can add 5 to 8 years or more to your retirement. This varies with distribution needs and the amounts saved in differing retirement vehicles.
About the Author
Robert T. Boyer, Ph.D., works with professional advisors to perform comprehensive, collaborative, integrated financial planning. VP of San Diego's Finest Real Estate, he developed the unique concept of Real Estate Financial Planning (REFP) to fill a void left by the financial planning industry. Including REFP enables the team to development a fully integrated financial plan.
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