It has long been the preference of many professional advisors to advise their clients to keep money in tax deferred accounts if they can and for as long as they can. The basic idea was to keep the money growing and avoid taxation. Honestly, we are rethinking that wisdom.
When I started my career over 20 years ago, some of my clients were retiring and now they are entering the final phase of their lives or have passed away. In the rearview mirror it is much easier to see the effect of this advice over time. What essentially happens, when you reach your later years and are required to take the money out, is potentially much higher taxation.
Remember, we have marginal tax rates where the percentage of tax increases with the amount of money being taxed. If someone makes $90,000 a year and they are filing single, their top marginal bracket is 24%. This means any additional income is taxed at that rate or higher, depending on how much it is. If they take up to $80,000 from their IRA that same year, it is all taxed at 24%. If they take more, they will move into the 32% tax bracket.
What happens is, early in retirement we pay less in taxes as we only take the minimum amount required from our retirement accounts. But the minimum amount required by the IRS, also called an RMD, only increases every year. Both because the numerator (value of my account) in the equation grows and the denominator (my life expectancy) in the equations shrinks. This has the effect of making our taxes later in retirement much higher for the benefit of lower taxes early in retirement.
This is at least what our gut tells us and what anecdotally we have seen across our careers. But we had to put the theory to the test to see how it worked out.
Thesis: Lifetime taxation is less when spreading retirement account withdrawals equally over retirement.
Question: Would it be better to thoughtfully liquidate retirement accounts starting as soon as someone retires?
For purposes of testing the theory, we must make several assumptions and hold some assumptions static, like taxes neither rise nor fall over retirement. Here are the key assumptions of this analysis.
- $60,000 in base taxable income
- Income increases by 3% per year as a cost-of-living adjustment
- The money coming from the IRA is not needed and therefore, the net after tax amount is invested every year in a taxable brokerage account and eventually left to the heirs.
- Over the course of retirement, the investments in both the IRA and the taxable brokerage account achieve a 6% annualized average rate of return.
- Subject is single and files their taxes that way
- Tax brackets and rates do not change over the experiment’s 28 years
Looking at three examples:
- Pat Smith retires at 65 and does not touch their traditional individual retirement savings account. They avoid taking distributions to avoid taxation of those distributions. When Pat is 72, they are required to take distributions, but only takes the minimum amount required. Assume Pat keeps this up until they pass at 92 years old.
- Pat Smith retires at 65 and starts taking the distributions from their traditional IRA retirement savings account right away. They simply take the value of the account on December 31st, then divide it by their remaining life expectancy and withdraw that amount. Initially this is 28 years, then 27, then 26, and so on.
- Pat Smith works with TenBridge Partners who calculate how much they would need to withdraw each year given 28 years of withdrawals at a 6% growth rate where they have a $0 balance in the retirement account at age 92. Pat then sets up an annual transfer of this amount to their taxable brokerage account with taxes automatically withheld and paid on their behalf.
After doing the analysis the thesis was proved true and the question answered in the affirmative. To see our analysis click here.
Example three (3), spreading withdrawals equally over our lifetime, not only led to the least amount of lifetime taxes paid, but it also led to the highest amount of income-tax-free inheritance for the heirs. The focus here is on “lifetime taxes paid”. You will notice that under example number one (1) Pat pays a lot less in taxes at the beginning of their retirement. It isn’t until 12 years later at 77 years old in year 2034 that example number one (1) surpasses example number three (3) in tax due. But it simply grows from there.
Whether the goal is to minimize the lifetime tax burden, or it is to maximize the estate value for heirs, it is potentially much better, depending on your personal circumstances, to have equally withdrawn the IRA over a lifetime. The traditional tag line of keeping the money growing and avoiding taxation as long as possible, just doesn’t quite hold water for everybody.
Of course, everyone’s life situation, tax situation and extenuating circumstances are different. That is why you work with financial professionals at TenBridge to do the analysis for you. So, please reach out and let us know how we can help. We’d be happy to help clients and non-clients alike do this analysis using their personal numbers and situation.
And as a caveat, the traditional advice professionals give is not bad. It is simply easier to keep the tradition alive rather than challenging the status quo. I did it too. But we are always challenging the way we do things at TenBridge and debating the best path forward, it is what makes our job exciting and how we deliver real value for our clients.
After all, it is always a pleasure to be of service. We look forward to talking with you.
This newsletter and analysis are for illustrative purposes only and to facilitate a conversation. Please consult with your tax professional and Certified Financial Planner Practitioner before making decisions regarding your specific situation. Rates of return, growth rates, and tax rates are not guaranteed and are for analysis purposes only.
From the desk of Erik Lawrence CFP®
www.tenbridgepartners.com / (971)277-1077