I recently met with someone who was very proud that she had accumulated enough in her bank savings account that she wouldn’t have to draw from her retirement accounts until several years into retirement. She was a bit confused when I told her she could actually run out of money sooner if she pursued this strategy because she only paid taxes on the interest from her savings account, yet all of her withdrawals from retirement accounts would be taxable. How could this happen?
Since we have progressive income tax brackets, not every dollar earned is taxed the same. The more income you have, the higher the percentage you pay. While the idea of not paying any income taxes may sound appealing, it could actually lead to paying more taxes in the future if most of your retirement savings are in accounts like 401(k)s or traditional IRAs. This issue can become more pronounced once you reach age 70.5 and must begin to take mandatory withdrawals from your IRAs.
A better strategy is to recognize that eventually you will pay income taxes on retirement accounts, so why not pay the tax at the lowest rate possible? For example, a single person could have income up to $46,250 (assuming they’re younger than 65 and take the standard deduction) and still be in the 15 percent tax bracket. The next higher tax bracket is 25 percent, which is significantly higher.
One caveat to following this strategy is to recognize that someone collecting Social Security retirement benefits has a more complicated situation because the rules for how much Social Security benefits are taxable is based on how much other income is being reported. Also known as the “tax torpedo,” a person’s effective tax rate could be significantly higher based on the calculation for taxing Social Security, so caution is warranted.
The idea of tax-efficient withdrawals has been supported for a number of years by academic research. Most recently, Dr. William Reichenstein from Baylor University published an article in the Journal of Wealth Management demonstrating that tax-efficient withdrawals could result in a portfolio lasting 20 percent longer than a less optimal approach. Reichenstein looked at several scenarios with different types of accounts. He found that drawing income from accounts such as 401(k)s and IRAs to use lower tax brackets had a significant impact on the longevity of an investment portfolio.
Based on this research, a better approach for the woman I spoke with would be to use her savings account in conjunction with her retirement accounts to use the lower tax brackets every year, ultimately allowing her money to last longer.
Justus Morgan is a fee-only financial planner with Financial Service Group Inc., a registered investment advisory firm at 4812 Northwestern Ave.; online at www.ToYourWealth.com.