Optimal Distribution Planning for IRAs and Retirement Plans Spending the Right Funds First
by: James Lange, CPA, JD

KEY IDEA: Spend after-tax dollars first and tax-deferred dollars second.

Topics include:

The optimal order for spending down assets.

Which Assets Should Your Client Spend First?

With retirement, an individual moves into distribution mode, i.e., begins to spend his or her retirement savings. This is not to say that accumulation stops. Income and appreciation on the investments, social security and any pension plan might still be exceeding expenses.

Your client may be fortunate enough to find that his or her social security, pension, and dividends and interest on their after-tax investments produce enough funds for living expenses. Let’s assume, however, that isn’t the case, and that your client is required to either invade his or her “after-tax” funds (the nest egg) or make taxable withdrawals from their IRA or retirement account to make ends meet.

In general, it is preferable to spend principal from after-tax investments rather than taking taxable distributions from IRA and/or retirement plans. A graphic comparison of the benefits of spending after-tax savings before pre-tax accumulations follows with the details in Mini Case Study 4-1.

Mini Case Study 4-1: Spend Your After-Tax Money First

Both Mr. Pay Tax Now and Mr. Pay Tax Later start from an identical position. They both have $300,000 in after-tax funds, with a cost basis of $255,000, and $1,100,000 in retirement funds. They both receive $25,000 per year social security income. They want to spend $8,000 per month, or $96,000 per year after paying income taxes. Their investment return is 8%, consisting of 70% capital appreciation with a 15% portfolio turnover rate, 15% dividend income, and 15% interest income. Income tax assumptions include the new lower rates established by JGTRRA of 2003. State income taxes are ignored.

Mr. Pay Taxes Now does not spend any of his after-tax funds until all the retirement funds are depleted. By spending his retirement funds first, he triggers income taxes on the withdrawals, reducing the tax-deferral period, and his balance goes down. He also subjects a larger share of his total funds to income taxes each year in the after-tax environment since his after-tax funds are growing at the rate of 8% per year. All income taxes due on the retirement funds and the after-tax funds cause a greater amount to be withdrawn from his retirement account. In 32 years, by paying taxes prematurely, he has sacrificed over $600,000 in growth. At this time when he is 97 years old, Mr. Pay Tax Now is out of funds, while Mr. Pay Tax Later has over $1,200,000 and that will last him another seven years. In states like Pennsylvania that do not tax retirement income but do tax after-tax investment income, the benefits of spending the after-tax money first is even greater. The principle stands: don’t pay taxes now—pay taxes later!

Mini Case Study 4-2: A Note to Those Who Fear Capital Gains Tax

One of the primary reasons people think it may be better not to spend the after-tax money first is because of capital gains. For example, if instead of having a basis of $255,000 on the $300,000 of after-tax funds, let us assume the basis is zero. All spending of after-tax funds will be taxed as capital gains. If we use the same assumptions as above, the graph above looks like this:

You may have a hard time telling the difference. These results show that Mr. Pay Tax Now is out of funds at age 96 rather than age 97 as in Mini Case Study 4-1, while Mr. Pay Tax Later still has over $1,200,000 left and that will last him another seven years. In both examples, the bottom line is that it is still wise to spend that after-tax money first, even when capital gains are involved. I will point out, however, that the step-up in basis rules may provide planning scenarios that contradict this conclusion. For example, in estate situations where only a short remaining life time is anticipated or where the plan is to pass on the funds inside the estate, it may be advantageous to not spend highly appreciated investments.

Mini Case Study 4-3: The Optimal Order for Spending Classes of Assets

Phyllis Planner is 65 years old and widowed (though the conclusion would be basically the same for a married taxpayer). She is thinking ahead to her retirement. She wants her money to provide her with a comfortable standard of living, and she also wants to leave some money to her three children. How should Phyllis evaluate which pool of money to spend first and which to save for as long as possible?

There are four general categories of money to support her retirement. They are ranked in order of what I recommend Phyllis spend first, exhausting each asset category before breaking into the next asset category.

1) After-Tax Assets Generated By Income Sources:
a) pension distributions.
b) dividends, interest, and capital gains on tax managed investments.
c) earned income, not reinvested.
d) social security.

2) Previously Saved After-Tax Assets (Investments that are not part of a qualified pre-tax retirement plan that would generate income subject to taxes annually).
a) Investments that will either sell at a loss or break even.
b) Highly appreciated investments.

3) IRA and Retirement Plan Assets (Assets subject to ordinary income tax).
a) IRA, 403b, 401(k), etc., dollars.

4) Roth IRA
a) Roth IRA dollars.

The assets in the income category should be spent first, since she has to pay tax on that money anyway. But let’s assume that Phyllis’s social security and the pension and dividends and interest are not sufficient to meet her spending needs. Then the question becomes “which pool of money should be spent next?” If we keep in mind the premise “don’t pay taxes now—pay taxes later,” the answer is obvious: the after-tax dollars. If we spend our after-tax dollars, except to the extent that there is a capital gain triggered on a sale, those dollars will not be subject to income taxes and the money in the IRA can keep growing tax-deferred.

Whenever you make a withdrawal from the IRA, you are going to have to pay income taxes. To get an equivalent amount of spending money from the IRA assets and the after-tax assets, you have to take the taxes into consideration. Assuming a 25% tax bracket, you need $1.33 from the IRA assets to get a $1.00 of spending money ($1.00 cash + $0.33 to pay the taxes). We get the .33 cents because $1.33 times 25% = .33. On the other hand, the after-tax money is withdrawn tax-free, so to get $1.00, you withdraw $1.00 (with the exception of capital gains tax at 15% on the appreciation when you withdraw the money).

Then, when Phyllis has exhausted her “after-tax” funds, then she delves into her IRA or pre-tax funds. Finally, when she exhausts her IRA and pre-tax funds, she spends her Roth IRA.

Why should she spend her traditional IRA before her Roth IRA? If tax-deferred growth is a good thing, then tax-free growth is even better. By spending taxable IRA money before Roth IRA money, she increases the time that the Roth IRA will provide income tax-free growth.

If your plan is to leave money to your heirs, their tax situations should be considered as well. If the heirs to the Roth have tax deferral/avoidance as a goal, and their tax bracket is the same as yours or higher, then the Roth assets are the best to inherit. The opposite conclusion may be reached if the heirs plan on spending the money soon after they inherit it and are in a lower tax bracket. If that is the case, it is possible that you would be better off spending the Roth IRA yourself. The facts of each case should be considered. In general, however, I would stick to what I recommended for Phyllis.

Mini Case Study 4-4: Figuring the Tax Bracket Advantage into the Spending Order

One possible exception to spending after-tax dollars first, is to “prematurely” make small IRA withdrawals to stay in a low tax bracket.

Though Joe and Sally Retiree, ages 65, have an estate of $1,000,000, their taxable income is only $30,000. When Joe reaches age 70½, his minimum distribution will push him in the 25% tax bracket. Joe decides to make voluntary withdrawals from his IRA every year until he reaches his minimum required distribution date as follows:

Top of the 15% bracket for married filing jointly (using 2003 tables) is $56,800. Joe and Sally already have $30,000 in income before any IRA withdrawal. If Joe then makes a $26,800 IRA withdrawal, he stills pays tax at the 15% rate. If he doesn’t, the later distributions will be taxed at 25%.

Depending on the circumstances, this might be a reasonable strategy. For many clients, particularly frugal clients, I would prefer a variation of this strategy. Instead of making an IRA withdrawal of $26,800, paying tax on the funds, and then being left with “after-tax” dollars that will generate taxable income, I would recommend Joe make a $26,800 Roth IRA conversion. Many clients will resist this advice, but I urge you to at least consider it.

If Joe doesn’t want to make a Roth IRA conversion, he should at least consider making “premature” IRA distributions based on tax brackets. Please note that adding income in the form of extra IRA distributions and/or Roth IRA conversions may have an impact on the taxability of social security benefits which should be worked into the numbers for how much to withdraw or convert.

James Lange is a tax attorney and CPA who provides specialized retirement and estate planning services to same sex couples with significant retirement plan accumulations.  He has prepared over 450 simple and complex retirement and estate plans.  These plans include tax-savvy advice, will and trust preparation, and sophisticated beneficiary designations for IRAs and other retirement plans. You can contact Jim by phone at (800) 387-1129, or (412) 521-2732, or by e-mail at admin@outestateplanning.com.