There’s plenty written about saving for retirement, but not so much about how to spend what you’ve saved: A Google search produced more than 15 times as many results for “how to save for retirement” as for “how to withdraw money during retirement.”
And indeed, you can save and invest for retirement over a working lifetime—40 to 50 years. But you also may have to rely on retirement savings for 20 to 30 years and how you withdraw that money can make a big difference in how long your nest egg lasts.
The conventional wisdom holds that you should withdraw from your nonretirement financial assets first, then your tax-deferred accounts (IRAs and 401ks) and then whatever tax-exempt accounts (like Roth IRAs) you might have. That seems sensible because, first of all, it’s easy to implement, and by not withdrawing from IRAs or 401ks now, you allow them to grow and delay paying taxes on them until you absolutely have to.
But more research shows that’s not an optimal strategy, since it doesn’t account for the impact of higher-than-anticipated taxes, especially when people wait to take Social Security. Less well known but more tax-efficient retirement-spending strategies can, by reducing the tax hit on your withdrawals, actually extend the life of your next egg, and that could mean the difference between running out of money and leaving something to your heirs.
Greg Geisler, an accounting professor at the Kelley School of Business at Indiana University, has studied retirement withdrawal (or “decumulation”) for years. In a recent paper, he and other researchers compared several strategies, particularly looking at their long-range tax efficiency.
Taxes, Geisler told me in a phone interview, are often overlooked in planning withdrawals from retirement accounts. Most people assume that taxes will drop when they get older and leave the workforce. And they sometimes do. But the big surprise comes in retirees’ early 70s, especially if they wait until 70 to take Social Security and until 72 to start withdrawing required minimum distributions (RMDs) from their IRAs, 401ks and other traditional tax-deferred retirement accounts. That increase in income can push them into a higher tax bracket.
“They look at their tax returns and they go, ‘Oh my goodness, I’m in the 22% or 24% or 32% tax bracket,’” Geisler said.
The reason for this is the “tax torpedo,” in which “provisional income”—which includes withdrawals from tax-deferred retirement accounts—and Social Security benefits can push marginal tax rates 50% to 85% higher. That’s how people who have fairly modest incomes find themselves paying taxes at a much higher rate than they expected.
“Tons of retirees who have a pretty good amount of Social Security and [retirement accounts they’ve built up] over the years, they’re all in the 22% bracket, every single year, once they get to age 72 and older,” Geisler said. And the tax torpedo may push 22% federal marginal rates as high as 40.7% once 85% of Social Security benefits are taxable.
So, people may have to dig deeper than they expected into their nest eggs to pay those unanticipated taxes, making it more likely they run out of money. But you can avoid that, Geisler said, with a tax-efficient strategy.
In the years from 65 to your early 70s, before you take Social Security and RMDs, you should consider tapping into your nonretirement accounts to sell appreciated stock, funds or ETFs to cover living expenses. Then, withdraw money from your tax-deferred accounts and shift the funds into a Roth IRA. But make sure both of these moves keep your taxable income below $40,400 if single and $80,800 if married, filing jointly (after taking the standard deduction of $14,250 and $27,800, respectively, if the taxpayers are over 65). Below that general threshold, capital gains are taxed at 0% while income is taxed at 12% on the federal level.
By spending profits in nonretirement accounts and shifting money into tax-free Roth accounts, you can keep your taxable withdrawals at a minimum later on by tapping into the pool of tax-free money you’ve built up in the early retirement years. (If you need the cash flow, however, you should consider taking money from your IRA or 401(k) rather than funding the Roth, said Geisler.)
Such a strategy, according to Geisler’s paper, can extend the lives of retirement nest eggs by up to 11% or three years. “It’s not just saving a little money on taxes,” said Geisler. “It helps your whole nest egg last longer.”
Of course, many people don’t have the assets or flexibility to make this strategy work, and because taxes are so individual, please consult your tax adviser and perhaps a financial adviser who has expertise in tax planning first.
But taxes are often a forgotten aspect of a neglected part of retirement planning, and they may have a bigger impact on retirement security than you’d think.