A New Rule of Thumb For Tapping Savings

EDITOR'S NOTE: This article was originally published in the September 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.

When it comes to tapping your retirement savings, a basic rule of thumb calls for withdrawing from taxable accounts first and allowing tax-deferred traditional IRAs and tax-free Roth IRAs to grow as long as you can. But a mounting body of research shows that you may be better off switching the order a bit.

In a recent study, researchers found that for some retirees, tapping part of a traditional IRA in the early years of retirement could pay unexpected dividends by reducing the size of required minimum distributions when they turn 70 1/2. Shrinking those taxable payouts could keep you in a lower tax bracket and actually boost your wealth over the long term.

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For this strategy to be effective, the authors say, part or all of your early IRA withdrawals must be sheltered from tax by tax deductions and exemptions. Consider a married couple in which each spouse is 65 or older and knows that at least $21,800 of otherwise taxable income in 2012 will be tax-free thanks to their standard deduction and personal exemptions. If the couple's taxable income before any IRA distribution would fall below that level, the couple could use "withdrawals from the tax-deferred IRAs to create tax-free income," co-researcher Alan Sumutka, associate professor of accounting at Rider University, in Lawrenceville, N.J., said in an interview.

Sumutka and his colleagues sought to determine which of 15 possible withdrawal strategies would produce equal payouts but leave a retired couple with the largest account balance after 30 years. They considered a 65-year-old married couple who retired in 2013 with $2 million, split 70% in traditional IRAs, 20% in taxable accounts and 10% in Roth IRAs. The annual rate of return was 6%. The couple's expenses the first year were $80,000 offset by $30,000 in Social Security. The study assumed that Bush-era tax cuts would be extended.

The most tax efficiency occurred when, in the years before required distributions began, the couple tapped their traditional IRAs up to the amount of their deductions and exemptions. They took the balance for the year's expenses from their taxable accounts, paying up to 15% on any long-term capital gains. Once they began taking RMDs, they continued to withdraw from their taxable accounts until they were depleted and then began tapping their tax-free Roth IRAs. They saved the rest of their traditional IRAs to last. After 30 years, the hypothetical couple still had $1.61 million.

The conventional taxable-accounts-first strategy ended in sixth place. The thinking behind this strategy is that your tax-advantaged retirement assets should be left to compound as long as possible. But that strategy left the couple with just $1.17 million.

Keeping Income on an Even Keel

A key to tax efficiency over a 30-year retirement horizon is to keep adjusted gross income and taxable income steady, the authors say. They were able to stabilize income in part by shrinking the IRA -- and, thus, the size of taxable RMDs. "If you leave too much money in the account, eventually you may be forced into a higher bracket," says co-researcher Lewis Coopersmith, associate professor of management sciences at Rider.

The researchers found that following the conventional strategy led to more volatility in income over the years and resulted in the couple spending 23 years in the 25% tax bracket, with just seven years in the 0% or 15% brackets. With the optimal strategy, the couple spent 14 years in the 25% bracket and 16 years in the 15% bracket.

Tapping the Roth before withdrawing from the balance in the traditional IRA also helped even out taxable income. "If I took the tax-deferred money before the tax-free money, I would have to pay taxes, so I would be reducing the total ending balance," says Coopersmith.

There are times when the common rule would work, the authors say. Those would be cases in which initial portfolios are large -- $8 million or more -- or contain 45% to 55% in taxable assets.

Couples with large taxable pensions would not likely benefit from tapping the IRA first.