Retiree Portfolio Which to Use First: Taxable or Tax-Deferred Accounts?

By David Braze (TMF Pixy)
December 27, 1999

Prior to the passage of the Taxpayer's Relief Act of 1997 (TRA 97), conventional wisdom held that retirees should first use up their taxable investments before touching tax-deferred accounts like retirement plans or IRAs. That's because most retirees would be taxed on any gain in a taxable investment as if it were ordinary income anyway. The only ones not taxed that way were retirees in the 31% or higher marginal brackets who could use a maximum long-term capital gains tax rate of 28% on their investments.

For everyone else, it made no difference whether the income came from taxable interest, dividends, or capital gains. Those proceeds would be taxed just as if they were ordinary income. Therefore, it made sense in the days before TRA 97 to let the tax-deferred investments continue to grow untaxed until the money had to be withdrawn. The tax-deferred compounding would let it grow larger than it could in a taxable account.

TRA 97, though, changed the maximum long-term capital gains rate to 20% for those in a 28% or higher marginal income tax bracket. Those in a 15% marginal bracket have a maximum capital gains rate of 10%. For the long-term, buy and hold (LTBH) investor, that change dumps conventional wisdom upside down and turns it on its ear. With the change in capital gains taxation rates, a retiree who uses a LTBH strategy may benefit her family far more by taking money from a traditional IRA first, and using a taxable account only when the IRA runs out. Sounds weird, doesn't it? Yet under current tax laws it's absolutely true. In a bit, we'll see why.

TRA 97 also increases the amount you may pass to heirs before estate taxes begin. Between 1997 and 2006, the point at which estate taxes kick in will change from anything above $600,000 to anything above $1,000,000 of the total assets you leave behind. Keep in mind that heirs take your taxable investments at their market value at the time of death. That means they can sell those assets immediately and owe Uncle Sammy nothing.

Assets in IRAs or retirement plans, though, do not pass at market value. Instead, anything in those tax-deferred vehicles on which you have not paid income taxes during your life will be taxed to heirs (other than spouses) at their (not your) ordinary income tax rates when they receive them. Also, the total market value of both taxable and tax-deferred assets counts as part of your estate for federal estate taxation purposes when you die. So even if your heirs won't be taxed on what they receive, your estate may still have to pay taxes before those assets get to those heirs.

The change in capital gains tax rates, the phase in of new estate taxation floors, and the potential taxation of tax-deferred assets to heirs all mean we should look at how we take our income in retirement from a new perspective -- that of the total tax impact on the family. Typically, we don't do that. We're so steeped in the concept of avoiding income taxes today that we fail to see the big picture. How can I ensure that I keep Uncle Sammy's and Auntie State's hands off my family's assets both in life and after I die?

I recently completed an in-depth analysis of that question from the perspective of a LTBH retiree with one-third of invested assets in a taxable account and two-thirds in an IRA. That ratio of taxable versus tax-deferred accounts is fairly representative of many folks who retire today. I could bore you to tears and lengthen this article significantly by listing all of the assumptions I made in the analysis. But I won't. Instead, I'll just say that I looked at a 62-year-old who retired this year, took a starting income from his portfolio, and left the rest to accumulate in his investment.

As the LTBH investment in both the taxable account and in the IRA, I used the actual returns from the Foolish Four for the period 1961 to 1998, and simply said those returns would duplicate themselves for the next 38 years. I did the same for inflation rates to allow the retiree's initial withdrawal to increase with inflation through the years. I also began minimum required withdrawals from the traditional IRA as required at age 70 1/2. If that withdrawal exceeded the inflation-adjusted payout required for that year, the excess after taxes was reinvested in the taxable account until needed. Finally, I looked at three taxpayers and assumed any withdrawals would be taxed at their marginal income tax rates. The initial withdrawals required and the amounts available for investment in both the taxable account and the IRA before that withdrawal are shown below.

                         Retiree in Marginal Bracket 
                           15%        28%       31%
Available before         ========   =======   ======
initial withdrawal:
   Taxable account        50,000   100,000   200,000
   IRA                   100,000   200,000   400,000
Initial withdrawal         9,000    18,000    36,000
For all three taxpayers, I looked at taking the initial and subsequent inflation-adjusted withdrawals from the taxable account first or the traditional IRA first. There were nine possible 30-year periods between 1961 and 1998, so I examined these portfolios as if they would start in each of those nine periods to determine if the starting date would alter the results based on actual historical data. The construction of the worksheets was enormous, and after all iterations had run, the file grew to 7.6 megabytes. It's totally impossible for me to post all of those spreadsheets on The Fool, so I have boiled down the summary to just seven columns for each taxpayer, and I show only one of the nine separate periods examined for each taxpayer. But that's enough because all of the periods showed the same result. Additionally, for the sake of brevity I have displayed only the first 19 years of that 30-year period.

In the tables linked below, all columns labeled "Taxable" mean that withdrawals came from the taxable account first. Those labeled "Trad IRA" mean withdrawals came from the traditional IRA first. The tables assume the retiree takes the required withdrawal for the age shown, and then promptly dies. The two columns labeled "Inc Tax in Life" show the cumulative income taxes paid on all withdrawals during the retiree's life. The two columns labeled "Total Taxes on Family" show the total taxes paid by the retiree in life plus, when applicable, estate taxes as well as income taxes paid by heirs on the traditional IRA. The last two columns labeled "Net Estate to Heirs" show how much passed to heirs after the payment of all taxes.

See Tax Tables »

The tables show that during the first 12 years of withdrawals these retirees paid higher income taxes by using the traditional IRA first. That was generally true of all the nine 30-year periods I studied, but that effect did range to as high as 18 years in one case. After that, though, income taxes in life were less when the traditional IRA was used for income first. Note that for all ages for all three taxpayers, use of the traditional IRA first resulted in a lower total tax burden to the family at death (i.e., the retiree's income taxes, estate taxes, and the heir's income taxes on inherited IRAs). Result? Use of the traditional IRA first resulted in more money staying within the family fold.
The moral we can take from this effort is simple. For an LTBH investor, the old conventional wisdom of using your taxable accounts first for retirement income may be harmful to your family's coffers regardless of when you meet your maker. Consider that as you plan your withdrawals in retirement.

And before you ask, yes, I did look at converting the traditional IRA to a Roth, waiting five years, and then taking withdrawals from that instead of the taxable account. While in general that approach would produce a higher net estate for heirs than using the taxable account until it was exhausted, the results were far better when the traditional IRA simply remained in place and was used first for withdrawals.

That's it for this week. If the Internet remains alive and well, I'll see you in Y2K. Stay safe for the holiday, and have a great new year!

Best to all... Pixy