|
< Back to Previous Page
Best Sequence of Withdrawals from Retirement Accounts is Not Always Obvious, Concludes Journal Study
Many retirees know that the sequence in which they withdraw money from their various retirement accounts—such as from taxable accounts first—can help stretch out the life of their portfolio. But which sequence is the best may surprise retirees, claims a new study appearing in the April 2006 issue of the Journal of Financial Planning, published monthly by the Financial Planning Association® (FPA®).
Two professors from the State University of New York in Brockport, New York—John J. Spitzer, Ph.D., and Sandeep Singh, Ph.D., CFA—examined withdrawal sequences using pairs of sub-accounts within a retirement portfolio. The pairs were taxable stocks versus taxable bonds, tax-deferred versus tax-exempt accounts, and tax-deferred versus taxable accounts. The question they asked was, “Does the order in which retirement sub-portfolio funds are withdrawn make a difference in how long the total portfolio lasts?” The answer, surprisingly, often depends more on investment return than tax advantages.
In the case of taxable stocks versus taxable bonds, the authors first assumed a 50/50 allocation and that the stocks would have an annual pretax return of 7.2 percent and the bonds a pretax return of 3.5 percent. They found that by withdrawing the lower-returning asset first—in this case, the bonds—the portfolio lasted three years longer than if the stocks were withdrawn first.
“It is clearly better to first take distributions from assets that have a lower expected return rather than a higher one,” they write. “The decision to withdraw first from the lower-rate-of-return asset is correct for any allocation of stocks and bonds, not only for the 50/50 allocation shown. Likewise, the decision holds for any marginal tax rate.”
In the case of a tax-exempt account, such as a Roth IRA, versus a tax-deferred account, such as a traditional IRA, it doesn’t make any difference whether you withdraw from the tax-exempt or the tax-deferred account first, as long as both are earning the same return. “The sequence of withdrawals does not change how long the money lasts,” write Spitzer and Singh.
But the above case assumed a single constant tax rate throughout the life of the accounts. If the distributions are exposed to multiple tax rates, such as 15 percent on some of the taxable withdrawal and 25 percent on the remaining taxable withdrawal, the story changes. In such a case, conclude the authors, simultaneously withdrawing money from both accounts can extend the life of the portfolio. The trick is withdrawing just enough money from the taxable account to stay below the next tax bracket and withdrawing the remainder needed from the tax-exempt account.
Finally, in the case of tax-deferred versus taxable accounts, conventional wisdom says to withdraw from the taxable account first in order to let the tax-deferred account continue to grow. Not necessarily, say the authors. “It turns out that which assets should be harvested first will depend on their respective rates of return.”
In their study, if a taxable account earned 7.2 percent before taxes, and the tax-deferred account earned 4.43 percent, the retiree could stretch out the life of the portfolio by half a year by drawing down the tax-deferred account first.
“A simple rule such as ‘leave the tax-deferred account for last’ should not be automatically followed,” write the authors.
|
