Three Steps to Generate More Income from Your Retirement Savings

Retirement Daily Guest Contributor

By Massi De Santis

Most retirees rely on multiple sources of personal retirement savings to generate retirement income. Besides Social Security, they typically rely on a combination of savings from tax-deferred accounts (TD), like 401(k)s and traditional IRAs, taxable brokerage and savings accounts (T), and tax-exempt accounts (TE) like Roth 401(k)s and Roth IRAs. The question is, in what sequence should we withdraw from the various accounts to generate more retirement income or make the portfolio last longer?

Big Differences in Outcomes

Research finds that having the right sequence of withdrawal can have a large impact on the ability to generate income from a portfolio, either in terms of expected account value at the end of a plan or longevity of the portfolio, in years. In an experiment published in the Journal of Financial Planning, researchers tried 15 different strategies over 30 years for a 66-year-old couple with $2 million available to them, spread across T, TD, and TE accounts. Comparing the total balance at the end of the 30-year mark, the authors show that while some strategies ran out of money, optimal strategies ended with over $1.6 million in total account balance. Related research shows that an optimal strategy can make your nest egg last up to six more years, from 30 to 36. This big difference can be very useful given current longevity trends.

Two Key Principles: Tax-Drag and Taxes

Two key principles can guide our decision. First, there is a tax-drag to growth in taxable accounts, and not in TD or TE accounts. Second, it helps to think of your TD accounts as a partnership with the government, where the government portion equals the marginal tax rate at the time of withdrawal. Remove that portion, and the remaining part, your portion, grows tax-exempt, just like a TE account.

The first principle says that your dollar in TD or TE accounts will grow faster than your dollar in a taxable account. The second principle gives you an incentive to find opportunities to lower the portion of the TD account that belongs to the government. Let’s apply the principles.

A Rule-of-Thumb to Start

You may be familiar with withdrawal sequence T, TD, TE: start withdrawing from your taxable account, then withdraw from the tax-deferred account, and finally from the tax-exempt account. The above-cited research shows that this sequence is not optimal in general. The reason is that it is not a good application of the second economic principle. It ignores that there are opportunities to turn some TD savings into tax-free or low-tax income, and the fact that larger withdrawals later on from TD accounts (including RMDs) can put you in higher income tax brackets. However, as we show below, it is a useful starting point.

First, Set a Goal

The first step is to set a goal for your desired expenses (not income). Once you know what you need, every sequence you choose will have different implications for the amount you need to withdraw every year, and hence the amount that you can spend on you versus the amount you pay in taxes. Consider this example: A couple of retirees, both 66 years old, plan to start receiving social security when they turn 70. They have $1 million between their 401(k) accounts and $700,000 in their joint taxable account. Their desired expenses are $105,000 per year and they have decided to postpone Social Security to age 70 when they will receive a combined benefit of $65,000. Hence, the couple will need to generate $105,000 in after-tax income until age 70, and $40,000 afterwards.

Next, Project a Tax Rate Using the Rule-of-Thumb

Their taxable income over time will vary with the chosen strategy. For example, if they decide to withdraw from their TD at age 66, their withdrawal (and their taxable income) will be $116,000. After paying federal taxes they end up with $105,000 (considering a standard deduction). If they decide to withdraw from their taxable account, their withdrawal might be $105,000, with zero taxable income. With so many combinations available over the life of a plan, how can we compare strategies?

A good way is to start with the rule-of-thumb sequence T, TD, TE. If the 66 year old couple followed this rule, their taxable income over time would look like the following plot.

De Santis 1
For illustration purposes only.

Then Smooth Your Tax Rate

The picture shows how the couple can improve on this strategy. Notice that, initially, their tax rate is zero, as the income and capital gains generated from the taxable account are lower than the standard deduction, and there is no Social Security income. Instead of using the standard deduction ($27,400) on capital gains income, it would be more efficiently employed against ordinary income, withdrawing at least that amount from the TD, 401(k) account.

In addition, the figure shows that taxable income crosses the 22% (25% after sunset of the 2017 Tax Cuts and Jobs Act) when the couple reaches age 72, due to required minimum distributions (RMDs) from the 401(k) accounts. Therefore, the picture is telling us that by filling up the 12% tax bracket in the first stage of retirement, the couple could reduce or eliminate the amount taxed later at 22%.

De Santis 2
For illustration purposes only

This can be accomplished by making TD withdrawals and Roth conversions of the same amount until age 71, using funds from the taxable account to pay for the tax liability. Doing so could reduce the marginal tax rate over the entire plan. And with the Roth conversion, the majority of any leftover amount would be tax-exempt at the end of the plan!

Key Steps

This process can be summarized in the following steps:

  1. Set a clear goal for desired expenses
  2. Project your tax rate under the rule-of-thumb sequence
  3. Find opportunities to smooth your tax rate

Step two requires you to compute likely account balances as you withdraw over time, and a pre-tax amount needed to meet your needs. There is obviously some uncertainty about that, but it’s a simple task if you start with reasonable expected returns and use a spreadsheet of financial planning software to project your plan. The goal is not to get it right to the penny, but to provide a guideline that you revise every year as you go through retirement.

Your situation may be different, but given the potential gains from a strategy designed to your situation, it makes sense to plan ahead. Having the right strategy can mean less worry about running out of your savings because you lived longer than expected, a higher desired income for the ideal retirement you have planned, or a larger bequest to your loved ones or your favorite charity.

About the Author – Massi De Santis

Massi De Santis is an Austin, TX, fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.


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