Withdraw From Taxable Accounts First And Let Tax-deferred Accounts Compound To Best Maintain Savings

Retirees who need to dip into savings to pay their yearly expenses should first take from their taxable accounts (i.e

. not IRAs, etc). Let the tax-deferral help your tax-deferred accounts grow faster for greater future savings. This article explains why.

The savings of most retirees can be lumped into two types of accounts:

* Tax-deferred accounts, and

* taxable accounts.

Tax-deferred accounts come from IRAs, 401(k)s, or similar type plans. They grow tax-deferred and you pay income tax only on what you withdraw from them. Because their investment earnings grow tax-deferred, none their yearly growth is lost to taxation if it's not touched. Their full earnings are available for compounding.

On the other hand, taxable accounts include CDs, mutual funds, bonds and stocks. Often these are income-type investments. Their yearly earnings are taxed whether you take money from them or not. That annual taxation on earnings robs some of those earnings from helping to compound future savings.

For comparison purposes, let's assume that the underlying investments of both types of accounts have the same annual investment growth rate. This could be from income-type investments. Such investments are typical for retirees looking for income to help pay their yearly living expenses.

-Which type account should you choose to withdraw from for paying annual living expenses?

If you must withdraw savings to pay yearly expenses, withdraw from the taxable account. That's because you've always got to withdraw from it to pay the taxable earnings amount on it anyway firstly. But beyond that, withdrawing for your expenses incurs no more taxation since you're just taking a return of your basis - assuming very little capital gains or losses for such an account.

If you withdrew from your tax-deferred account, you must pay income tax - at your income tax rate - on everything you withdraw. That's because tax-deferred accounts generally have zero basis. So you're withdrawing an amount equal to the tax you owe on your withdrawal amount in addition to the amount you need to pay for your annual living expenses.

So, overall you're pulling more out of a tax-deferred account than a taxable account to pay the same fixed amount of living expenses. Additionally, what money you have in either account will compound faster in the tax-deferred account than in the taxable account. That's because even though the underlying investments may have the same annual earning rate, the tax-deferred account allows all of it to compound; the taxable account robs some of those earnings from compounding because it has to go to annual taxation.

As an example, let's assume you have a $100,000 in both a tax-deferred account and a taxable account with both accounts having an investment that earns 3% annually. So each account produces $3,000 of earnings during the year. Now if you have $5,250 of annual living expenses you must pay at the end of that year, what would be the comparative result of taking that $5,250 from each type account if your income tax rate is 25%?

If you take the money from that taxable account to pay the living expenses, you must take a total of $6,000, first $750 (=25% of the $3,000) to pay the earnings tax due plus the $5,250 for your living expense. That leaves only $97,000 (=$103,000-750-5250) in your taxable account. Your tax-deferred account grew to $103,000 at that year's end.

If you take the money from your tax-deferred account to pay the living expenses, you must take $7,000, first $1750 (= 25% of $7,000) to pay the income tax on the full withdrawal plus $5,250 for your living expense. That leaves $96,000 (= $103,000 - 1750-5250) in your tax-deferred account. Your taxable account grew to $102,250 since you had to pay that $750 on taxable earnings of $3,000.

-Comparison of total savings:

You can see that taking your living expense money from your taxable account leaves your overall savings higher at $200,000 (= $97,000 in taxable account, and $103,000 in tax-deferred account) than if you take your living expenses from your tax-deferred account which leaves your overall savings at $198,270 (= $102,250 in taxable account, and $96,000 in tax-deferred account).

Concluding, to better maintain your overall savings while taking money for living expenses from your savings, withdraw first from your taxable accounts and leave your tax-deferred accounts alone to compound.

If you're required to make minimum required distributions (MRDs) from your tax-deferred account (after turning 701/2), then restrict your withdraws to only the MRD amount. Take the rest from your taxable accounts as I said above.

by: Shane Flait

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