A New Tax Efficient Retirement Withdrawal Strategy changes everything we have been told. Primarily about which funds to tap first for our retirement funding. Everyone has heard that we should always start our retirement funding by withdrawing from our taxable investments first. Then once those funds are depleted tap our Tax advantaged IRA and 401K retirement accounts. Finally our tax exempt Roth IRA funds would be tapped. Only if needed once our IRAs are gone.
It turns out that advice as being the best fund withdrawal strategy may have been a little too simplistic. It didn’t really consider the overall tax-owed-consequences vs. the delayed tax investment growth potential. The New Tax Efficient Retirement Withdrawal Strategy will squeeze another 4 to 6 years of retirement funding over what we have all been taught before.
The New Tax Efficient Retirement Withdrawal Strategy Reverses Everything
Research was done by William Reichenstein, Ph.D., CFA*: Professor and Powers Chair in Investment Management, Hankamer School of Business, Baylor University, Waco, TX, USA. His results show that the conventional retirement fund withdrawal belief should be reversed. This is due to long-term tax implications and their impact on retirement portfolio funding longevity.
What is the New Tax Efficient Retirement Withdrawal Strategy?
Simply stated. The new strategy is that we start by funding our retirement by first taking money from our tax-deferred 401K/IRA accounts. We limit those withdrawals to stay below the upper threshold of the 15% tax bracket. We then tap our non-retirement account savings/investments only when we need more than what the 15% tax bracket allows. Then lastly we should tap our tax exempt Roth investments.
The basic philosophy of this New Tax Efficient Retirement Withdrawal Strategy is this. A strategy where we never pay more than 15% in taxes. (With the tax law changes that started in 2018, this would now be to stay at or below the 12% tax rate). That is where the increase in portfolio funding years is achieved.
Supporting examples were presented in William Reichtensteing’s research. If a retiree used the commonly known retirement fund withdrawal strategy. Meaning starting with their taxable investment funds before tapping their IRA/401K funds. They would run out of money in 30 years. However with his new approach the same portfolio would last 34.37 years. An advanced strategy that includes two Roth IRA conversions was shown to extend portfolio funding to 36.17 years.
The New Tax Efficient Retirement Withdrawal Strategy and Early Retirement
Clearly retiring early before age 59 ½ will present challenges due to early withdrawal penalties. To totally follow Reichtensteing’s New Tax Efficient Retirement Withdrawal Strategy takes using an IRS rule. To fund early retirement with an IRA and avoid the 10% early withdrawal penalty a retiree is limited to what is allowed through the IRS SEPP 72t rules . The other penalty-free option is being age 55 or older to tap a 401K.
Early Retirement – What I Did
When I retired early at the age of 51 most of my investments were in tax advantaged retirement accounts. I did fund my early retirement lifestyle by using the IRS SEPP (Substantially Equal Periodic Payments) 72t guidelines. This means I receive a penalty free monthly amount from my IRA. In a way I was already using the New Tax Efficient Retirement Withdrawal Strategy. It was out of my own personal necessity. Not a premeditated tax efficiency move.
I have also since retired early from an encore-career. One where I grew my non-retirement taxable savings and investments. I use those after tax funds to supplement my 72t withdrawals. My 72t payments are limited to the initial IRS acceptable amount when I started it. They must continue for the 5 years or age 59 1/2, whichever is longer. There are no inflation adjustments for 72t payments.
In Closing
I’m always interested in new ideas and concepts when it comes to retirement. I always find it fascinating to discover things that buck the conventional thinking. I am a Leisure Freak after all. There is little that is traditional about my retirement thinking. Check out Reichtensteing research and his examples to see if you agree.
Please note. I am not a financial planner and only share this for informational purposes. Before you make any drastic changes to your retirement funding plans do your research. If you need help then seek the advice of a CFP.
Your thoughts and comments are welcomed. What do you think about Reichtensteing’s research findings?
Are you considering the New Tax Efficient Retirement Withdrawal Strategy?
Are you at least willing to look into it?
Good read. I’m like you (retired early) so we have to take money from taxable accounts but we will use our Roth’s when we hit the magic age.
Thanks for the comment Steve. I believe there are many ways to accomplish the right withdrawal strategy to meet our unique circumstances. My continued curiosity and resulting alternative discoveries has me more keenly aware of things like tax efficiency. Especially when it comes to later in retirement after starting Social Security and the age 70 1/2 RMD starts. It is far more complicated than simply spending all non retirement accounts first, then IRA and then Roth funds.
Tommy
Although I’ve encountered elsewhere the concept of Roth recharacterization after poor performance, not the idea of deliberately using multiple Roths to keep one winner and revert the losers. A nifty little loophole easy to overlook.
I always suspected the conventional wisdom was wrong. Because it ignored the benefits of tax smoothing in a progressive regime. Since money goes into tax deferred account at higher marginal rate, then exits at a lower effective rate. So for most middle income folks, 401k beats Roth during the working period.
Reminds me of the endless blog debates about Roth vs IRA/401k. Well, here is the scoop: Blanchett, David M. 2006. “Roth 401(k)s are Wrong for Most 401(k) Participants: A Quantitative Analysis.”
http://www.davidmblanchett.com/Roth401ks-JournalofPensionBenefits.pdf
This paper has a minor glitch on page 24, exhibit 6, which should say “Decreasing Replacement Ratio Equals Higher Benefit of Contributing to a Traditional 401(k)” instead of “Increasing Replacement Ratio Equals Higher Benefit of Contributing to a Traditional 401(k)”. David Blanchett is one of the bigger retirement researcher brains out there. He also questions the excessive income replacement ratios propounded by the finance industry.
Then there are the impacts of Social Security, taxes, RMDs, pensions, annuities, etc., so this smoothing takes some long term planning. I’ve found the ORP calculator
https://i-orp.com
to be very useful in modeling income and tax flows (I run the full blown version for best results). Takes some effort to set up and interpret, but well worth it. I’ve found it estimates normal income taxation reasonably accurately, but except for high income levels, overestimates combined SS/other income taxation.
Thanks for the comment Steve, Wow! A lot of in depth info. I am going to take some time and check out the links you provided. I never worked anywhere that offered Roth 401Ks so I have little background with them. I did contribute to Roth IRAs when I was working but only because I was maxing out my 401K contributions. The PDF download will be an interesting read.
Thanks again for the info.
Tommy
This is just what I needed! I am so disorganized. And when I pull up my bank statements, looking at all of the numbers kind of makes my brain go fuzzy. I needed to be able to categorize everything and see it as more than a jumbled list sorted by transaction date. Thank you very much! I think I will do something like this quarterly.
Thanks.
Thanks for the comment Bradley. I think most of us underestimate the necessity to take control of our financial life and the skills it develops.
Tommy