Distribution in Retirement
Posted in : Investing:
- On : Oct 17, 2005
Changing from asset accumulation to asset distribution takes a major shift in thought and process for those moving from pre-retirement to the retirement stage of life. The steady, every-week paycheck is now replaced by pension, Social Security and more important, discretionary withdrawal decisions from retirement investment accounts.
The latter, if handled correctly, offers the promise of a relaxed, enjoyable retirement. To get there requires a certain amount of planning.
The first step in the process is to accurately formulate a budget to live by. The process of evaluating how you spend your money is as useful as the end result. Most go through their working years spending what they make without ever really analyzing where the money goes. When examined more closely, it becomes obvious that there are fixed costs … rent or mortgage, food, transportation, insurance, etc. … and variable or discretionary expenses … recreation, eating out, gifts, etc. … over which one can exercise considerable choice.
Many who go through this process are able to cut their spending by significant amounts without materially affecting their lifestyle simply because when there is a paycheck coming every week they are inclined to be more generous spenders.
Part of the budget for retirement has to include potential capital expenses such as major home repairs or an automobile purchase.
Once a prospective budget is put together, subtract fixed payments from Social Security and guaranteed pensions … the difference is the amount you will have to make up from retirement savings.
Retirement savings come in two tax flavors … qualified money, or money coming out of IRAs or defined contribution plan distributions … and non-qualified money coming from retail investment accounts, rental income, or work related. The former is generally taxed at ordinary income tax rates and the latter will be taxed as ordinary income, rental income, dividends or capital gains depending upon the source.
The object of the game is to maximize your after-tax wealth, which implies paying taxes on retirement income at the lowest possible rates.
If you have a choice it is generally better to spend money on which taxes have been paid first, and defer spending from qualified plan accounts as long as possible. Money left in a qualified account, which is allowed to grow and compound without paying taxes benefits from the fact that a larger principal amount is compounding.
For example if you withdrew $10,000 from an IRA, paid the taxes at 28%, and invested the money to grow at 8%, after 15 years you would have a hypothetical $16,678 after taxes. The same $10,000 left in a conventional IRA would accumulate a principal sum, inside the IRA, of $31,722. If the principal sum of either account were invested in taxable bonds paying 6% interest and then distributed as income, the taxable account would generate $1,000.68 and the IRA distribution would generate $1,903.32. Since both amounts are taxed at the same rates, the value of tax deferred compounding is clear.
In general, spend first from sums on which taxes have been paid … these might include inheritances, or tax free sales proceeds from a home sale. If in a higher tax bracket, invest for income in tax-free municipal bonds. For other taxable distributions look for qualified dividends and capital gains transactions, both taxed at a Federal maximum of 15%.
Hold risky assets that could potentially produce a capital loss inside a taxable investment account. The losses can be used to offset other capital gains. This is not the case inside an IRA.
In IRA and other qualified accounts, invest in bonds paying ordinary interest. As long as the interest income earned stays inside the qualified accounts, you will pay no taxes.
Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.