Withdraw From Your IRA After Using Up Your Taxable Accounts to Keep Your Wealth Longer

As a retiree you've probably accumulated savings in both government-regulated retirement accounts - such as a 401(k) or an IRA - and regular taxable accounts. You'll withdraw from them for your annual living expense.

But different tax treatments that apply to the investment earnings and withdrawals for each type of account make it confusing about which type you should withdraw from first. Below I'll show that withdrawing first from your taxable accounts allows you to preserve your wealth longer.

Investment earnings of government-regulated retirement accounts grow tax-deferred, so these accounts compound at their annual return rates. But you pay income tax on what you withdraw from them since your contributions were tax-deductible. The character of the investment within such plans doesn't usually influence this tax treatment.

By taxable accounts, I mean those that you contributed to with after-tax money. There's no particular tax advantage associated with the account. The character of the investments in these accounts and their return determine their tax treatment. So, interest and dividends in such accounts are typically taxed annually as income. Only long term capital gains get a lower tax treatment, usually. Withdrawing any more than the earnings from such investments brings no additional tax since it represents a return of your basis - i.e. your previously taxed contributions.

With that said, it's better to withdraw from your regular taxable accounts before your IRA-type accounts to pay for annual living expenses during retirement since this ordering of withdrawals preserves your wealth longer. To show this, I'll assume comparable investments in each account type; and, for simplicity, I'll assume whatever earnings those investments produce would be taxable each year in a taxable account.

This implies the investments produce dividends and interest as earnings. In fact, a highly reliable dividend and interest paying investment mixture is ideal for IRA-type accounts since it produces a solid return that'll compound annually under a tax-deferred account.

First Observation:

If you don't withdraw from either type of account for living expenses, the IRA-type account will grow faster - for equal yearly returns in investments.

That's because the IRA-type account return is the yearly compounding rate. The taxable account's earnings are taxed so some of the return is lost. If you're in the 25% tax bracket, you must withdraw 25% of the earnings to pay that tax. That leaves only 75% of the return to compound. You lose part of the return; and that undermines the magic of compounding.

Second Observation:

Withdrawing for your annual living expense from your taxable account will deplete that account slower than withdrawing from your IRA-type account if investment returns can't offset the withdrawals.

That's because you must pay the annual taxes on your taxable account. Pulling more out for living expenses comes out tax free as a return of basis.

When withdrawing from your IRA-type account, you must always withdraw more than your living expenses since you have to pay income tax on whatever you withdraw too. So that depletes your IRA account faster than it would your taxable account.

If returns are high enough so both investments grow each year in spite of expense withdrawals, your taxable account will grow slower than the IRA account. That's because the same percent of the taxable account's earning are necessarily lost. On the other hand, the excess withdrawal to pay those 'withdrawal' income tax for the IRA-type account remains constant - but shrinking percentage-wise.

But, additionally, it's also best not to touch the IRA-type account at all - so it can compound as fast as possible as we found under the first observation.

If you must make minimum required distributions from your IRA-type accounts, just take the minimum while taking the balance you need for living expenses from your taxable account.

Investments whose character is heavily tax-advantaged - such as capital gain-based investments and real estate rental investments- are usually best handled outside of government-regulated retirement accounts.

Shane Flait writes and consults on financial, legal, and tax issues. He tells you what the issues are all about and gives you workable strategies to accomplish your goals. Find out more and get a free report on Managing Your Retirement http://www.easyretirementknowhow.com

You can contact him at contact@easyretirementknowhow.com