Keep Your Wealth Longer by Withdraw Income from Your IRA or 401(k) Only After Using Up Your Taxable

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 the different tax treatments that apply to the investment earnings and withdrawals of each type of account makes it confusing about which type you should withdraw from first. Below I'll show that withdrawing from your taxable accounts first 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-deductable. 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 and their returns 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 more than the earnings of such investments bring no additional tax since it represents your basis - i.e. contributions previously taxed.

With that said, it is better to withdraw from your regular taxable accounts before your IRA-type accounts to pay for annual living expenses during retirement since this approach 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 will be taxable each year.

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 earning 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 the tax. That leaves only 75% of the return to compound. You lose part of the return - which helps the magic of compounding.

Second Observation:

Withdrawing for your annual living expense from your taxable account will deplete itself 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. If there was no return, you'd be withdrawing only your living expense tax-free.

When withdrawing for your IRA-type account, you must always withdraw more than your living expense since you have to pay income tax on whatever you withdraw. So the taxable account depletes slower than the IRA account.

If returns are high enough to prevent investments from shrinking, 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, but the excess withdrawal to pay those 'withdrawal' income tax for the IRA account remains constant (shrinking percentage-wise). But of course, it's best to not to not touch the IRA-type account at all - so it can compound as fast as possible 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, real estate renting, and the like - are usually best handled outside of government-regulated retirement accounts.

Article Source: http://www.a1-articledirectory.com

Shane Flait writes and consults on financial, legal, tax, and retirement issues. He explains the issues and gives you workable strategies to accomplish your goals. Find out more and get a free report on Managing Your Retirement => www.easyretirementknowhow.com/FreeReportandSignUp.htm , You can contact him at contact@easyretirementknowhow.com

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