In most areas of life, it’s often best if we ignore the little things that we typically can’t control, such as traffic on the way to work or rain on your wedding day. However, in my opinion, you should sweat the small stuff when it comes to investing, because seemingly little details can meaningfully impact your bottom line.
In recent years, many people have become aware of the detrimental impact of higher costs on their investments, as evidenced by the significant cash flows going into low-cost mutual funds and ETFs.¹ Equally important for retirees spending from their portfolios is the tax impact on annual spending because of spending order, which is simply the order in which you withdraw money from your accounts. Like low-cost investing, understanding how to efficiently spend from a portfolio can help fund a better life for tomorrow.
For most investors, once retired, spending needs persist even though salaries may not. While pensions, Social Security, and other income sources may provide for some of your retirement income needs, they likely don’t provide for all of them, requiring you to spend from your portfolios. So then the question is, “how?”
Complicating matters is the fact that many investors have one or more “retirement” accounts, such as a traditional or Roth IRA, or 401(k), in addition to savings and investing accounts. So, the retirement spending order would seem straightforward, right? Shouldn’t you spend first from the accounts that were specifically established to provide for retirement spending? Not so fast. All of these accounts─both retirement and nonretirement─have their own tax implications and, as we know, taxes are not one of life’s “small stuff” items to be overlooked.
Generally speaking, an investor whose goal is to maximize spending during their lifetime should spend from accounts in the following order²:
Required minimum distributions (RMDs), if applicable. These are the first assets to use for spending because investors 70½ and older are required by law to take RMDs from tax-deferred accounts. The penalties for not taking these distributions are quite steep: 50% of the required distribution amount.
Cash flows on assets held in taxable accounts. Taxable flows─including interest, dividends, and capital gains distributions on assets held in taxable accounts─are next because you already pay taxes on these amounts each year. As a result, it’s better to use these flows to meet spending needs rather than reinvest them and possibly have to sell assets later to meet future spending needs. In the case of capital gains distributions, you may be subject to additional taxes, including much higher-taxed short-term gains if you held the assets for less than one year. You can direct your investment company to automatically send these distributions to your money market or checking account─–thus essentially creating a paycheck for yourself.
Taxable assets. At this point, you will need to start selling assets from either your taxable accounts or retirement accounts. We believe investors should deplete their taxable assets prior to spending from their tax-deferred or tax-free accounts, but for different reasons. Taxable spending should precede tax-deferred spending because swapping the order would accelerate the payment of income taxes and forfeit tax-deferred growth, resulting in lower asset balances and spending. On the other hand, investors should spend from their taxable accounts before spending from their tax-free accounts to maximize the long-term growth of their tax-free accounts and spending. Two things to keep in mind when selling assets: Try to minimize the impact of taxes by selling assets at a loss or minimal gain (if possible), and if selling assets results in your asset allocation getting out of whack, you can rebalance within your tax-advantaged accounts without incurring taxes.³
Tax-advantaged or “retirement” assets. Once you exhaust your taxable portfolio, the decision to spend from tax-deferred or tax-free assets comes down to your tax rate expectations. Generally speaking, you should spend from your tax-deferred accounts when you believe your tax rate will be the lowest. By minimizing the taxes you owe, you can keep a larger share of your assets.
We found that investors who do focus on what may seem like a “small” decision can add up to 70 basis points of average annualized return to their bottom line as compared with an investor who spent from retirement accounts prior to spending from taxable accounts.⁴ Over time, the impact on an investor’s savings can really add up, as seen in the chart below of a hypothetical $100,000 initial portfolio grown at 7.0% and 6.3% (70 bps lower return) over a 30-year retirement horizon.⁵ This example shows that the investor who thought about spending order could have had an additional $80,000 to spend compared with the investor who overlooked this seemingly “small detail.”
Please keep in mind that this order assumes your goal is to maximize lifetime spending and may not be the “preferred” order if your bequest or other estate planning motives supersede maximizing spending during your lifetime. I don’t know about you, but after my 7- and 9-year-old daughters are educated and on their way, I plan on making the most of my retirement years or die trying!
For those of you who feel this process is a bit more than you want to manage, or have estate planning considerations, this is certainly one area where seeking advice can make a lot of sense and may even pay for itself.
In my opinion, by “sweating the small stuff” of spending order, you can live a little larger in retirement!
¹ See http://www.vanguard.com/pdf/s706.pdf for more information.
² See http://www.vanguard.com/pdf/icrsp.pdf for more information.
³ Keep in mind the wash-sale rules. A wash sale occurs when an investor sells a security at a loss and purchases a substantially identical security within 30 days before or after the sale. Therefore, the wash-sale period for any sale at a loss lasts for 61 days (day of sale plus 30 days before and after). To deduct the loss for tax purposes, an investor would need to avoid purchasing a substantially identical security during the wash-sale period. Consult a tax advisor or see IRS Code 1091 for more information.
⁴ See http://www.vanguard.com/pdf/ISGQVAA.pdf for more information.
⁵ Assuming initial spending of 4% or $4,000 grown by 2.5% annually in both scenarios. This hypothetical example does not represent any particular investment nor does it account for inflation.