Maximizing Your Retirement Dollar

"The quality, not the longevity, of one's life is what is important." - Martin Luther King, Jr.

I don't think I have ever said that my blog is a must read but if you are approaching, planning for, or in retirement then this blog is a must read.  Trying to make our retirement dollars last through our remaining life expectancy is one of the most important considerations that we have.  Not running out of money before you die has to be a priority and therefore maximizing your retirement dollar is critical.

In an excellent article in the Financial Analysts Journal by Kirsten Cook, William Meyer and William Reichenstein, the authors present a methodology for extending your investment portfolio without changing your investment strategy or the amount that you have invested but by simply using the tax code to your advantage.  Now some of my international readers may think this does not apply to them but I am sure that reading this article will spark some ideas that you can use at home to assist your portfolio.

The common rule of thumb is that in retirement you should first exhaust your taxable investments (TI), then your tax deferred investments (TDI) and finally your tax exempt investments (TEI).  The authors of the article point out that if the tax rate is flat there is no difference between the TDI or the TEI, It is only when there is a progressive tax structure (such as the one in the United States) where a difference exists.  In a flat tax environment whether you have a TDI or a TEI account will result in the same net amount.  You can try it on a calculator if you like but believe me placing an amount net of tax into a TEI and growing it at a set interest rate for any amount of time will give you the same result as placing the whole amount into at TDI and withdrawing the total amount and deducting the same tax rate as before.  In this environment it makes no difference which tax protected account you withdraw from first.  The only way you can extend your dollars is by drawing down on your TI portfolio first.

Turning to the progressive tax environment results in a completely different equation.  As before drawing down on your TI first is a must but after that things get interesting.  The first thing to determine is the total amount that can be withdrawn before you trigger the next higher tax bracket.  Once you have these amounts you can start to plan and it is surprising to discover that the optimal tax strategy may be to withdraw amounts from your TDI before it is required.  The authors in fact discovered that the optimal strategy is one where you convert two or more blocks of your TDI portfolio into TEI investments.  This is allowed as a Roth conversion in the United States.  Each block needs to be placed in its own separate account.  The accounts are opened and funded at the beginning of the year with investments from the TDI portfolio.  Each allocation amount is the maximum allowed in the lowest (or second lowest depending on the size of the portfolio) tax bracket.  So for example in the United States in 2013 an individual could have placed $47,750 and only triggered the second tax bracket of 15%.  At the end of the year the converted TEI with the highest value is left as a TEI and the others are reconverted back to the TDI therefore only one conversion is taxed.  Doing this throughout the portfolio extended the life of the portfolio by an average of 6.5 years!

So you may be asking why even have a TDA why not invest everything into a TEI?  The answer is that there are benefits to the TDA in that you should be able to fund it with more money as you did not need to pay tax on the money before funding and this larger amount will grow tax deferred therefore growing to a larger ending balance than the TEI.  The key then is trying to minimize the tax burden on the withdrawals from this investment and I have shown you one clever technique above.  A second technique is to maximize the withdrawals on this account in any year where you have large expenses such as medical bills that will offset the tax paid on this withdrawal.  Doing this will also extend the life of the portfolio.

So while I do not typically like to delve into taxes this is an excellent way to stretch the life of the portfolio and this could be critical to some of us.  Furthermore having investments in TDI and TEI investments can be beneficial so do not steer everything away from the standard TDI investments as these can provide a higher value and if planned for correctly should not cause you too many tax nightmares.  In the meantime as I have now stretched out your portfolio I think you and I better start limbering up our bodies so that we can enjoy the extra years.