Savings Withdrawals As Tax Hikes Loom

By Arden Dale
Of DOW JONES NEWSWIRES
1 June 2009

NEW YORK (Dow Jones)--Looming tax hikes make it important for retirees who write their own paychecks to rethink the order in which they tap savings accounts.

Conventional wisdom in many quarters is that it is best to use taxable accounts first and let tax-deferred savings compound.

But there are always exceptions, and now "we have to plan knowing tax rates are going up," says Laurence J. Kotlikoff, a professor of economics at Boston University.

Doing the math on withdrawals is largely a matter of figuring a person's current tax rate versus what he or she thinks it will be in the future, according to Dallas Salisbury, president and chief executive of the Employee Benefit Research Institute, a nonprofit group in Washington. Then it's a question of looking at where the money is being stashed.

For example, a traditional 401(k), 403(b) or individual retirement account lets one invest savings before taxes and watch them compound tax-free until withdrawal, at which point the money is taxed as ordinary income. With a Roth 401(k) or Roth IRA, money is invested after taxes and compounds tax-free, but a qualified withdrawal is taken free of taxes.

With that in mind, says Salisbury, a person may decide to convert his entire 401(k) plan to a Roth IRA in 2010 because he thinks the only possible direction of tax rates in the decades ahead is up.

A host of other things should also be taken into account: whether or not one plans to spend the money right away, how much taxable income is involved, how money in the accounts in invested, mortgage interest and other deductions, and Social Security payments.

Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research, says tapping a tax-deferred IRA can make sense, for example, when the deferred balance is so big that waiting for required minimum distributions at age 70 1/2 would lead to a much higher tax bracket.

However, says Spiegelman, he is generally a proponent of the notion that it's better to use taxable accounts first if they allow one to generate income at a lower tax rate (long-term capital gains, qualified dividends, tax-free muni interest, for example).

Spiegelman is among many financial advisers who believe ordinary income tax rates are likely to rise for the top two brackets under the Obama administration, along with rates for long-term capital gains and qualified dividends.

The different rates matter when it comes to tax-efficient placement and ordering of withdrawals. Spiegelman predicts that changes aren't going to be enough to warrant a new approach.

The bottom line, though, says Salisbury: "Rules of thumb work for some and are dumb for others, so you are always best off to do a personal plan based on circumstances and expectations."

Kotlikoff is president at a company that offers both free and paid retirement plan modeling at www.esplanner.com and www.esplanner.com/basic, which offer case studies. One study, called "Beating the Tax Man," compares Roth and traditional retirement accounts and considers which to tap first.

(Arden Dale is a Getting Personal columnist who writes about personal finance; she covers topics including tax and estate planning, retirement, investment strategies, and financial needs of small businesses. She can be reached at 201-938-2052 or by email at arden.dale@dowjones.com.)