MaineNewsDirect.com

Retirement Distribution Strategies

In my previous entries on building a better retirement portfolio, I discussed starting with your needs first, then developing growth portfolios with lower volatility by using proper diversification and risk controlled strategies. The next step is to create a distribution strategy. This can save thousands of dollars in taxes and maximize returns, significantly lowering the probability of running out of money during your life. These are the things you should be thinking about:

1.) Set a Periodic Schedule: Once you know your cash flow needs, set a schedule on when to liquidate from your portfolio. Monthly or quarterly is ideal. I recommend keeping one to two years of your needs in a cash equivalent or defensive holding. This serves as a “safety valve” if the market tanks, allowing your portfolio the time to recoup to its original value prior to the drop in the market. Make sure you establish a trigger point when you are going to default to your safety valve. For example, when your portfolio is down over a certain percentage. And better to set this before a down market rather than making ad-hoc decisions in mid-capitulation. This avoids making decisions based on emotion, which never ends up working in your favor.

2.) What to Liquidate First: The key is rebalancing. By now you should know how your portfolio should be broken down between stocks, bonds, cash, other asset classes and underlying sub-categories. Over time, the individual holdings will vary in performance. When you need cash from your portfolio, simply sell assets that will keep the portfolio in line with its original asset allocation. Doing this will always require you to liquidate out-performers as you continue along, selling assets at their high and keeping your portfolio risk in check. In most cases the liquidations will keep things balanced; although every once in a while you may need to rebalance regardless of cash flow needs during a bull or bear market.

3.) Tax Circumstances: Strategy should tie in with your ongoing tax circumstances and account characteristics (see below). For example, the amount of Social Security (SS) that is taxable depends on your income. You may want to liquidate taxable assets trading at a loss or low gain or use tax-free Roth assets to allow you to have more tax free SS income. You may want to use the same strategy if you have a large, one time medical expense; since the deductible amount has to exceed 7.5% of your Adjusted Gross Income (AGI), you want to keep your income as low as possible to maximize the deduction. Or if you have a large balance in a tax-deferred account, you may want to liquidate Traditional IRA funds first or gradually if future required minimum distributions (RMD’s) will put you in a higher income tax bracket later. Tapping into the tax-deferred account may make sense if you are living in a state with no-income taxes now, but plan to move to a state with a high income tax burden. Taxes count so tend to them carefully.

4.) Account Type Investment Strategies and Where to Draw From First: Although everyone has a unique set of tax circumstances (see above), generally you should balance your tax situation with the tax implications of the accounts you hold. Here is how you should be generally thinking about your account strategy:

Regularly Taxable Account: Interest income is taxable at higher ordinary income rates unless tax exempt in some manner. Dividends are taxed at either ordinary or advantageous capital gains rates (until 2011). Short-term capital gains are taxed at ordinary income rates and long-term gains at advantageous rates. Excluding amounts earmarked for the safety valve, the account should be holding primarily stocks or tax-free bonds because they are more tax efficient. In order of timing, generally the brokerage account should be the first account to tap into; assets with higher gains should be considered (unless the higher income has negative ramifications with your personal tax situation) since the current lower long-term capital gains rate is set to expire after 2010.

Tax-Deferred Accounts: Accounts such as Traditional IRA’s or 401(k)’s are taxed as ordinary income when withdrawn. You want to put more of the taxable bonds or other tax-inefficient, mild growth holdings of your asset allocation in this type of account. This is because they will be treated the same from a tax perspective if they were held in a taxable account (just deferred until withdrawn). This will allow you to place higher growth assets in a brokerage account or a Roth where they can compound more with better tax ramifications. Also, placing more defensive assets in a tax-deferred account will tend to compound slower, resulting in lower amounts distributed and taxed at ordinary rates over time. This generally should be tapped into after regularly taxable assets are withdrawn; or together with a taxable account if you have a high balance in tax-deferred accounts and future RMD’s would result in a much higher tax rate in the future.

Tax-Free Accounts: Roth IRA’s/401(k)’s are tax free if the distribution is qualified. Generally you want to put high growth assets into this account. The higher compounding will mean larger amounts that you can draw upon in your later years without any taxes. Since these accounts are not subject to RMD (Roth 401(k)’s are subject to RMD’s, but can be avoided by rolling into a Roth IRA with other stipulations), they have advantageous estate planning characteristics and with higher risk/reward benefits amplifying over a longer time horizon, this should be the last source of retirement funds in most cases.

As you see, there are quite a few moving parts involved, but if you set up an ongoing procedure and structure to tap into the assets, the entire strategy should benefit you over time. You will find that it will enable you to have a much more enjoyable rest of your life and less time worrying about what the future will hold.

E-mail this entry to a friend