One of the most important factors in determining how much you can spend in retirement receives scant attention, but not here. Simply stated, the more of your nest egg that you have in taxable retirement savings, the less you will have available to spend in retirement. Why? Because income taxes are due on all or almost all withdrawals from traditional IRAs, 401(k) plans, 403(b) plans, pension plans, etc.

Here’s a simple and admittedly greatly oversimplified example of the magnitude of the difference. Jack and Jill will both have $500,000 in retirement savings when they retire. Jack’s savings are all in tax-deferred retirement accounts, principally a 401(k) and a traditional IRA. Jill’s savings are all in after-tax accounts, including a Roth IRA. If Jack needs $15,000 in spending next year and assuming the withdrawal will be taxed at 20%, he will need to withdraw $18,750 to cover the $3,750 income tax on the withdrawal ($18,750 x 20% = $3,750, leaving $15,000 left over to spend). Jill, on the other hand, will have to withdraw only $15,000 since no taxes will be due on the withdrawal of already taxed money.  

Looking at the entirety of their resources, since Jack’s investments will have to be taxed every time he makes a withdrawal, he could have as much as $100,000 less than Jill for retirement spending ($500,000 x 20% tax equals $100,000 in taxes on the retirement accounts).

Now consider a pair of qualifications that will likely reduce the magnitude of this disturbing, but oversimplified difference:

• The money in Jill’s account (unless it came from an inheritance) likely required her to pay considerably more taxes over the years compared with Jack who enjoyed both tax deductions for most of his contributions as well as tax-free growth of the money held in his retirement accounts. All other things being equal, which they are not in this example, Jack would have more money in his accounts than Jill because Jack enjoyed tax savings on his retirement plan contributions.

• While Jill will continue to pay income taxes on dividends, interest, and realized capital gains in her non-tax-deferred accounts, Jack’s money will continue to grow without incurring taxes until the money is withdrawn.

So, the difference will probably not be as great as portrayed in the above example. But the lesson still stands. If your tax-deferred retirement accounts comprise a large portion of your retirement savings, you need to consider the toll that income taxes take on your withdrawals.

Finally, in no way do you make a mistake putting as much money as you can afford into retirement accounts. Jack reaped some substantial income tax savings by so doing, but, alas, Uncle Sam still wants to collect on those accounts. The longer Jack can delay that exaction, the better off he will be financially since his money continues to grow tax-deferred while Jill will probably have to pay some taxes on dividend and interest income and realized capital gains along the way. In short, do not forget to calculate the tax burden you may have as this could make all the difference between your retirement savings lasting and not.

Wishing You a Celebratory Independence Day !!!