In his elegant book, Retire Secure!, James Lange, JD, CPA, argues strongly for a specific spending order of your assets. His recommended order is this:
James Lange's Recommended Spending Order of Assets in Retirement
#1 After-Tax Assets Generated by Income Sources
- Pension distributions
- Capital gains distributions from your mutual funds or generated by mandatory activities like rebalancing
- Social Security
- Any required minimum distributions (RMD) from tax-deferred accounts or Roth 401(k)s.
- Rent from investment real estate
- “Retirement job” income
#2 After-Tax Assets
Lange wisely advises you to liquidate your assets with a loss first, then assets with minimal gain, and finally assets with significant gains.
#3 Tax-Deferred Assets
This includes your 401(k) and IRA. We're talking about withdrawals above and beyond your RMDs.
#4 Tax-Free Assets
This includes withdrawals from your Roth IRA and any withdrawals above and beyond the RMD in your Roth 401(k).
While I agree with his general sentiment, I don't think this is nearly as hard and fast a rule as he makes it out to be for a number of reasons. There are so many exceptions to this rule of thumb, that I'm not even sure it ought to be a rule of thumb. I was also disappointed that he didn't address when to borrow from any permanent life insurance policies or annuities you may have been suckered into buying. I'd like to try to fill in the gaps with this post.
Obviously, Spend Income First
His first rule, that you should spend your income first, is obviously true. I can think of no exceptions to this. Even if you have taxable account investment losses, you probably ought to spend your income and just tax loss harvest the losing investments.
8 Exceptions to Lange's Order of Spending
Exception #1 Don't Generate Unnecessary Capital Gains On Your Death Bed
Mr. Lange's second rule, to always spend your taxable assets before your tax-deferred assets, has several exceptions to it. The general rule exists because the longer you wait to pay taxes, the more time the investment spends in a tax-protected account, boosting its growth (and asset protection in most states.)
The first exception to the general rule is that if you are on your death bed with low basis taxable assets. According to the rule of thumb, you should spend that money instead of raiding a traditional IRA. However, that IRA is going to get taxed at some point, whereas those taxable assets get a step-up in basis at death. Better to pay a tax that must be paid eventually, than to pay one, even at a lower rate, that can be avoided altogether.
Exception #2 Beware the SEPP Penalty
The second exception is if you are in a Substantially Equal Periodic Payments program. This is when you want to raid your retirement accounts before age 59 1/2 without paying the 10% withdrawal penalty. Once you start the program, you have to take out the payment every year until you turn 59 1/2 or you will pay an unnecessary penalty. Although it is possible that decades of compounding in a tax protected account will make up for that penalty, that seems unlikely to me for someone who is already into their retirement accounts in their 50s.
Exception #3 Donating Appreciated Shares
The third exception is when you have a good reason to have a taxable account. One of these is donating appreciated shares to charity. No sense in paying a tax that you can avoid altogether.
Exception #4 Don't Pay Estate Taxes on the Government's Portion of your IRA
The fourth exception involves those who actually have an estate tax problem (estate larger than the Federal exemption of $11.4 Million ($22.8Million Married), or in a state with a lower exemption). If you have an estate tax problem, it is helpful to have some taxable money to use to pay the estate taxes without having to pay both estate taxes and income taxes at the same time.
Although that is a relatively weak argument by itself, if you are over the estate tax exemption this can have a dramatic effect. Remember, tax-deferred money belongs to both you and the government. Wouldn't it suck to pay estate taxes on the government's portion of the money?
A great way to reduce your estate is to take money out of your retirement account, gift it to an irrevocable trust, and buy permanent life insurance with it. Now you're not paying estate tax on either the government's portion of your IRA, or on the amount you gifted to the trust. Plus, neither the trust nor its eventual beneficiaries have to pay any income tax on life insurance.
Exception #5 Whose Tax Rate Is Higher?
Mr. Lange's third rule is to basically spend all of your tax-deferred money before any of your Roth money. While I don't disagree that I would rather inherit a Roth IRA than a traditional IRA, the family may pay less tax overall if your heirs in lower tax brackets pay the tax rather than you. Plus, if the government ever changes the rules (changes the income tax to a value-added tax or sales tax for instance), no sense in pre-paying your taxes.
Exception #6 What About Tax Diversification?
This is my biggest beef with the order of accounts presented by Mr. Lange. One of the biggest benefits of having both tax-deferred and tax-free accounts in retirement is to have some “tax diversification.” That basically allows you to determine your tax rate in retirement.
The theory is that you fill up the lower tax brackets (0%, 10%, 12%, 22%, and maybe even 24%) with tax-deferred account withdrawals (and later Social Security). Then, if you need more money than that, you pull it from the tax-free accounts. This allows you to save money at 32%, 35%, or even 37% when contributing to your tax-deferred accounts, while paying taxes at an effective rate well under 20% upon withdrawing it.
This “arbitrage” is one of the biggest benefits of using tax-deferred accounts to save for retirement. But if you actually plan to spend all or most of your retirement savings in retirement, Lange's plan would have you not only pay all the taxes up front (what happened to “Pay Taxes Later”) but to pay them at a higher rate than you would have to if you had been tapping both accounts at the same time. I don't think the right answer to “Tax-deferred or Tax-free first?” is tax-deferred; I think it's both.
Exception #7 Permanent Life Insurance Omission
Mr. Lange didn't address when to tap the cash value of permanent life insurance policies in his book. In fact, I don't think I've ever seen a serious work that did (if you know of one, please post it in the comments.)
I've done some thinking about it. While you could use cash value like a Roth for some tax diversification, there is a significant difference between a Roth and permanent life insurance cash value. Roth withdrawals are tax-free and interest-free. Life insurance is a little more complex.
Initial insurance withdrawals (partial surrenders) are tax-free and interest-free, up to the amount paid in premiums. Beyond that, gains are taxed at your ordinary interest rate (not the lower capital gains rate.) You can also borrow from the policy. These funds are tax-free, but not interest-free. You're essentially borrowing money from the insurance company using the cash value of the policy as collateral.
If you're planning to borrow much out of your life insurance policy, it is probably best if it is a non-direct recognition policy. That means that if you had $100K in cash value, the company would loan you $90K, but it would still use the entire $100K when calculating the dividends paid. With a direct recognition policy, the company would base your dividends on just $10K. It would also be helpful if the interest rate charged for the loan (including any fees) were similar to or lower than the dividend rate.
All of this makes it really hard to determine where in your distribution plan life insurance cash value should fall. Neither tax-free, interest-free policy surrenders up to the basis nor tax-free loans are a free lunch. They are both subtracted from your death benefit. You don't get both the cash value and the death benefit. So it really depends on what you plan to do with the death benefit.
I would rather inherit a Roth IRA than the proceeds of a life insurance policy, but what about a traditional IRA? A traditional IRA beats cash/taxable account/life insurance proceeds IF it can be stretched out over many, many years where the tax-protected growth can make up for the fact that the government owns part of the account. Where that break-even point lies is complicated and will change with future tax law and income changes. But if it the money is going to be spent this year, a Roth IRA and cash/taxable account/life insurance proceeds are pretty much equivalent.
While I haven't run the numbers, I suspect the right answer is to hold the cash value in reserve, tapping it only if you end up running out of all your other assets, and if unneeded, simply passing it on to your heirs as a death benefit. An exception, of course, would be made if the alternative is to pay an unnecessary capital gains tax on highly appreciated taxable assets. It may also be worth tapping cash value prior to both IRA and especially Roth IRA money if your heirs are very young and can be relied upon to maximize the stretch benefits. No wonder Lange didn't include it in his list. The devil is in the details.
Exception #8 What About Annuities?
While we're on the subject of insurance-based investing products you probably shouldn't have bought in the first place, let's talk about annuities. With life insurance surrenders, the tax treatment is “first-in, first out” (FIFO) meaning you get the premiums paid back out first. With the surrender of/withdrawal from an annuity, it's “last-in, first-out” (LIFO). That means the first dollars you get out of the annuity are fully taxed at your regular income rate.
Perhaps the best way to get reasonable tax treatment on an annuity is to actually annuitize it, then at least a portion of the first payments you get is tax-free. (Annuitized payments come out pro-rata between the basis and the earnings.) That is what I would do, then just throw the annuity payments in with Lange's first category of after-tax assets generated from income sources.
Again, like life insurance and even retirement account withdrawals, I would make annuity withdrawals before cashing in highly-appreciated taxable assets if life expectancy were short in order to take advantage of the step-up in basis at death.
Lange's Order is Good But Not a Reliable Rule of Thumb
In short, while Mr. Lange's list provides a good starting point, I think he has broken Einstein's rule with this one. Einstein said, “Make things as simple as possible, but no simpler.” I fear he has made this complex decision far too simple with his recommended list. I don't think this subject lends itself to a reliable rule of thumb at all. Spending significant time analyzing your own situation with or without a talented financial planner is probably worthwhile.
What do you think about which assets to spend first? Did Mr. Lange nail it? How do you plan to tap your retirement assets? Will you spend all your tax-deferred before your Roth? Or will you go for tax diversification? If you own a permanent life insurance policy or annuity, when and how do you plan to use the cash value? Comment below!