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
This includes:
- Pension distributions
- Interest
- Dividends
- 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!
I have read Lange’s book. I plan to spend the income generated from my taxable accounts first. Last year that was $191k. A couple of legacy mutual funds paid out big capital gains however. I do have 70k in annuities sold to me many years ago and I think they will provide about 500/month or so. I plan to delay social security until 70 unless I get sick. That should pay 3200-3300/month. I have no Roth accounts. I will look at converting some of my tax deferred money after I retire prior to RMDs and SS. I do not have any permanent life insurance. I plan to self insure for LTC.I think the quote that there are many roads to Dublin really applies to this topic.
And when the income alone from your taxable accounts is $191K, you’re probably more likely to have an estate tax issue than a running out of money issue. Nothing better than when all your problems are “first world problems.”
Yeah, if you indeed have an estate tax issue you may want to convert your IRAs into ROTHs. That reduces the estate, keeps the IRAs from being income taxable (especially if you have high earning heirs), and let’s you control your tax better in the future as there are no more RMDs. If you are on your death bed with a $5,000,000 IRA and looking at an estate tax bill then this could be huge. This strategy pretty much swaps out the taxable accounts for Roth money for you heirs while potentially leaving about the same amount of total inheritance.
The way I forsee the future during withdrawls, it is definitely more complex than a couple of simple rules. As I keep aging those numbers change as well. Considering actual RMD keeps increasing which changes the tax picture every year. Unfortunately as this occurs my brain will get older and eventually I will not be unable to to deal with those numbers and will need to set up some basic rules that someone else could follow. Hopefully a trustworthy son or daughter can take control and do the fiduciary liquidation for us.
For me it’s quite simple as all my after tax are munis
Glad to pay the taxes on my Ira bundle
Changing to fla residency to avoid state and estate taxes
Check your states laws about state estate taxation
In nj it’s a big hit
If you are in RMD’s and have no itemized deductions, i.e. house is paid off, you should consider making your donations from your IRA assuming Congress keeps extending this provision.
I agree on not paying capital gains on your death bed, really this should be to sell losses and minimal gains and not sell large capital gains if in bad health.
Have you ever commented on the Separation of Service Rules? That squashed the need for 72t distributions before age 59 1/2.
Great point. For 401(k)s and similar, all you have to be is 55 and “separated from service” to avoid the 10% penalty.
http://www.irs.gov/taxtopics/tc558.html
Technically it works if you turn age 55 in the year you separate from service so you could be 54.
Most will have most of their wealth in Rey plans
Not many options to avoid the taxman
My living expenses are 1.5mil taxable account averaging over 5% in Div and CG plus SS 37K plus one Annuity withdrawal of 20K plus my RMD 17K plus cash from savings account prn. per year. My advisor wants me to put some of my other assets into 2 irrevocable trusts for my two children (in low 30′) one trust holding a life insurance on my spouse (61) and the other an annuity so that both these assets goes out of Estate Tax and not taxable to beneficiaries. Other assets namely 500K taxable managed brokerage, 500+K annuity which give me 28K/yr today which will increase 5% until withdrawal starts, Spouse IRA as an annuity which will give 20K today with 6% annual increase until RMD starts in 2020, another annuity 10K/yr withdrawal with 7% annual increase, two ROTH’s 60K total. I am 70 and kind of uncertain about future tax, estate tax and financial advice I am getting.
Do you have a state estate tax problem? It doesn’t sound like you have a federal one. I also worry about what a portfolio of only $1.5 M throwing off 5% in income consists of. And of course, any recommendation to buy life insurance or annuities should be very carefully evaluated as these are very high commission products often sold inappropriately.
Sorry to those who had comments deleted. We had an issue and had to restore a back-up, losing a few comments. I’ll cut and paste some of them below:
From Hatton: I am still working part-time to pay income taxes and ever-escalating health insurance premiums. Life is good!!
From Anonymous: Wonderful nuances with this post.
A couple key questions / thoughts:
[I] Doesn’t Lange’s advice “liquidate your assets with a loss first, then assets with minimal gain, and finally assets with significant gains,” run counter to (1) the need to rebalance and and (2) the adage to buy low and sell high?
[II] Does the advice above contradict Kitce’s and Guyton’s thoughts on withdrawal sequence for a withdrawal policy statement (WPS) ?
In the post https://www.kitces.com/blog/crafting-a-withdrawal-policy-statement-for-retirement-income-distributions-guyton/ , Kitces provides a sample WPS from Dr. Guyton: https://www.kitces.com/sample-withdrawal-policy-statement-wps-from-jon-guyton/
Quoting from this, they recommend:
“Following years with positive results that cause the equity category to exceed its target allocation the excess amount is sold and reinvested in Cash or Fixed income to fund future WDs. Yearly WDs are funded from equities when markets are favorable and from fixed income when they are not, using the priority: 1) Cash, 2) Selling Fixed Income assets, 3) Selling Equity assets in descending order of the prior year’s performance.”
Rather than recommending selling assets with the biggest loss first followed by those with the minimum gains as Lange suggests, they appear to be recommending
-when markets are favorable sell equities with the biggest gains first, and
-when markets are unfavorable, sell fixed income, or if unavailable sell equities with the smallest gains first.
– Your thoughts / analysis appreciated –
In reply to Anonymous (from me):
You’re confusing two separate issues. You need to do both rebalance and choose which assets to spend first. You can probably do your rebalancing mostly in tax protected accounts, which actually gets easier as the taxable accounts disappear.
Anytime you have a taxable loss, you should liquidate it to tax loss harvest. Try to avoid realizing significant gains. But that doesn’t mean let your asset allocation get out of whack.
From Anonymous again:
Great point regarding rebalancing versus withdrawals.
However, if we have one large after-tax (fully taxable, not qualified) account to withdraw from, wouldn’t Lange’s advice to “liquidate your assets with a loss first, then assets with minimal gain, and finally assets with significant gains,” contradict Michael Kitce’s and Guyton’s advice:
“Following years with positive results that cause the equity category to exceed its target allocation the excess amount is sold and reinvested in Cash or Fixed income to fund future WDs. Yearly WDs are funded from equities when markets are favorable and from fixed income when they are not, using the priority: 1) Cash, 2) Selling Fixed Income assets, 3) Selling Equity assets in descending order of the prior year’s performance.”
https://www.kitces.com/sample-withdrawal-policy-statement-wps-from-jon-guyton/
And in reply:
You simply have two issues to deal with that most people can address separately. It’s important that you keep them separate in your mind, even if you must do them together.
You maintain an asset allocation and rebalance it to maintain the desired risk level in the portfolio.
You withdraw your particular assets in a particular manner in order to manage your taxes.
If there are contraindications for you in following appropriate rules for both of these tasks, then it is up to you to decide which is more important to you- to be more tax-efficient in your withdrawals, or to maintain an appropriate amount of risk.
But keep in mind what Lange is saying. First, there’s no sense whatsoever in carrying a loss. If you have a taxable loss, tax loss harvest it every time even if you don’t need to spend the money or rebalance the portfolio. So, if you haven’t done that, and it is time to withdraw some money, then it makes perfect sense to do what you should have done earlier. Then you can rebalance by purchasing the asset class you just sold (keep in mind tax loss harvesting rules) to keep the portfolio in balance. If you’re at that stage of life where you cannot rebalance with new contributions and dividends etc and actually must sell an asset to rebalance, then you’re not going to be able to withdraw your assets in the most tax-efficient manner possible. That’s one important reason to use retirement accounts, so you don’t have to deal with this issue.
The bigger question here is how did you end up with nothing but one large fully taxable account and what are you doing about it?
From Luis:
This is,probable ,the most confusing issue about withdrawls in retirement.This research http://www.onefpa.org/journal/Pages/Tax-Efficient%20Retirement%20Withdrawal%20Planning%20Using%20a%20Comprehensive%20Tax%20Model.aspx,give some light,i hope more and more smart people write about…
The often repeated rule of thumb that recommends spending down after tax accounts first and then tax-deferred accounts does not appear to be applicable in my situation ( unless I am missing something, please correct me if I am). I retired at age 50 and am currently 60 years old. For the past 10 years I have lived off of my after tax investments to ovoid the 10% early withdraw penality. When I turned 59 and 1/2 , I reversed the order and began spending from both , tax deferred and after tax accounts up to the upper limit of the 15% tax bracket which is 93,000/yr if you include standard deductions and excemptions for married filing jointly. So, if I have one million in an after tax account that generates 40,000/yr in tax- free qualified dividends, why would I deplete an asset that throws me 40,000 tax free cash per year? I also have one million in an IRA in which I pull 40,000 per year out of. This needs to last untill age 70 when SS of 45,000/yr kicks in. I’m also doing roth conversions whenever there is room in the 15% tax bracket to do so. I don’t ever intend to spend down the principle in my after tax account, it should hopefully fund 1/2 of my living expenses inperpituity. So your comment about withdrawing funds in tandom to mitigate the tax blow is spot on for my situation. Of course, my caveat is that I have been blessed to be married to a wonderful woman for 37 years who doesn’t spend money like a drunken sailor. Now that our kids are through college and on their own, we live very comfortably on 80,000/yr
That was exactly my point.
I was able to get a copy of the third addition and I have to say this is the book I have been looking for. It’s easy to read without skimping on the details. Combines excellent big picture planning with very specific, tangible and actionable information. This is an excellent book for all stages of financial and legacy planning, starting with the savings or accumulation stage then moving on to how to best draw down the retirement savings and finally ending with addressing estate planning and leaving a legacy. James Lange discusses his unique cascading benefits plan which allows for wealth preservation across generations. I believe that this is a must read for anyone interested in both maximizing their retirement spending power and providing for the next generation.
This topic is near and dear to my heart as I’m within a year or two of full retirement. The math is variable and seems complex to me. Tax rates and laws change and are state dependent . . . I suspect the “right answer” is rarely as simple or straight forward as Mr Lange states.
Just because this topic isn’t complicated enough already, I thought I’d add another concept into the mix . . . . https://www.jpmorganfunds.com/blobcontent/111/431/1323407059259_RI-TAXCLIFF.pdf
I played with the numbers for my situation, this plan makes sense for me . . .
In our 50s. Not working as, and may never work again as, docs. Almost living off military pension and working on compromising my frugalness with his relaxed, correct attitude that we can afford to draw from our savings (ie he wants to buy a boat!). I also get nervous when I discuss our net worth with the kids and their eyes gleam a bit.
So I’m working out how much he could safely spend and what I should do to feel like I’m getting my share. We agree each of us spending about 1% of our net worth (to take out 2% max) might be safe and if it’s for extras/ one off purchases, more easily stopped.
If he really wants that boat we’ll sort out whether to wait a few years for cash flow to fully fund it, liquidate some holdings (self-borrow), or get a boat loan. (5 years ago I told him ‘go back to work as a doc for two years to pay for it’.) I am deciding if I need to spend my share, trying to hire a housecleaner (what would make me happiest I think) and whether that should really be MY luxury not ours, and deciding as I type that political and charitable donations should, at this stage of our life, be made as if I have to sacrifice a bit to afford them, not just to burn through as much money as my husband does. Travel, however…