Should I tap my IRA first in retirement?

This article was posted on May 1, 2002.

Like many things pertaining to early retirement, the conventional wisdom that you should spend your taxable accounts first, then wait to tap your IRA later often doesn't make sense. As a matter of fact, the earlier you retire, the less sense it makes.

Under current tax law, IRA holders must make required minimum distributions (RMDs) from their IRA at age 70-1/2. This distribution is calculated by dividing the combined balance of all your traditional IRAs and 401(k)s by the factor in Appendix C of IRS Publication 590, Page 87. At age 70, this factor has a value of 26.2. A $1 million IRA would require a $38,168 distribution ($1,000,000/26.2) at age 70-1/2.

The top Federal tax bracket of 38.6% begins with a taxable annual income of $307,050 for 2002. Under current law, this limit is indexed for inflation each year. Assuming 3% per annum inflation, the $307,050 bracket limit would rise to $412,650 in 10 years and $554,550 in 20 years. An individual who is 50 years old today would expect the top bracket to rise to $554,550 when he's 70 years of age. The future value of the top tax bracket for various ages is listed in Column 2 of the table below.

The minimum IRA value needed to reach the top Federal tax bracket of 38.6% is simply the lower 38.6% bracket limit (the values in column 2) times 26.2 (the factor from IRS Publication 590, Appendix C.) Column 3 contains the results of the calculation.

A retiree holding a large IRA at age 50 will likely see substantial growth in the account by age 70-1/2. Assuming a 10% per annum return, $1.00 grows to $6.73 in 20 years. Finding the current IRA value needed to reach the 38.6% tax bracket at age 70-1/2 is a simple matter of dividing the values in Column 3 by Column 4. The results appear in Column 5.

This simple table assumes your required IRA distribution at age 70-1/2 is your only income. In practice, most retirees will have Social Security benefits or a pension to add to their taxable income. It's likely you'll need an even smaller IRA balance at age 70-1/2 to force you into the top Federal tax bracket.

Conclusion

If you are fortunate enough to have a substantial IRA/401(k) balance at an early age, it may make sense to tap this account first when you retire. This is especially true if you hold mostly long-term buy and hold (LTB&H) stocks in your taxable account. No matter how large your taxable account gets, capital gains are taxed at a maximum of 20%. If your IRA gets large enough, the required distributions could be taxed at almost double that rate (i.e., 38.6%). Tapping your IRA first (while you are still in a lower tax bracket) and letting your taxable account ride may well save you money.

Do your own analysis

Retire Early has developed a simple Excel spreadsheet you can use to evaluate the effect of different inflation assumptions and investment returns on the required minimum distribution (RMD) from your IRA at age 70-1/2. Just change the inputs in the blue colored fields on the spreadsheet.