Where You Save for Retirement Is as Important as How Much

Joel S. Greenwald, MD


July 15, 2021

In What’s My Number?, I shared the basics of the most common question I get as a financial planner: “What’s my number?” Or, how much money do they need to retire? My honest answer? It depends. Without having more information, it’s a question without an answer. It’s virtually meaningless without knowing (1) what your desired retirement looks like and (2) how much you want to spend annually.

A third factor, though, is nearly as important: Where is your money saved? Depending on what type of accounts you can use for retirement, the answer to “What’s my number” may change.

What Types of Accounts Make Up Your Portfolio?

Different tax treatments are applied to different types of accounts. These fall into at least three buckets: 

  • Pre-tax money in employer retirement plans: Money that you withdraw from pre-tax accounts (such as 401(k), 403(b), or IRA accounts) is treated as taxable income. The more you withdraw annually, the higher your tax bracket and income-based marginal tax rate may be.

  • After-tax money in an investment/brokerage account: Money invested outside of employer retirement plans, IRAs and Roth IRAs, and other tax-favored accounts are subject to capital gains taxes on profits from the sale of assets. Long-term gains (from assets you’ve held for more than a year) can be taxed at up to 20%, depending on your income. 

  • Money in a Roth IRA and/or Roth 401(k): These accounts are the most favorable of the three buckets. Counted as after-tax money, you won’t owe taxes on any investment profits. You get to keep the full amount, without the capital gains taxes. 

How much you have in each of these three buckets will have substantial implications on what you can spend during your retirement.

Having Your Retirement Assets in One Bucket Is a Problem

It’s a giant red flag when I see a client has all their retirement savings in one big pre-tax “bucket.” Why? There’s less flexibility and control over your tax situation. The biggest danger is that you’ll end up in a higher tax bracket, paying more than you need to in taxes.

Here’s a scenario: Imagine you and your spouse are both 65 and in your first year of retirement. You have also decided to delay starting Social Security until age 70. You’ve got all your retirement savings in an IRA, from which you’ll pay all your bills throughout retirement.

You decide $15,000/month ($180,000/year) in spending will meet your needs. But do these figures really add up? Like many people, you may have forgotten to add in what you’ll pay in taxes. Let’s use the scenario above to show why this is so important. 

Federal taxes: The money you withdraw annually from your IRA will be taxed as income by the federal government. To have $180,000 to spend, you will need to withdraw $212,000 and pay $32,000 in federal taxes.

Marginal taxes: Here, your marginal tax rate (the federal tax you pay on the last dollar you withdraw) will be 24%.

The result: By only using IRA savings, you are spending more than your planned-for $180,000 per year to cover your expenses. And that’s not even counting any state taxes. The lesson here is that taxes must be part of your retirement savings assumptions.

What Happens if Your Spending Level Changes?

Let’s look at another scenario. Say in Year 2 of retirement you spend an additional $115,000 above your planned baseline of $180,000 on a new car, a dream vacation, and a new roof. Now your total expenses are $295,000, not $180,000. What are the tax ramifications?

Rather than go through all the numbers here, I’ll do the math for you. The $295,000 in “income” you want to spend from your IRA will push your average tax rate from 15% to 19%. Now you’ll need to withdraw $364,000 from your IRA and $69,000 of this will go to federal taxes. Your marginal tax rate will jump from 24% to 32%. 

In Year 2, relying solely on a pre-tax IRA for spending has eroded your retirement money to an even greater degree than in the previous year. Wouldn’t you say it’s time for a different strategy?

Going Beyond Your IRA: The Benefits of Tax Diversification

In years when you have higher expenses, tax diversification may prevent you from being pushed into a higher tax bracket. Looking at Year 2, your tax advisor might suggest, for example, that you withdraw the first $212,000 (for your baseline spending of $180,000) from your pre-tax IRA account at the 24% marginal federal tax rate. 

Next, you’ll have to identify the most tax-efficient way to cover your additional one-time expenses using other buckets. Maybe you’ll sell assets from taxable brokerage accounts, where capital gains are taxed at a lower rate than income tax. Or you might use money in your Roth IRA, which is withdrawn tax-free. 

Even in this brief example, we can see that having several retirement spending buckets will give you more flexibility and control over how much you pay in taxes and how much you can keep for living your retirement in comfort.

Tax Diversification During Accumulation Provides a Healthy Portfolio

In the “What’s My Number” discussion, it’s not just a question of how much money you save. It’s also a matter of what types of accounts you fund. During your working years, you should max out your annual contributions to pre-tax accounts. At the same time, you should be building up taxable and tax-free accounts to give you more tax-efficient options for retirement spending. Find the right balance, and you’ll feel more secure about maintaining your comfort in retirement.

The above article is intended for informational purposes only. Please consult a legal or tax professional regarding your situation.

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About Dr Joel Greenwald
Joel S. Greenwald, MD, is a graduate of the Albert Einstein College of Medicine in Bronx, New York, Joel completed his internal medicine residency at the University of Minnesota.

He practiced internal medicine in the Twin Cities for 11 years before making the transition to financial planning for physicians, beginning in 1998.

Joel's wife is a radiation oncologist, so medicine remains a frequent topic of dinner table conversation.

Knowing firsthand the challenges of practicing medicine, Joel's passion is making the lives of physicians easier by helping relieve them of financial worries.

Connect with him on LinkedIn or on his website.


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