Despite all the advice and calculators that purport to show you how much you need to retire and when to withdraw it, retirement planning is an inexact science.
It is also far from a one-size-fits-all formula. Needs will hinge on a number of different factors, including lifestyle and location.
But there may be another flaw to consider if you are using a retirement calculator in your planning. Researchers at Baylor and Texas Tech have published a study that found a number of retirement calculators don't use efficient ways to measure tax liability.
As a result, they say someone relying on one of these calculators might lose six or seven years of retirement income.
"Through our research, we found there are better strategies for creating retirement income than the ones the industry is currently using," said William Meyer, CEO of Retiree, Inc., and one of the authors. "These strategies provide greater tax efficiency, creating six or more years of income. That's a game changer for a retiree."
The authors attempt to debunk the conventional wisdom around tax-efficient retirement withdrawals. They say these practices suggest an investor should withdraw funds from one account at a time moving to the next one after the previous is exhausted, starting with tax-deferred accounts and moving to tax-exempt accounts.
But the authors claim that isn't the most efficient way to withdraw money, at least when it comes to tax liability.
Progressive tax rate factor
The study contends that the most tax-efficient strategies take into account progressive tax rates. It recommends retirees think about drawing from multiple accounts at the same time, while using Roth IRA conversions. They say it takes advantage of years when the saver has lower marginal tax rates.
When funds are withdrawn from a Traditional IRA or 401(k) savings plan, the money is taxed as ordinary income, because the saver was able to deduct contributions from federal taxes. Since contributions to a Roth IRA are not tax deductible, withdrawals – including any capital gains – are not taxed.
Tax ramifications of retirement withdrawals may be one of the lesser-understood aspects of retirement planning and have made the whole subject somewhat controversial.
Dara Luber, senior manager of retirement at TD Ameritrade, told ConsumerAffairs back in February that retirees need to pay closer attention to the tax implications of retirement.
When you turn 65, the way you file your taxes may change. There may be certain credits and deductions you qualify for, and you will be able to take a higher standard deduction, which may be more advantageous than claiming itemized deductions. Tax planning may change, especially if you are withdrawing funds from a tax-deferred retirement account.
“You may want to take into consideration things like your required minimum distribution if you are 70 and a half, you may want to take into consideration some state tax benefits in terms of your Social Security, and how that's taxed,” Luber said.
Keep in mind certain credits or deductions you've qualified for in the past may no longer apply. You may need to consider paying estimated quarterly taxes once you hit retirement.