Caution: Objects in Your Retirement Portfolio May Be Smaller Than They Appear

If you're saving for your retirement primarily through an employer-based plan like a 401(k), 403(b), or 457, checking your balances can provide a little bit of a thrill, particularly in cheery market environments like what we've had so far this year. Because you're contributing pretax dollars to these plans (unless you've opted for Roth treatment) and your earnings aren't being dunned by taxes from year to year, saving within the confines of a 401(k) can be a relatively painless way to amass a nice chunk of change. And even in weak markets, your robust ongoing contributions, unfettered by taxes, can help offset losses among your investments. Seeing your balance grow from year to year is a strong motivator to stick with the plan and even bump up your contribution rate as your salary allows.

At the same time, you have to be careful not to derive a false sense of security from what might appear to be a large kitty on the surface. There are two key reasons why. The first is inflation, which reduces the purchasing power of your retirement portfolio over time. Given that inflation is usually in the neighborhood of 3% or so a year, and close to nonexistent in other years, it might seem tempting to blow it off when determining the viability of your retirement portfolio. But as I discussed in this article, rising costs can actually be an enormous swing factor; portfolios that properly anticipate the role of inflation could be hundreds of thousands of dollars larger than those that do not.

The second big reason is taxes. Making pretax contributions to a 401(k) or other company retirement plan can give your portfolio a real boost. But the tax collector needs to take a cut at some point, and for traditional 401(k) contributions, that point is when you begin taking withdrawals in retirement. Taxes will also reduce your take-home amount for retirement assets held in a taxable account; even though you've already paid taxes on the amount you've invested, you'll still owe taxes on most income and all dividend distributions. If you don't factor those taxes into your retirement planning, you could face a standard of living that's dramatically below what you thought it would be.

Take, for example, someone adhering to the 4% rule for their retirement portfolios--a topic I discussed in this article. Assuming a $1.5 million starting portfolio with 40% of its assets in bonds and the remainder in stocks, a retiree employing the 4% rule could tap her portfolio for $60,000 a year. Assuming a 3% income distribution from the $600,000 bond portfolio ($18,000) and a 1.5% dividend yield from the $900,000 in stocks ($13,500), the retiree would draw the remainder of the $60,000 ($28,500) by selling existing holdings.

But those are all gross numbers--they don't incorporate that at least some of that money will be taxed, and the tax treatment will differ depending on where she's holding the money.

Understanding the Tax Impact
Let's take a look at some very simplified examples involving Retiree 1 and Retiree 2. (Note that I'm not including state taxes in this discussion.) Both individuals are in the same 25% income-tax bracket, but Retiree 1 holds her money in a taxable account and Retiree 2's money is all in tax-deferred vehicles.

If Retiree 1 holds the money in a taxable account and was taking steps to minimize taxes, she could take the $18,000 from her bond portfolio free and clear by holding municipal bonds. (Most planners would argue for diversifying bond assets across both munis and taxable bonds, but we'll set that aside for now.) She'd owe taxes on her dividend distribution--at a 15% tax rate, her dividend distribution would go from $13,500 on a pretax basis to $11,475 on an aftertax basis. The taxes she'd owe on the remaining $28,500 withdrawal would depend on her cost basis in those assets--she wouldn't owe taxes on the amount she originally invested, but she would owe taxes on the appreciation at the time of sale. Assuming her cost basis is $20,000 for those shares and she'd held them at least a year, she'd owe long-term capital gains tax of 15% on the $8,500 of appreciation, reducing her aftertax payout from that asset sale by $1,275 to $27,225. All told, her aftertax income would be $18,000 (bond income), $11,475 (dividend income), and $27,225 (asset sale), or $56,700 total. That's not a huge divergence from $60,000, but it's not a rounding error, either.  

Now assume Retiree 2 has the same portfolio size, asset mix, withdrawal rate, and 25% tax bracket. The key difference, however, is that Retiree 2 holds her entire nest egg within the confines of her former employer's 401(k) as well as a traditional IRA that she rolled over from an earlier employer, so none of this money has been taxed before. Using the 4% rule and taking into account that Retiree 2's entire withdrawal will be taxable at her ordinary income-tax rate, her take-home amount could readily shrivel below $50,000.

Now, Retiree 2's aftertax income may in fact be a livable income stream for her, when combined with income from other sources such as Social Security. More importantly, the fact that Retiree 2 has enjoyed tax-deferred compounding for all of these years--because she's saved within the confines of her IRA and 401(k)--gave her a better shot of coming into retirement with a much larger nest egg than Retiree 1, assuming they had invested the same amounts initially. Retiree 2 also gets to continue to enjoy tax-deferred compounding on her assets as long as she holds them inside the IRA and 401(k) wrappers. And if Retiree 2 made any contributions to a traditional nondeductible IRA, she'd be able to subtract her cost basis when determining the taxes due upon withdrawal from those accounts.

To be sure, my point isn't to discourage investors from saving within tax-deferred accounts like 401(k)s and IRAs, even though they'll take a haircut when they make withdrawals from them. Rather, it's to underscore the importance of factoring in taxes when determining the viability of your retirement plan. If you're calculating your withdrawal rate by hand, you'll want to be sure to give your withdrawals a tax haircut, as in my examples above. If you're using an online calculator to see if your retirement portfolio is on track, you'll want to make sure it is segregating your retirement assets by their tax treatment. Also bear in mind that tax rates could realistically go up in the future, too. In fact, dividends are set to return to their pre-2003 tax treatment in 2013--they'll once again be taxed as ordinary income--and long-term capital gains will be 20% for most investors starting next year, barring Congressional action. Higher tax rates will make it even more important to factor taxes into the mix when gauging the viability of your retirement plan.

In addition, note that none of my examples above includes Roth assets, which can be particularly valuable to retirees taking withdrawals because they're not taxed at all, provided you've followed the rules on distributions. If you're taking $60,000 from a Roth account in retirement, what you see is what you get.

Finally, my examples also underscore the value of keeping careful track of cost basis in your taxable accounts. As the example of Retiree 1 illustrates, you won't owe taxes on the price you originally paid for your securities (you've already paid tax on that money, after all), so it pays to keep scrupulous track of your purchase prices so you don't end up paying tax twice. This article provides some more color on cost basis.

A version of this article appeared Jan. 30, 2012.

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