Spigot Planning

If you’re retired, chances are you should be engaged in spigot planning. Say, what!? What is spigot planning?

Chances are you have built up retirement savings in different types of savings buckets. Perhaps you have assets housed in ordinary taxable accounts, in traditional (pre-tax) tax-favored retirement accounts, and in Roth retirement accounts. Spigot planning is the art of determining which buckets to tap to meet your annual spending goal, i.e., which spigot to turn on or off. Through clever spigot planning, you can possibly increase your long-term standard of living.

Here’s one way to approach the task. Let me set the stage. You’re retired. Say you’ve got three savings buckets: a taxable investment account, a traditional IRA, and a Roth IRA. You’ve gone through the process described in Saturday’s post, and you’ve adopted a long-term spending plan of some kind. Let’s say your plan calls for you to spend 6% of your assets this year. Start by pretending you will tap each of your buckets in proportion to their value. Then look at alternatives to see if one of them improves your long-term lot. Should you delay taking Roth distributions, and spend more of your taxable assets? Or vice versa?

Of course there are many factors to consider. And one of the most important is the tax consequences. In general, it is beneficial to delay distributions from Roth and traditional tax-favored retirement accounts for as long as the law (and your resources) allow. But going too far down that road might bunch up your taxable income in later years and put some of those distributions into a too-high tax bracket. It’s certainly not easy weighing that long-term cost against the long-term benefit of tax deferral.

Here’s a way you might be able to get the best of both worlds. Let’s say you plan to open up the taxable spigot full force, and take all of your spending this year from your taxable account. That’s good, in that it maximizes the tax deferral benefit of your two tax-favored retirement accounts. But it’s bad, in that it will put you in an extra-low tax bracket this year, at the cost of putting you in an extra-high bracket in later years. What to do, what to do? Eureka! I’ve got it! Use some of this year’s low tax bracket to convert some of your traditional IRA to a Roth IRA—just enough to get you to the top of your extra-low tax bracket. Then you can tap some of that newly bulked-up Roth IRA in a later year—tax-free—to avoid kicking yourself into a higher bracket. Voila! You retain (actually improve) the benefit of tax deferral and avoid creating a future high tax bracket.

When playing with spigot planning, be sure not to make the mistake of spending too much. After all, one of the primary goals of your spending plan is to equalize spending by the Present You and the Future You; more accurately, to equalize after-tax spending. So when you turn down the traditional IRA spigot, and yurn up the taxable account spigot, you’re building in a bigger tax bite into future years’ spending, which needs to be taken into account.

And one last thing:
Happy 200th birthday, Charles Darwin!