Once retired, how do you determine which investments to tap first: IRA, mutual funds, stocks, bonds? Withdrawing a fixed amount each month could create a mountain of paperwork at tax time.
Tax paperwork in retirement is sort of like the door hitting you on the way out. Just when you want your hassles to ease up, there's a whole new set as you start tapping into various accounts for living expenses.
Tax burdens can be mitigated somewhat, but the top priority should be to keep your investments growing so you'll have enough money for 20, 30 or 40 years of retirement. This, not tax hassles, should guide decisions on which investments to tap first.
Back when people didn't live so long, investment money often was channeled into bonds at retirement to provide a safe, dependable income. But earning 5 percent or 6 percent a year is not good enough these days because even modest inflation can dramatically reduce a fixed income's buying power over the decades. So you probably need to hold some stocks and stock funds.
Start by examining all your holdings' prospects. Those that seem too risky or are likely to produce lackluster profits are good candidates for sale, even if you'll have to pay tax on past profits. Sale proceeds can be used for living expenses or redirected to more promising investments.
If you are happy with your portfolio but need to pull out some cash, look for assets that will trigger the least tax when sold. That includes those that show the least profit. When selling a portion of one asset, for instance, sell the shares purchased at the highest price. Also look for shares owned at least one year, so you'll pay the long-term capital gains tax of 20 percent rather than the higher income tax rate.
Generally, tax-deferred investments such as IRAs and 401(k)s are the last things to sell. You want to enjoy the tax benefits as long as possible, leaving money in the account to grow rather than using some of it to pay tax on withdrawals.
Of course, these are just guidelines. If you think you could end up in a higher tax bracket later, it might make sense to tap IRA and 401(k) accounts first so you could pay tax at today's lower rate. But if you already are retired, it's not likely you will go to a higher tax bracket.
You also should consider estate planning issues, which can be complex. Think about hiring an estate lawyer or other financial adviser. A good long-term plan can cost several thousand dollars, but that's easily worth it if it saves you from costly missteps.
There's no escaping the hassle of figuring taxes, but there's also no reason to make this worse by selling assets every month to raise cash.
Instead, sell enough to generate the cash you'll need for the next 12 months. Then look for ways to convert another portion of your portfolio to a series of bonds equivalent to four years' expenses. Divide it into quarters and buy bonds with maturities of one, two, three and four years.
As you run out of cash in 12 months, the one-year bonds will mature, providing cash for the next 12 months. A year later, the next bonds will mature, and so on.
Each year, sell enough of your stock and stock-fund holdings to buy another four-year bond.
This system will give you a dependable and predictable source of cash for living expenses. The bonds should earn more interest than you'd get if you put five years' worth of cash in a bank account. And you should enjoy the higher returns offered by stocks without having to worry about selling stocks in a downturn to pay immediate expenses. The buffer period created by bonds will allow you to pick the best time to move money out of the stock market.
_ Jeff Brown is a business columnist for the Philadelphia Inquirer.