Helping retired and retiring clients make decisions about their money and managing their investment assets can be quite challenging, to say the least. Fortunately, we have a number of studies that help us frame the issue of a portfolio's sustainability. I have found the work of Bill Bengen, Michael Kitces and Jon Guyton to be particularly helpful. Unfortunately, a client's actual experience in retirement is likely to be vastly different from what we simulate during the planning process. Life happens and reality conflicts with theory. Even if life events bring no surprises, good or bad, managing financial investment decisions can still offer challenges.

A simple tax-related example of this is the hypothetical scenario of two people, Tom and Jerry, both age 65 retiring on the same day with exactly the same family and health profiles. Both have $1 million of investment assets and need an additional $40,000 annually to meet their spending needs. Each has the experience, temperament and tolerance for risk to handle a balanced portfolio. Tom, however, has all of his million dollars in a taxable brokerage account while Jerry has all of his in an IRA funded entirely with pretax contributions.

Because of the role of taxes, their prospects for a sustainable portfolio are quite different. Most planners would not be particularly concerned about Tom's ability to sustain $40,000 annually in additional expenditures because his withdrawal rate would not need to be much more than 4% in order to accommodate the taxes. Tom may not be able to avoid entirely current taxation on ordinary income items in his portfolio, but he is able to benefit from lower rates applied to long-term capital gains and zero taxation on basis.

Jerry on the other hand, must incur taxable income at ordinary income tax rates on every dime he removes from his IRA. This could be a monstrous difference. Even if his marginal federal rate is just 15%, he must remove almost 18% more than he needs to cover the taxes. At a 35% tax rate, Jerry needs to remove almost 54% more, $61,538.46, in order to have $40,000 to spend. That would be a 6.15% withdrawal rate, pushing, if not exceeding, the higher limits of the ranges cited in most sustainability studies. Said another way, if Jerry lives in a state with no income tax, he needs $1,538,461.54 in order to get his withdrawal rate to the oft-cited 4%.

While true that it is easier to accumulate $1.5 million when the client gets a tax deduction for his contributions, pays no tax on interest, dividends, or capital gains, and possibly gets matching money from his employer, it is also true that in retirement a dollar in an IRA is worth less than a dollar in a taxable account. Of course, most clients have both retirement accounts and taxable accounts, which can make tax management interesting.

With both taxable and tax deferred accounts available, there is an opportunity to enhance overall results by paying attention to asset location as well as asset allocation. Using one common theory, we would design a portfolio to provide a desired risk-reward profile. We would put holdings that generate ordinary income or are otherwise tax inefficient into the deferred accounts, leaving more tax friendly holdings in the taxable accounts. For instance, stocks that pay no dividends and municipal bonds would go in the taxable account whereas corporate bonds, TIPS and stocks whose dividends are taxed at ordinary rates would go in the tax deferred accounts.

In the real world this is not always practical or desirable. Take the case of the millionaire who has $950,000 in a taxable account and $50,000 in an IRA. With such a small amount of the overall asset base in the IRA, there is little capacity to stuff tax inefficient holdings into a deferred state. Unless you are willing to forgo less tax-efficient asset classes, the added taxation bumps up the gross return required to net the desired expenditures, thus increasing the withdrawal rate. For a millionaire needing only $40,000 per year this may be fine, but for persons needing more or in a high tax bracket, the tax burden imposed on ordinary income can push the withdrawal rate to an uncomfortable level.

Stuffing the IRA with tax inefficient assets can also create behavioral issues. With the IRA comprising only 5% of the portfolio, it may only hold one or two asset classes. If that IRA holds nothing but say, TIPS or real estate investment trusts, it will behave very differently at times than the more balanced taxable account.

This requires a different set of expectations to be managed than would be indicated if the IRA and the taxable account held an identical ratio of stocks to bonds and thus behaved similarly. The same behavioral issue exists when the ratio of tax deferred to taxable accounts is skewed in the opposite direction. However, the household that has the majority of its assets in retirement accounts has other issues to deal with if they take tax minimization too far through its choice of asset location.

From where one takes their withdrawals can matter a great deal also. Many 65-year-old retirees want to delay withdrawing money from their IRAs incurring ordinary income tax for as long as the can. Further, many financial planning software packages assume that nonretirement money is spent first and retirement accounts are not tapped until needed or required at age 70 1/2.

Unfortunately, the household that has little in taxable accounts can easily back themselves into a corner by trying to minimize taxes. For instance, assume our millionaire's profile indicates a 60/40 portfolio and has $900,000 in an IRA and $100,000 in a taxable account. Using the asset location priorities we just discussed, that taxable account will hold nothing but stocks. This causes a conflict with the desire to minimize taxes because avoiding IRA withdrawals would mean liquidating those stocks to provide cash flow. It also bears no resemblance to the long-term time frames investment theory usually prefers for owning stocks.

Even if the stocks did nothing, the taxable account is empty in just 2 1/2 years when the client spends $40,000 annually. If the market tanks early in retirement and the client takes his $40,000 at the beginning of the year, the account may be emptied in much less time. $100,000-$40,000 = $60,000. Knocking off say, 30% in a bad market leaves $42,000. Before he reaches his 67th birthday, our 65-year-old, tax-hating retiree is stuck paying ordinary income tax every time he needs money for the rest of his life. That may be a highly undesirable condition.

His stocks would need to return almost 30% each and every year in order to last five years. Bonds are probably even more unlikely to get the account to last until age 70, but they are also most likely not going to result in an empty account in less than two years.

So, again, reality conflicts with theory. We may not be able to make the theoretical optimal choices regarding asset location. We may choose also to tap retirement accounts earlier than desired or sooner than a software package assumes. Of course, to complicate things further our choices may need to be altered due to changes in the tax code among other things. As it is today, the marginal rates and brackets are only "clear" through 2012. Will capital gains rates go up? Will any dividends remain "qualified" dividends? Will state income tax rates increase? Etc. etc.

Unfortunately, there are several ways that a household's income taxes and withdrawal needs can change dramatically even if today's tax code never ever changed. We'll talk about some of those next time.

Dan Moisand, CFP, has been featured as one of the America's top independent financial advisors by most leading financial advisor publications. He has spoken to advisor groups on five continents on topics such as managing investments and navigating tax complexities for retirees, retirement readiness, and most topics relating to the development of the financial planning profession. He practices in Melbourne, Fla. You can reach him at 321-253-5400 or [email protected].