Make sure you are pouring from the right bucket

Most people enter retirement with two buckets of money. One bucket is the IRA or 401(k) plan, where money grows free from taxation but will be taxed as ordinary income when it is withdrawn. The other bucket is an investment or savings account, often in the form of a living trust.

Now that their life-long source of working income has ceased, they need to make plans for drawing down their life savings for retirement.

A healthy couple retiring at age 65 has a joint life expectancy of about 25 more years. So, the money needs to last a while. The money will last longest if it is invested wisely, spent prudently and withdrawn from the two buckets in a tax-efficient manner.

Along with an investment plan, you need a withdrawal plan. After adding up Social Security and any other retirement income you will receive, you will likely find that you need a little more from the two buckets. The key question is: which bucket?

Any money drawn out of an IRA will be taxed at ordinary income tax rates, just like wages and salaries. The marginal federal and state tax rate on that money will be about 34 percent if the total taxable income for a couple is between $57,000 and $115,000. The tax rate goes as high as 44 percent at higher income levels. Taxable income includes Social Security, pension income, investment income and IRA withdrawals. Money drawn from an IRA is taxed this way even if the IRA earns no investment return - and even if it drops in value.

On the other hand, money in a living trust or other investment account has a more complicated tax treatment. Dividends and long-term capital gains are taxed at a combined rate of 24.3 percent. Short-term capital gains and taxable interest are taxed at the same rate as IRA withdrawals, or 34 percent in our example.

Municipal bond interest is not taxed at all. If you are in a 34 percent or higher tax bracket, you should probably own municipals instead of taxable bonds. Hence, on average, regular investment accounts are taxed at a lower rate than IRA withdrawals.

In addition, withdrawals of the principal, or basis, of an investment account are not taxed at all. The bottom line is that money spent from a taxable investment account usually results in a much smaller tax bill than money spent from an IRA.

I have run numerous calculations and spreadsheets to analyze the optimal way to withdraw retirement spending money from these two buckets. In virtually every case, there is a simple rule of thumb for deciding how to draw down your savings.

First, add up outside sources of income, such as Social Security and pensions, and subtract how much you will owe in taxes on those sources.

Let’s say you are left with $4,000 per month after taxes. We will further assume that you really want to spend $6,000 per month.

Take the extra $2,000 that you need entirely from your taxable investment or savings accounts. Do not draw a dime out of the IRA. At the end of the year, you will owe some taxes on the investment account’s income and gains, and you will pay those taxes from the investment account.

Keep following this rule as long as there is sufficient money in the investment account to do so. You probably want to keep the balance above some minimum to make sure that you have a rainy-day fund on hand. If the investment account falls below your rainy-day minimum, you begin to take money from the IRA.

Spend the taxable investment account first. When it is nearly gone, only then do you dip into the IRA bucket.

When you reach age 71, you will be required to take a minimum annual amount from your IRA. Repeat the above process, only this time adding the minimum required IRA withdrawal to the other sources of income.

Continue to fill any gaps from your taxable investment account.

There are perhaps some rare exceptions to this rule. If you think you might be one of those exceptions, consult with your accountant or financial advisor.

Your IRA should generally be the only then do you dip into the IRA bucket.

When you reach age 71, you will be required to take a minimum annual amount from your IRA. Repeat the above process, only this time adding the minimum required IRA withdrawal to the other sources of income.

Continue to fill any gaps from your taxable investment account.

There are perhaps some rare exceptions to this rule. If you think you might be one of those exceptions, consult with your accountant or financial advisor.

Your IRA should generally be the bucket of last resort for spending withdrawals. You will save taxes on a year-to-year basis and your money will grow faster since the IRA funds are tax-sheltered while they wait for you to spend them.