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Leverage Tax-Efficient Withdrawal Strategies to Boost Your Retirement Income
- By Travis Echols
- •
- 09 Feb, 2018
As I have
written in the past, investing in
retirement is greatly different from
investing for
retirement. Someone has compared it to hiking up a
mountain versus hiking down a mountain.
The
way our bodies are designed, we are more prone to accidents when walking down a
steep incline. Retirees should view investing in retirement in a similar way. It is in many ways more difficult to decumulate assets to provide a life-time income than to accumulate them for that purpose. A different set of rules apply.
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Part of what makes investing in retirement more difficult is the fact that there is no room to make up for mistakes--by earning and saving more money. In retirement, we have saved what we have saved and now it is time to make it last the rest of our lives. This task is fraught with many dangers. Retirees still need to think about growth to combat the rising cost of living, but also about preservation to make sure their hard-earned savings are not prematurelydepleted, especially due to sequence risk.
Investing in retirement is more challenging because typically retirees need to take money from their portfolios for supplemental income. Retirees don’t want to run out of money before they run out of life. They also don’t want to short-change themselves out of income they could have enjoyed spending on themselves or others.
To get the most income from a retirement portfolio, it is necessary to decumulate your investments in a tax-efficient manner.
Normally this means analyzing how withdrawals should be made from the different tax-type of assets: taxable (i.e., nonqualified) accounts, tax-deferred accounts (e.g., 401(k)s, traditional IRAs), and tax-free accounts (e.g., Roth 401(k)s and Roth IRAs).
Conventional wisdom says to take taxable money first, then tax-deferred, and lastly tax-free. And this withdrawal order is usually more tax-efficient than an equally pro-rated withdrawal strategy.
However, a study done by Cook, Meyer, and Reichenstein in 2015 demonstrated that often a more tax efficient strategy is to decumulate taxable accounts coupled with Roth conversions to max out the lower tax brackets, then max out the lower tax brackets with tax-deferred withdrawals coupled with Roth distributions.
In essence what they showed was that taking advantage of filling up the lower tax brackets in the earlier, low-income years helped the retiree to avoid paying more taxes in the higher brackets later in retirement. Hence, it can lower the overall average tax burden.
A more recent study published in the Journal of Financial Planning explored the effects of Social Security Benefits and Required Minimum Distributions (RMDs) on tax-efficient withdrawal strategies. In the February 2018 edition, Greg Geisler, Ph.D. and David S. Hulse, Ph.D. made the following conclusions.
- The importance of decumulating investments in a tax-efficient manner is often under-estimated in retirement planning.
- Due to the 50%
and 85% phase-ins
of taxes on Social Security benefits, the investor can
face effective marginal tax rates that are much higher than the statutory rates
(rates as high as 46%). [Remember, since these phase-in provisional income thresholds
are not indexed for inflation, more and more of Social Security benefits will be taxable from a "real dollars" perspective.]
- The study showed that maxing out the lower (15/12%) bracket resulted in a high degree of tax efficiency, even when considering the complexities of Social Security benefits and RMDs.
- For smaller retirement nest-eggs of $600,000 versus $2-3 million, the strategy to max out the 10% bracket can create greater tax efficiency. For larger nest-eggs, retirees can often lower taxes by maxing out the 25% bracket (22% and 24% with the new tax law).
- They
concluded that the strategy is not best for every situation but it is a good
starting point to find the best strategy. (For example, one problem is not having enough non-qualified, taxable account assets to pay for living expenses and the taxes on the conversion. Every situation has to be carefully evaluated each year to be sure it makes sense. It is most beneficial to implement in low-tax years for various reasons such as extra deductions or low income, etc. )
- Finally, the study showed that delaying Social Security benefits and increasing traditional IRA-to-Roth IRA conversions while maxing out the lower tax brackets can significantly lengthen a portfolio’s life. And that is a huge benefit when considering the financial danger posed by living a long time (i.e., longevity risk).
This proposed strategy estimates a $467,010
greater ending portfolio than a pro-rata withdrawal
strategy without the Roth conversions, assuming the current tax law sunsets in 2025 as scheduled($374,000 more if the current tax laws do not sunset). This proposed strategy will result in a $443,980 greater ending portfolio than a sequential (i.e., taxable,
then tax-deferred, then tax-free) withdrawal strategy without the Roth conversions.
You can see in this case how it is the Roth conversions
in the years prior to the start of RMDs at age 70½ that accounts for the lion’s
share of the tax-savings. [Note: In this case, the spending shocks around age 90 (the time horizon for which we planned), reflect estimated end-of-life long term care expenses based on national averages.]
With the Roth recharacterization rule terminated in the most recent tax bill, we will meet toward the end of each year to assess the amounts to convert. (see Highlights from the New 2018 Tax Rules).
Assuming the 2018 tax laws sunset as scheduled in 2025 and otherwise do not change significantly in the future, implementing this strategy successfully could result in an extra $450,000 for my clients to either spend in retirement or leave for their heirs!
I think Dr. Geisler and Dr. Hulse were correct in concluding that the importance of decumulating investments in a tax-efficient manner is often underestimated.
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- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
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Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
Protecting your lifetime retirement savings from excessive taxes is a crucial part of holistic financial planning. This involves protecting your IRA, 401k, lump sum pension rollover, Social Security, and any other type of retirement account or income stream from crushing tax rates.
So let's be sure to differentiate tax preparation
from tax planning
.
Tax preparation , also called tax return preparation, looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning on the other hand looks at taxes in the context of your overall financial picture. A tax planner not only looks in the rear-view mirror but will look forward 20 to 30 years at your projected tax liability and ask what can be done to lower your lifetime tax bill.
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Originally written on Aug 2, 2018 and updated for tax law changes.
If you are no longer working and have reached the age of 72,
you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution
(RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more,
but this requirement is the minimum
you must take or be severely penalized. Fortunately,
this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)
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If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.
Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo . There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)
However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA) , with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.
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The latest book I am reading is “ The Psychology of Money ” by Morgan Housel. Chapter 3 is entitled “Never Enough”. In this chapter, Housel talks about when rich people do crazy things. He tells stories of wealthy people who never had a sense of enough and wrecked their reputations, families, freedom, and happiness because of it. I have also talked to older couples who tell me they once had a much better retirement in view, but the quest for more led them to make unwise investment decisions that left them financially crippled in retirement. The importance of knowing when you have enough is not only vital to when you retire but also how you retire. It can affect how you invest, how you withdraw, and your overall satisfaction before and during retirement. Be sure to read to the end where I summarize a few key takeaways. Housel makes the four following observations in chapter 3 of his book. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Whether you do mini-Roth conversions over several years or big Roth conversions in a few strategic years, the Roth conversion strategy could save you tens if not hundreds of thousands of dollars over your retirement. This article will get deep into the issues of Roth conversions for retirees and the ten steps to take to be sure it is done properly. Be sure to scan or read to the end where I will give you the simple answer to getting your Roth conversion questions answered. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Making big financial decisions immediately following the death of a close family member can be dangerous. It is often best to allow some time before tackling big financial decisions. On the other hand, some people find getting immersed in the finances is helpful in coping with the loss. Whatever way is best for you, you will need to give it your
careful attention to avoid big financial mistakes. The different types of accounts have different rules. I'll address the most common types. In the case of the death of a parent or anyone other than your spouse in which you are a non-spouse beneficiary, there are many rules that you must know to make the best decision for you and your family. (In this article, I use the common parent-child inheritance, but the planning strategies can apply to other non-spouse situations.) Your decisions can have major tax and investment consequences, both now and in the future. And some of these decisions have time deadlines keyed to your parent’s date of death. Also, some of these decisions are irreversible. You can download my free Estate Planning Survivor Checklist here
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So, you don’t want to rush in and make decisions without knowing the rules, and you don’t want to wait too long and be stuck with fewer options. (In this article, I am not addressing estate taxes. As of 2021, only estates valued at $11.70 million or more are subject to federal estate tax. But there are plenty of other tax pitfalls to navigate around. I am also going to focus on liquid savings like investment and retirement accounts, versus real estate which will be for another time.) Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Delaying Social Security makes a lot of sense for many retirees; but there are common pitfalls that can cost you a bundle. As you know, the longer you delay your Social Security Retirement benefit, the higher your lifetime monthly payments are figured to be. This increase in delaying continues until age 70, after which there are no further increases for delaying. This increase for each month that you delay filing is not small, especially considering the current low interest rates. Even after full Social Security age, your payment goes up by 8% per year until age 70. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . Here are the five big mistakes of delaying your Social Security retirement benefit. |
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Are you wondering about the impact of the
2020 election results on your retirement? If so, you are not alone. The two political parties are greatly polarized. While the Democrat party has moved further toward ethno-centric socialism, the Republican party has moved further toward nationalistic populism. The difference in the two parties’ goals for our country is wider than ever. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . |
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
Serving Cumming, GA, Forsyth County, and the surrounding areas of John's Creek, Alpharetta, Milton, Duluth, Buford, Suwanee, Flowery Branch, and Gainesville
