Withdrawal Strategies to Make Your Nest Egg Last Longer

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1 Withdrawal Strategies to Make Your Nest Egg Last Longer Ibbotson Associates/IFID Centre Retirement Income Products Executive Symposium William Reichenstein, PhD, CFA Baylor University 1

2 Presentation based on Ch 6 of William Reichenstein, In the Presence of Taxes: Applications of After-tax Asset Valuations, FPA Press, August

3 Outline: 1. Dollar in tax-deferred account is like (1- t n ) dollar in Roth 2. Effective tax rates on bonds and stocks held in Roth, tax-deferred account, and taxable account 3. Optimal withdrawal sequence in retirement Tax-deferred account (TDA) includes 401(k), 403(b), Keogh, etc. Roth denotes tax-exempt account including Roth IRA, Roth 401(k), and Roth 403(b). 3

4 1. Dollar in tax-deferred account is like (1- t n ) dollar in Roth 4

5 Assumptions Initially assume ordinary income tax rate during retirement is flat 25%, t n = (Later, we will relax this assumption.) 5

6 $1 TDA versus $0.75 Roth IRA The $1 of pretax funds in a tax-deferred account will buy the same amount of goods and services in retirement as $0.75 of aftertax funds in a Roth when invested in the same asset. For example, if cumulative pretax return is 100% then they each buy $1.50 of goods and services. TDA denotes tax-deferred account. 6

7 Implications The $1 in TDA can be separated into $0.75 of investor s after-tax funds + $0.25, the government s share of current principal. Roth grows tax exempt. After-tax value of TDA grows tax exempt, too. Effective tax rate is 0% for both. For asset allocation, $1 of pretax funds in TDA is converted to $0.75 of after-tax funds. You can convert pretax dollars in TDA to aftertax dollars by multiplying by (1 t n ), where t n is the tax rate at withdrawal in retirement. 7

8 After-tax value of Tax-deferred Account Assume 100% cumulative pretax return. If t n is 25% then $1 or pretax funds in tax-deferred account grows from $0.75 after taxes today to $1.50 after taxes. Its after-tax value grows at the pretax rate of return. 8

9 2. Effective tax rates on bonds ands stocks held in Roth, taxdeferred account, and taxable account 9

10 After-tax Ending Wealth Models for Bonds and Stocks in Roth, TDA, and Taxable Account Beginning investment value: $1 Bonds Stocks Roth (1+r) n (1+r) n TDA (1+r) n (1-.25) (1+r) n (1-.25) Taxable Account (1+r(1-.25)) n Active Investor: (1+r(1-.15)) n Passive Investor: (1+r) n (1-.15)+.15 Exempt Investor: (1+r) n r=pretax return, n = investment horizon in years For simplicity assume all stock returns are capital gains Maximum long-term capital gain tax rate of 15%. Active investor realizes all gains each year, technically, in a year and one day. 10

11 Effective Tax Rates for Bonds and Stocks in Roth, TDA, and Taxable Account Beginning investment value: $1 Bonds Stocks Roth 0% 0% TDA 0% 0% Taxable Account 25% Active Investor: 15% Passive Investor: <15% Exempt Investor: 0% r=pretax return, n = investment horizon in years For simplicity assume all stock returns are capital gains 11

12 3. Optimal withdrawal sequence in retirement - Initially let s assume the couple has funds in 401(k), Roth IRA, and taxable accounts. - Later, we will add non-qualified annuities. 12

13 Rule of Thumb Recall that the effective tax rate on funds held in Roth and tax-deferred account is 0%, while effective tax rates > 0% on funds held in taxable accounts. Rule of Thumb: Withdraw funds from taxable accounts before retirement accounts* *Retirement Accounts are TDAs and Roths 13

14 Simulations Assumptions Retiree s Portfolio: $2,000,000 after taxes Taxable Accts = $800,000 after taxes Roth IRA = $200,000 after taxes 401(k) = $1,000,000 after taxes 14

15 Simulations Assumptions Goal: Withdraw largest constant real after-tax amount each year for 30 years --66 year old retired couple retiring in Jan Gross bond returns = 5% --Gross stock returns follow (bad sequence) or (good sequence) --Expenses = 1% --Taxable income = withdrawals from 401(k) 15

16 Two Withdrawal (WD) Strategies Taxable Accounts 1 st 1. WD from 401(k) to satisfy RMDs, if any 2. WD from taxable accounts 3. WD from retirement accounts Retirement Accounts 1 st 1. WD from 401(k) to satisfy RMDs, if any 2. WD from retirement accounts 3. WD from taxable accounts 16

17 Table 2. Additional Longevity from Taxable Accounts 1st Strategy Returns Initial Taxable Retiremt Additional Seq. Withdrawal Accts 1 st Accts 1 st Longevity Poor $73, yrs Good 98, Poor 100, Good 100,

18 Exceptions to Rule of Thumb Key idea: The government effectively owns t n of principal in tax-deferred accounts, where t n is the tax rate upon withdrawal. Minimize t n, the government s share! 1. Before RMDs begin after 70.5, your client s taxable income may be low. If so, withdraw funds from tax-deferred accounts (or convert funds from traditional IRA to Roth IRA) to use low tax brackets. 18

19 2005 and 2008 Tax Brackets Tax Rates on Taxable Income Couples Filing Jointly % $14,000 $16,050 15% 59,400 $65,100 19

20 Idea: Young Retired Couple Who Will be in 25% Tax Bracket after 70.5 Rule of Thumb Withdraw funds from taxable account Better Strategy 1. Withdraw funds from 401(k) to top of 15% bracket and 2. Additional funds from taxable accounts 20

21 Exceptions to Rule of Thumb 2. When t n is low perhaps due to large contribution or deductible medical expenses withdraw funds from taxdeferred accounts. --Idea: If either spouse will be in nursing home or assisted living facility then it would be best to save sufficient fund in tax-deferred accounts to pay for those years. 21

22 Exceptions to Rule of Thumb 3. If unrealized capital gain on asset held in taxable account will be held until receiving step-up in basis at death or the appreciated asset will be donated to charity then do not realize the gain, even if this means withdrawing funds from retirement accounts. 22

23 Examples --If your client is terminally ill, don t realize capital gains until after death. --If your client will donate the appreciate asset to qualified charity then don t realize the capital gain. 23

24 Withdrawal Strategy from Tax-deferred Accounts and Roths no Bequest Motive Objective: maximize portfolio s longevity Withdraw funds from tax-deferred accounts to top of low tax bracket and then withdraw additional funds from Roths. 24

25 Withdrawal Strategy from Tax-deferred Accounts and Roths Bequest Motive Objective: maximize after-tax value of accounts for retiree and beneficiary Your retired client has funds in TDA and Roth IRA and her beneficiary son is in a lower tax bracket: She should withdraw funds from Roth IRA and save TDA for son. If her son is in a higher tax bracket, she should withdraw funds from her TDA and save Roth IRA for son. 25

26 Examples --If retiree is in 25% tax bracket and her son is in 15% tax bracket then she should withdraw funds from Roth IRA and save TDA for son. The $100 in TDA is worth $75 after taxes to retiree but $85 after taxes to her son. --If your client will leave $20,000 to charity after her death then dedicate $20,000 in TDA for this goal. 26

27 Effective Tax Rates for Bonds and Stocks in Roth, TDA, Taxable Account, and Non-qualified Annuity Beginning investment value: $1 Bonds Stocks Roth 0% 0% TDA 0% 0% Taxable Account 25% Active Investor: 15% Non-Q. Annuity < 25% < 25% r=pretax return, n = investment horizon in years For simplicity assume all stock returns are capital gains 27

28 Rules of Thumb For bond investments, withdraw from taxable accounts then non-qualified annuities with withdrawals from TDAs and Roths last. For stocks (with < approx. 20 year investment horizons), withdraw from annuities then taxable accounts with withdrawals from TDAs and Roths last. 28

29 Complications For annuities, this rule of thumb ignores 1) frequently higher expenses on annuities 2) surrender fees that may reduce optimal withdrawal to 10% free withdrawal per year 3) return-of-principal death benefit would holding encourage stocks in annuity and is an offsetting factor favoring annuities. 29

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