Create a Withdrawal Strategy that Exploits Marginal Tax Rates
(READ TIME: ~5 MIN)
- The real economic value of a dollar of savings depends on which type of investment account it is held in and how and when it will be taxed.
- Maximizing the after-tax value of your savings requires taking money from the right places and executing strategies at the right time.
- Material economic differences exist between withdrawal strategies and the most commonly recommended strategies tend to lead to the highest lifetime tax bills.
It's ironic that financial advisors and individuals spend so much time and energy on the accumulation side of the retirement planning equation, but when it's time to start living off those savings…..crickets. Yet the strategy you use to withdraw your assets can matter as much or more. Financial advisors who charge based on the size of your portfolio don't want to see the assets leave when you retire, so they tend to give overly conservative advice like, "live off the dividends and interest" or "let’s start at 4% and inflation adjust from there” (See our Insight entitled “Why a Flat Fee Advisor is Best for Retirees” for more), but they never really recommend how to withdrawal the funds. Few individuals, even though they may be well-versed in investments and portfolio construction, have much of an idea of what to do either. Decumulation, or how to withdraw savings to fund retirement, is just not something many people discuss or study.
A Dollar of Savings is Not Necessarily a Dollar of Savings
The problem is this is precisely where real retirement planning kicks in. So much value can be gained or lost when developing an optimal withdrawal strategy. You can easily see why when you stop to think about it. A dollar of savings is not necessarily all equal in real economic terms. The real economic value of a dollar of savings depends on which type of investment account it is held in and how and when it will be taxed. For instance, a dollar of savings from a Roth account is truly worth a dollar. A dollar from your taxable (or brokerage) account may only be worth $0.85, $0.80, or $0.76, depending on your capital gains tax bracket, amount of gain, and when you take it. A dollar from your pre-tax retirement account (401k/IRA) can be worth as little as $0.50 if you made enough to be taxed at the highest possible State and Federal brackets and withdrew the savings during this time. The point is that it’s the after-tax value of your savings that matters.
Maximize the Value of Your After Tax Savings
Maximizing the after-tax value of your savings requires taking money from the right places and executing strategies (like Roth conversions – See our Insight entitled “What Drives Value in a Roth IRA Conversion Strategy” for more) at the right time. There are dozens of different withdrawal strategies: conventional wisdom, constant proportion, xx% bracket management, and so on. The problem is that no one strategy is optimal for the entirety of one’s retirement because too many events happen during retirement that will impact the level of your marginal taxation. These events include:
- Claiming Social Security
- Instability of tax policy (the current Tax Cut and Jobs Act tax rates expire at the end of 2025)
- Required Minimum Distributions (RMDs) will eventually force you to take taxable income from retirement savings
- Medicare IRMAA surcharges (based on income earned two years before starting Medicare)
- One spouse will inevitably be left in a “widow’s penalty” for at least some unknown time period
A withdrawal strategy that maximizes the after-tax value of your savings is really a multiphase series of withdrawal strategies that navigate the potential increases and decreases in your marginal tax rates during these years when incomes can rise and fall. As you can imagine, this multiphase series of withdrawal strategies must be highly customized to each individual/couple.
The Driver of Withdrawal Strategy Value
The key goal and value driver is finding a way to fill the lower tax brackets during the beginning of retirement (when you’re most likely funding from your brokerage account) and throughout retirement (meaning you ensure you can claim just enough income to do so). It's about finding the “just right” balance based on what we know and then adjusting when the unknowable happens (changes to tax policy and rules).
Your Withdrawal Strategy Can Lead to Materially Different Economic Outcomes
William Reichenstein, Ph.D., CFA, shares a case study in his column entitled “Why Multiphase Withdrawal Strategies Beat Single-Phase Withdrawal Strategies,” published in the Journal of Financial Planning in June 2023. In his case, a married couple had a financial portfolio worth $3 million and planned to spend an inflation-adjusted $13,000 monthly. The table below shows his summary of outcomes using just five different withdrawal strategies (note, “SSB” stands for Social Security Benefit):
Clearly, there are material economic differences between these strategies. Unfortunately, the most commonly recommended withdrawal strategies (if one is recommended -- Conventional Wisdom and Proportional because of their ease) tend to perform the worst and leave retirees with a much larger lifetime tax bill than would be necessary with some better planning.
If you are ready to determine your optimal withdrawal strategy, we stand by ready to help. You can click here to schedule an informal, 20-minute introductory Zoom call to get started.