Conventional wisdom, of the sort passed along by the largest financial services firms and financial planning software packages, encourages retirees to withdraw funds in a certain way after they retire. It says funds should come from taxable accounts first until they are exhausted, then from tax-deferred accounts (such as traditional IRAs) until exhausted, and then from tax-exempt accounts like Roth IRAs. The idea is to withdraw funds from the least tax-favored taxable accounts first, while preserving funds in the most tax-favored Roths until last.
But that wisdom is based on the mistaken belief that funds growing tax-deferred in a TDA are not as tax-advantaged as funds growing tax-exempt in a Roth.
Here we demonstrate that, properly viewed, funds in a tax-deferred account are just as tax efficient as funds in a Roth. Then we’ll use an example from an article we co-authored in 2015 to demonstrate that a tax-efficient withdraw strategy can last three years longer than a portfolio following conventional wisdom.
The Government Is Your Partner
Tax-deferred accounts are best viewed as partnerships with the government. As we know, funds in TDAs generally contain only pretax funds. Thus, in general, withdrawals from TDAs are fully taxable as ordinary income. Initially, assume that every time a retiree withdraws funds from her TDA, the government gets 25%. We will show that each dollar in this retiree’s TDA is best viewed as $0.75 of her after-tax funds plus $0.25, which is the government’s share of the current principal. Furthermore, we will show that funds held in a TDA are just as tax-favored as funds held in a Roth.
Let’s compare the purchasing power of $0.75 of this retiree’s after-tax funds held in a Roth to $1 of her pretax funds held in a TDA. To hold everything else constant, the retiree holds the same assets in the Roth and TDA. She can move the funds from investment A to investment B and still later to investment C, but the underlying investments are the same. The investment earns a pretax geometric average return of “r” percent per year for “n” years, at which time the funds are withdrawn and consumed. Since the investment horizon, “n,” can be any length of time, it fits all investors.
The initial investment of $0.75 in the Roth is worth $0.75(1 + r)n, after “n” number of years. She withdraws these funds and buys $0.75(1 + r)n of goods and services.
Before withdrawal, the $1 of pretax funds in the TDA is worth $1(1 + r)n before taxes for “n” number of years hence. After withdrawal, it is worth $0.75(1 + r)n after taxes and can buy this amount of goods and services, which is the same as the original investment of $0.75 in after-tax funds in a Roth.
Thus, if the marginal tax rate on withdrawal is 25%, then each $1 in a TDA is best viewed as $0.75 of the investor’s after-tax fund with the government essentially owning the remaining $0.25. Notice that the investor’s share of the $1 of pretax funds grows from $0.75 after taxes today to $0.75(1 + r)n after taxes for “n” number of years hence. The after-tax value grows effectively tax exempt, just like having $0.75 of after-tax funds held in a tax-exempt Roth. Thus, properly viewed, the tax-deferred TDA is just as tax-efficient as funds held in a tax-exempt Roth.
Lessons From Cook
In a paper we wrote with Kirsten Cook, “Tax-Efficient Withdrawal Strategies,” which appeared in the March/April 2015 issue of Financial Analysts Journal, we explained how you can create smarter withdrawal strategies than those offered by the conventional wisdom. The hypothetical client in the article was a female retiree in her mid-60s who had funds in a taxable account, a TDA and a Roth. For simplicity, we assumed she had no Social Security benefits, given the complexities involved in taxing these benefits. (We will address those issues in our next article.)
She began annual withdrawals in 2013. For simplicity (and so the reader could easily follow the article), we assumed there would be no inflation, so the standard deduction, personal exemption and tax brackets remained constant from year to year. We also assumed her spending would be constant at $81,400 each year. She began with $549,601.17 in a taxable account, $916,505.12 in a TDA, and $234,928 in a Roth. Her asset allocation was 100% bonds with a 4% return.
We came up with different strategies for this retiree, one of which followed the conventional wisdom, wherein the retiree withdrew funds from the taxable account only for the first seven years to meet her spending needs. In year eight, she withdrew the remaining funds from the taxable account plus additional funds from the TDA to meet her spending needs. In years nine through 24, she withdrew $99,271.67 from the TDA, and of that, $51,521.67 was taxed at 25% to meet her spending needs. In year 25, she withdrew the remaining funds from the TDA plus additional funds from the Roth. Beginning in year 26, she withdrew $81,400 from the Roth. The portfolio lasted 33.15 years. That is, it met 15% of her needs in year 34.
To understand why the conventional wisdom is not the optimal withdrawal strategy, we noted that the retiree has income below the top of the 15% tax bracket in years one through eight. Withdrawals from taxable accounts are usually largely, if not entirely, a return of principal.
For example, a withdrawal of $30,000 from a savings account provides $30,000 to live on, but it is entirely a return of principal. In year one, our retiree is in the 15% tax bracket. But in year seven she is in the 0% bracket, meaning her adjusted gross income is not sufficient to offset her standard deduction plus personal exemption. In years nine through 24, she pays taxes at the 25% tax rate on $51,521.67 of TDA withdrawals. In year 26 and later, all withdrawals are from Roths, so her adjusted gross income and tax bracket are zero.
The government gets “t” of each dollar withdrawn from the TDA or converted from a TDA to a Roth, where “t” is the marginal tax rate. The objective is to look for opportunities to withdraw funds from TDAs to minimize the average marginal tax rate. In our 2015 article, we describe three strategies that improve upon the conventional wisdom strategy for this retiree.
In one of the more optimal strategies, for the first 19 years this retiree withdraws $47,750 annually from the TDA to fill the top of the 15% tax bracket plus additional funds from the taxable account. The $47,750 is the sum of standard deduction for someone 65 or older of $7,600, personal exemption of $3,900, and taxable income at top of 15% tax bracket of $36,250. In years 20 and beyond, the retiree withdraws $47,750 from the TDA to fill the top of the 15% tax bracket plus additional funds from the Roth. This strategy offers 1.22 more years of portfolio longevity than the conventional strategy. That comes from a) shifting some TDA withdrawals from years nine through 24 (taxed at 25%) to years one through eight to fill up tax brackets of 15% and lower and b) shifting TDA withdrawals to years 26 and beyond to fill up the 0% through 15% brackets.
Two additional withdrawal strategies rely on converting funds from the TDA to a Roth. In one, the retiree converts $47,750 from the TDA to the Roth at the beginning of years one through six, and withdraws additional funds from taxable accounts to meet her spending needs.
After the taxable account has been exhausted, she withdraws $47,750 annually from the TDA and additional funds from the Roth to meet her spending needs. This allows the portfolio to last 35.51 years, which is 1.14 years longer than our prior strategy. After the year six distribution, this second strategy has $377,144 more in the Roth and $377,144 less in the taxable account than our previous strategy did. Because funds in a Roth grow tax-free, while funds in the taxable account grow at an after-tax rate of return, this new strategy allows the portfolio to last longer.
Our third strategy examines the impact of a Roth conversion with recharacterization on portfolio longevity. This strategy as modeled in the 2015 article has the retiree convert two separate $47,750 amounts from the TDA to Roths at the beginning of years one through 27.
In one Roth, she holds U.S. stocks. In the other, she holds one-year bonds. At the end of each year, the retiree keeps funds in the higher-valued Roth and recharacterizes funds in the lower-valued Roth. To understand why this recharacterization option is valuable, suppose the Roth containing $47,750 of stocks at the beginning of 2013 was worth $63,116 at year end as it would have been if the funds were invested in the Vanguard 500 Index Admiral shares. This third strategy allows the retiree to avoid ever paying taxes on the $15,366 appreciation. In contrast, if stocks lose value, then the funds are recharacterized and the retiree is in the same position with respect to this stock investment as if she never converted these funds to a Roth. Meanwhile, she keeps the modest return on one-year bonds that were converted to the Roth, and the $47,750 beginning-of-year conversion value fills the top of the 15% tax bracket. This strategy allows the portfolio to last 36.17 years, 0.66 years longer than the second strategy. In short, it adds more than three years of additional longevity compared to the conventional wisdom (which, we should point out, is already considered a tax-efficient withdrawal strategy).
The best way to view TDAs is that they are a partnership with the government. The government effectively own “t” of the current principal, where t denotes the marginal tax rate in the withdrawal year. A tax-efficient withdrawal strategy requires a retiree to time withdrawals of funds from TDAs and conversions of funds from TDAs to Roths such that she minimizes the average marginal tax rate. In contrast, someone following the conventional wisdom strategy will generally be in relatively low tax brackets in years when funds are being withdrawn from the taxable account, in relatively high tax brackets in years when funds are being withdrawn from TDAs, and in the 0% bracket when funds are being withdrawn from Roths. In this article, we presented three withdrawal strategies that improve upon the conventional wisdom. In the most efficient strategy, this retiree was able to extend the longevity of her portfolio by more than three years compared to the conventional wisdom.
In our next article, we will discuss the taxation of Social Security benefits, and how this should affect the way individuals withdraw funds from their financial portfolio to maximize their portfolio’s longevity.
William Reichenstein, Ph.d., CFA is professor of investment management at Baylor University and Principal at Incomesolver.com. William Meyer, is founder and managing principal of Incomesolver.com. Reichenstein will address some of the issues in this article at Financial Advisor’s Inside Retirement conference in Dallas on May 12.