Why the Conventional Wisdom Is Never the Optimal Withdrawal Strategy

FEATURE | Why the Conventional Wisdom Is Never the Optimal Withdrawal Strategy

RETIREMENT INCOME PLANNING Why the Conventional Wisdom Is Never the Optimal Withdrawal Strategy

By William Reichenstein, PhD, CFA®, and William Meyer

ow good is your advice about how But the after-tax value of a TDA grows to generate retirement income? In Han article we published recently effectively“ tax-exempt, i.e., without any taxation. with a colleague (Cook et al. 2015), we Thus, contrary to the conventional wisdom, the TEA discussed how a retiree can tax-efficiently is not more tax-favored than the TDA. withdraw funds from taxable accounts, tax-deferred accounts such as a 401(k), ” and tax-exempt accounts such as a Roth individual retirement account, to make with the government. Initially, assume that Now, let us relax the assumption that the the portfolio last longer. each time the retiree withdraws $1 from the marginal tax rate on TDA withdrawals is TDA the government gets $0.25. Here the 25 percent. In this case, it makes sense for Conventional wisdom says that a retiree TDA is like a partnership where the retiree, the retiree to look for opportunities to should withdraw all funds from the taxable as majority partner, gets to make the invest- withdraw funds from TDAs when the tax accounts until exhausted, then from tax- ment decisions, but the government, as rate is unusually low. As we demonstrated deferred accounts (TDAs) until exhausted, minority partner, gets 25 percent of the in Cook et al. (2015), a taxpayer who fol- and then from tax-exempt accounts (TEAs). withdrawal amount. So, each $1 in a TDA lows the conventional wisdom will likely be The idea is to withdraw funds from the is $0.75 of the taxpayer’s after-tax funds, in a relatively low tax bracket in the early least tax-favored account first, followed by and the government effectively owns the years of retirement, when funds are with- the TDAs next, preserving until last the other $0.25. drawn from the taxable account, and in the funds in the most tax-favored TEAs. That late years, when funds are withdrawn from is, the conventional wisdom is based on the But the after-tax value of a TDA grows the TEA. It makes sense to shift withdraw- idea that funds growing tax-deferred in a effectively tax-exempt, i.e., without any tax- als from the middle years when funds are TDA are not as tax-advantaged as funds ation. Thus, contrary to the conventional withdrawn from the TDA and taxed at rela- growing tax-exempt in a TEA. wisdom, the TEA is not more tax-favored tively high tax rates to the early and late than the TDA. years to fill up the lower tax brackets.1 But this idea is wrong. The largest financial services firms and all financial planning Suppose the investor holds a TDA with $1 A Hypothetical Example software rely on (and promote) the conven- of pretax funds. The underlying assets can Cook et al. (2015) presented an example of tional wisdom. This article will help you be stocks or bonds, but they earn a geomet- a female retiree in her mid-60s who has understand why the conventional wisdom ric pretax return of r per year for n years at funds in a taxable account, a TDA, and a is never the optimal withdrawal strategy which time the funds are withdrawn and TEA. For simplicity, we assumed she has and how you can create smarter withdrawal spent. The market value of the TDA at no Social Security benefits, because of the strategies for your clients. withdrawal is $1(1 + r)n. The government complexities surrounding the taxation of takes 25 percent of this amount, and the these benefits. She begins annual with- Background investor gets $0.75(1 + r)n after taxes. The drawals in 2013, at the beginning of the Investors don’t pay taxes on tax-deferred investor’s after-tax funds grow from $0.75 year. We assumed there is no inflation, so investments until they withdraw the funds. today to $0.75(1 + r)n, i.e., they grow effec- the standard deduction, personal exemp- So a TDA is best viewed as a partnership tively tax-free at the pretax rate of return. tion, and tax brackets remain constant

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from year to year. We also assumed her 33.15 years, i.e., it met 15 percent of wisdom. The additional longevity comes spending is constant at $81,400 each year, her needs in year 34. Compared to tax- from shifting some TDA withdrawals from and that her asset allocation is 100-percent inefficient Strategy 1, the conventional years 9–24 that are taxed at 25 percent bonds with a 4-percent return.2 wisdom extended the portfolio’s longevity to (1) years 1–8 to fill up the top of the by an additional 3.15 years. Henceforth, 15-percent tax bracket and (2) year 26 and In reality, the longevity of a financial portfo- when we compare withdrawal strategies beyond to fill up the 15-percent bracket. lio can be affected by (1) withdrawal strat- to the conventional wisdom, the reader The idea is simple and effective. Shift TDA egy, (2) asset allocation, (3) asset location, should realize that the comparison is to withdrawals that are taxed at 25 percent in (4) level of asset returns, and (5) size of port- what already is considered to be a tax- the conventional wisdom to earlier and folio relative to spending level. Our goal, efficient withdrawal strategy. later years when they would be taxed at however, was to show that tax-efficient 15-percent or lower tax rates. withdrawal strategies can add longevity to To understand why the conventional wisdom the financial portfolio while holding every- is never the optimal strategy, we noted that Strategy 4 thing else constant. The easiest way to hold the retiree has income below the top of the Cook et al. (2015) explained two additional everything else constant was to assume an 15-percent tax bracket in years 1–8. In complex withdrawal strategies that rely on all-bond portfolio. However, Cook et al. year 1, she is in the 15-percent bracket. But converting funds from the TDA to a Roth (2015) also showed that its main conclusions in year 7 she is in the 0-percent bracket, TEA. In Strategy 4, the retiree converts were not affected by these assumptions. In meaning her adjusted gross income is not $47,750 from the TDA to the TEA at the particular, the portfolio’s longevity always sufficient to offset her standard deduction beginning of years 1–6 plus additional funds increases as we move from Strategies 1 to 5, plus personal exemption. She pays taxes at from taxable accounts to meet spending which are described below. the 25-percent tax rate on $51,521.67 of needs. After the taxable account has been TDA withdrawals in years 9–24 and she exhausted, she withdraws $47,750 annually Cook et al. (2015) examined five withdrawal has an adjusted gross income of $0 for each from the TDA and additional funds from strategies: year beginning in year 26. the TEA to meet her spending needs. This allows the portfolio to last 35.51 years, Strategy 1 1.14 years longer than in Strategy 3. Strategy 1 is the opposite of the con- In these later years, After the beginning of year 1 distribu- ventional wisdom. The retiree with- she“ withdraws $47,750 from the tion, Strategy 4 has $47,750 more in draws funds from the TEA followed the TEA and this amount less in the by the TDA, and then the taxable TDA to fill the top of the 15-percent taxable account compared to Strategy account. We set the beginning bal- tax bracket plus additional funds 3. After the year 6 distribution, ances of the TEA, TDA, and taxable from the TEA. Strategy 3 adds Strategy 4 has $377,144 more in the account such that they would be TEA compared to Strategy 3. Because exhausted after three, 16, and 30 1.22 years of portfolio longevity funds in a TEA grow tax-free, and years. Strategy 1 is a tax-inefficient compared to the conventional funds in the taxable account grow at withdrawal strategy. wisdom. an after-tax rate of return, Strategy 4 allows the portfolio to last longer than Strategy 2 ” Strategy 3. Strategy 2 is the conventional wisdom. The retiree withdraws funds from the tax- Strategy 3 Strategy 5 able account only for years 1–7 to meet In Strategy 3, for the first 19 years this Strategy 5 examines the impact of a Roth spending needs. In year 8, she withdraws retiree withdraws $47,750 annually from conversion with recharacterization on port- the remaining funds from the taxable the TDA to fill the top of the 15-percent folio longevity. This strategy, modeled in account plus additional funds from the tax bracket (sum of standard deduction, Cook et al. (2015), has the retiree convert TDA to meet spending needs. In years personal exemption, and taxable income at two separate $47,750 amounts from the 9–24, she withdraws $99,271.67 from the top of the 15-percent tax bracket) plus TDA to TEAs at the beginning of years TDA with $55,521.67 being taxed at additional funds from the taxable account. 1–27. In one Roth TEA, she holds U.S. 25 percent, which meets spending needs. When the taxable account is exhausted, she stocks. In the other, she holds one-year In year 25, she withdraws the remaining has funds remaining in the TDA and TEA. bonds. At the end of each year, the retiree funds from the TDA plus additional funds In these later years, she withdraws $47,750 keeps funds in the higher-valued TEA and from the TEA to meet her needs. from the TDA to fill the top of the 15-percent recharacterizes—i.e., undoes or converts Beginning in year 26, she withdraws tax bracket plus additional funds from the back to a TDA—funds in the lower-valued $81,400 from the TEA, which meets TEA. Strategy 3 adds 1.22 years of portfolio TEA. To understand why this recharacteri- spending needs. The portfolio lasted longevity compared to the conventional zation option is valuable, suppose the TEA

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Table 1: Summary of Withdrawal Strategies Longevity of Withdrawal Strategy Financial Portfolio Strategy 1 Withdraw funds from TEA then TDA then taxable account. 30 years Strategy 2 Withdraw funds from taxable account then TDA then TEA, that is, follow the conventional wisdom. 33.15 years Withdraw funds each year from TDA to take taxable income to top of 15-percent bracket and then withdraw additional funds from taxable account. After taxable account is exhausted, with- Strategy 3 34.37 years draw funds from TDA to take taxable income to top of 15-percent bracket and then additional funds from TEA. Convert funds at beginning of years 1–6 from TDA to TEA to take taxable income to top of 15-percent bracket, and withdraw additional funds from taxable account. After taxable account Strategy 4 35.51 years is exhausted, withdraw funds each year from TDA to take taxable income to top of 15-percent bracket and withdraw additional funds from TEA. Make two TDA-to-TEA conversions at beginning of years 1–27 and withdraw additional funds from taxable account. At end of each year, recharacterize lower-valued TEA. Beginning in Strategy 5 36.17 years year 28, retiree withdraws funds each year to take taxable income to top of 10-percent bracket and withdraws additional funds from TEA. containing $47,750 of stocks at the begin- more than six years of portfolio longevity maximum. After this point, the marginal ning of the year is worth about $63,000 at compared to tax-inefficient Strategy 1 and tax rate is again equal to the tax bracket; the end of the year, as it would have been more than three years compared to the i.e., an additional $100 TDA withdrawal in 2013 if the funds were invested in the conventional wisdom. causes taxes to rise by $25. So, the marginal S&P 500. Strategy 5 allows this retiree to tax bracket is the same as the tax bracket. avoid ever paying taxes on the $15,250 The Role of Social Security For a moderate-income retiree, the marginal appreciation. In contrast, if stocks lose value, The modeling in Cook et al. (2015) was tax rate may rise from 15 percent (15 percent then the funds are recharacterized and the complex despite simplifying assumptions. bracket but before Social Security benefits retiree is in the same position with respect to One of these assumptions was that the are taxed) to 22.5 percent (15 percent bracket this stock investment as if she never con- retiree receives no Social Security benefits. × $1.50), to 37.5 percent (25 percent bracket verted these funds to a TEA. Meanwhile, she We made this assumption because it would × $1.50), to 46.25 percent (25 percent bracket keeps the modest return on one-year bonds take several pages to explain the taxation of × $1.85), before falling to 25 percent after that were converted to the TEA, and the Social Security benefits. As explained and fully 85 percent of benefits are taxed. Because $47,750 beginning-of-year conversion value illustrated in Meyer and Reichenstein this rise in marginal tax rates from 15 per- fills the top of the 15-percent tax bracket. (2013) and Reichenstein and Meyer (2015), cent to eventually 46.25 percent before the taxation of Social Security benefits falling to 25 percent is more extreme than Strategy 5 allows the portfolio to last results in a substantial hump (i.e., rise and the 15 percent to 25 percent jump in tax 36.17 years, 0.66 years longer than Strategy 4. then fall) in the marginal tax rate as addi- bracket for the retiree in Cook et al. (2015), Moreover, as explained in Cook et al. (2015), tional withdrawals are made from the TDA. Cook et al. (2015) understated the value the conversion-with-recharacterization strat- In short, because of the taxation of Social added of a tax-efficient withdrawal strategy egy as modeled understates the additional Security benefits there is a wide range of for many taxpayers. longevity of this strategy for at least two rea- income wherein every time the retiree sons. First, it considered only two converted withdraws an additional $100 from a TDA Cook et al. (2015) ignored the taxation of amounts, and the retiree could make more it causes an extra $50 or $85 of Social Social Security benefits as well as several than two separate conversions at the begin- Security benefits to be taxed. other features of the tax code that can cause ning of the year. Second, it assumed the the marginal tax rate to exceed the tax recharacterizations occurred at the end of the Suppose the retiree is in the 25-percent tax bracket. A partial list of these other compli- calendar year (that is, in about 12 months), bracket. If the additional $100 TDA with- cations includes (1) substantial jumps in but in reality recharacterizations are allowed drawal causes an extra $85 of Social Medicare Part B and D premiums as income through October 15 of the next calendar year Security income to be taxed, then taxable exceeds threshold levels by $1, which are de (that is, 21.5 months after the beginning-of- income rises by $185. And, 25 percent of facto tax increases; and (2) the net invest- year conversion date). $185 is $46.25. That is, the federal-alone ment income tax. Not surprisingly, these marginal tax rate is 46.25 percent, which humps in the marginal-tax-rate curve often Table 1 summarizes the results from Cook substantially exceeds the 25-percent tax increase the value added (i.e., additional et al. (2015). In short, the most tax-efficient bracket. Eventually, 85 percent of Social withdrawal strategy—Strategy 5—added Security benefits are taxed, which is the Continued on page 22 ➧

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© 2016 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved. RETIREMENT INCOME PLANNING software to help with your analysis to Endnotes 1. Cook et al. (2015) note that retirees should try to retain Continued from page 11 develop a good withdrawal strategy. funds in a TDA to cover large medical expenses. There is a nontrivial possibility that the taxpayer or spouse will have large deductible medical expenses in some portfolio longevity or increase in after-tax It is clear that how you withdraw your years, which tend to occur late in life. Ideally, the value of the portfolio that remains for heirs clients’ assets makes a big difference, and it retiree can save TDA funds to cover expenses during high-medical cost years, when the retiree will be in a after the client’s death) that a financial advi- can be a differentiating value proposition to lower—possibly 0-percent—tax bracket. sor can add to a client’s portfolio by recom- baby boomers. Don’t rely on the conven- 2. If we assume a stock exposure, then we would have to decide what portion of unrealized capital gains was mending a tax-efficient withdrawal strategy tional wisdom, which never results in an realized and taxed each year and what portion of the compared to the analysis covered in Cook optimal withdrawal strategy and always realized gains were short-term versus long-term gains. To keep the analysis tractable, we thus assumed an et al. (2015). leads you and your clients to leave a lot of all-bond portfolio, where all returns are realized and money on the table. taxed each year. Conclusion 3. The software at www.incomesolver.com models numerous preset withdrawal strategies and returns the The good news is that financial advisors William Reichenstein and William Meyer are strategies that maximize the longevity of the client’s co-authors of the book Social Security portfolio or maximizes the after-tax value of the port- can use financial software to help add sub- folio that remains for heirs after the client’s death. In stantial value to their clients’ accounts.3 Strategies: How to Optimize Retirement addition, advisors can test their own withdrawal strat- The bad news is that, due to the complexi- Benefits. Reichenstein, PhD, CFA®, is head of egies that may be variations from preset strategies. ties of the tax code and the need to inte- research for Social Security Solutions and grate these complexities into the analysis, holds the Pat and Thomas R. Powers Chair in References Investment Management at Baylor University. Cook, Kirsten, William Meyer, and William Reichenstein. we believe proper analysis requires special- 2015. Tax-Efficient Withdrawal Strategies. Financial ized and detailed software to try to find the He earned a BA in math from St. Edward’s Analysts Journal 71, no. 2 (March/April): 16–29. University, and a PhD degree in economics Meyer, William, and William Reichenstein. 2013. The best withdrawal strategy. That is, due to the Tax Torpedo: Coordinating Social Security with a complexities of the tax code and the com- from the University of Notre Dame. Contact Withdrawal Strategy to Minimize Taxes. Retirement him at [email protected]. Meyer is Management Journal 3, no. 1 (spring): 25–32. plex interrelated nature of withdrawal Reichenstein, William, and William Meyer. 2015. Social decisions, it is far too difficult to try to chief executive officer of Social Security Security Strategies: How to Optimize Retirement determine the best withdrawal strategy by Solutions and managing principal of Retiree Benefits, 2nd Edition. Retiree Income, Inc. yourself or with existing software packages Inc. He earned an MBA from the UCLA

that have only the standard rules of thumb Anderson School of Management. Contact To take the CE uiz online, visit www.IMCA.org/IWMuiz and conventional-wisdom sequences. him at [email protected]. Instead, we believe you will need to rely on

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