“Looking before you leap…” isn’t nearly as important as knowing how and where you will land. This rendition of Samuel Butler’s famous quote has no more fitting application than when considering retirement planning.
More than ever, people are retiring with wealth. But they often do so without having an effective plan that determines from which account they should withdraw first to best preserve their assets. Creating a personal distribution program is the best assurance of generating a tax-efficient cash flow. Not only can this extend portfolio longevity and minimize chances of running out of money prematurely, but studies show minimizing unnecessary tax erosion can effectively equate to adding up to 0.70 percent additional annual return without assuming more investment risk.
When creating a withdrawal plan with clients, we advise that five critical steps be followed:
- Estimate Normalized Retirement Expenses
Things often change as soon as the best laid plans are made; so is the case with estimating annual expenses. Knowing change is so much a part of our lives, we advise investors to first develop a “normalized” expense profile that considers those outlays expected year in and year out (see our white paper: What Are Your Retirement Expenses?).
- Estimate Extraordinary Expenses
Trips, home repairs, medical expenses, supporting kids and parents—unforeseen items can crop up to thwart even the best plans. Figures that estimate timing and amount should be added to the expense baseline to help better prepare for the eventual reality.
- Estimate Fixed Income
Obligatory inflows represent a cornerstone of our cash flow model. Common sources may include:
- Social security retirement benefits
- Traditional pension payouts (note if cost of living adjustments are provided)
- Required Minimum Distributions (RMDs) for investors over age 70 ½
- Payout annuities where accounts have been “annuitized” and may continue for a specified period or for one or more lives
- Employment such as consulting and part-time work
- Prioritize Discretionary Sources
Creating a system that prioritizes from which accounts cash can be drawn first will help optimize tax costs and is our best assurance of portfolio sustainability, e.g., not running out prematurely.
- Identify the “Gap”
The difference between obligatory in-and-out flows yields a “gap,” that is, the shortfall between expenses and income to be met from portfolio withdrawals.
In prioritizing withdrawals and from which accounts they might occur, investors find it helpful to first picture their portfolio as consisting of four distinct “buckets” capable of generating cash flow with varying tax implications as noted:
- Taxable: Accounts that incur taxes whenever earnings or transactions are realized. Examples include dividends, interest and capital gain, all of which are usually taxable whether reinvested or taken as distributions.
- Tax-Free: These accounts provide cash flow without incurring any income taxes (may be subject to state, local and alternative tax depending on issue). Examples include municipal bond interest (may be federal or federal and state exempt), life insurance cash value loans, and qualified withdrawals from Roth IRAs.
- Tax-Deferred: Typically consist of annuities that have discretionary withdrawal capabilities (as opposed to those that have been annuitized and would be included under “fixed income” above). Discretionary annuity withdrawals are typically taxed as earnings first until drawn down to principal, which can then be accessed without tax implications.
It is also important to note that since investment changes can often be made within deferred accounts without tax implications, deferred accounts can offer a tax-free environment within which investment rebalancing can more easily occur.
- Tax Qualified: Pre-tax investments such as IRAs, 401(k)s, profit sharing and pensions reside here because all distributions are typically fully taxable (except for rare accounts that may hold “after-tax” contributions). As such, withdrawals from these accounts are usually the least tax efficient of the four buckets. Similar to tax deferred accounts, investment rebalancing can occur with no tax cost.
Effective “withdrawal sequencing” helps us optimally prioritize distributions from both a tax as well as an investment standpoint, which again gives us our best chance of avoiding premature portfolio depletion. Depending on whether a higher or lower tax bracket is expected in upcoming years, tactics and priorities will vary. Specifically:
Higher Tax Bracket: In years where a higher marginal tax bracket is expected, spending corpus from the taxable bucket first can be an inexpensive tax strategy for enhancing cash flow. Although spending principal may push against conventional wisdom, doing so can actually enhance portfolio sustainability. Several factors account for this:
- Taxable dividends and interest are often reinvested but are taxable nonetheless, so diverting these can provide added cash flow without incurring additional taxes.
- Appreciation from investment sales can be taxed as long-term capital gains which are typically taxed at rates less than ordinary income, another inexpensive way to generate cash flow.
- Postponing withdrawals so deferred and qualified accounts can remain in those tax-friendly environments longer can effectively help replenish assets spent elsewhere.Particularly since growth within these accounts is not eroded by taxes and significant withdrawals, these offer an accelerated growth potential.
When done properly, a greater cash flow can be generated for the tax dollar expended.
Lower Tax Bracket: When we anticipate being in a lower marginal bracket, it is advisable to accelerate withdrawals from tax-deferred and qualified buckets. Although this too may seem counter-intuitive, it is often more advantageous to optimize taxes in the lower brackets than strive to pay the lowest dollar of taxes possible. Key reasons for this include:
- Higher brackets in future years may be due to changes in personal circumstances and/or bracket increases from the government’s deficit reduction efforts. Therefore, accelerating these taxable distributions beyond RMDs allows the current tax rate on these funds to be “locked in” now.
- Preserving tax-advantaged sources (assets taxable at lower rates) for future access is helpful when tax brackets may be greater so that lower taxable assets can accumulate and be withdrawn at a later, more opportune date.
- Accelerating qualified distributions can reduce future required withdrawals when tax brackets could be greater and potentially reduce future income taxes for heirs.
Of course, over time, increased taxes and reduced tax-advantaged growth can cause lower terminal wealth and jeopardize portfolio longevity. However, this strategy provides persuasive advantages particularly when tax brackets fluctuate between higher and lower in alternating years.
Optimizing Taxes by Prioritizing Retirement Withdrawals
Effectively managing RMDs can be a valuable component of a personal distribution plan. As legal requirements for those over age 70 ½, RMDs can represent a cornerstone of mid and late-retirement cash flow. Since they are ordinary income (except where post-tax distributions are involved), RMDs come at the highest tax cost compared to other distributions such as qualified dividends and capital gains. There are two important strategic approaches to consider:
- Qualified Charitable Donations (QCDs): This program, renewed annually and made retroactive to each January 1st, allows RMDs to be satisfied with amounts that are paid directly to charities with no tax implication (up to specified limits[iii]). Particularly for those investors who are philanthropically inclined, RMD requirements can be satisfied without incurring the usual ordinary income tax on distributions. What cash flow is lost from this effort can be augmented by taking tax-qualified dividends and capital gains. Overall the strategy can enhance tax efficiency and portfolio sustainability.
- Roth IRA Rollover: This allows taxable IRA distributions to be deposited into a Roth IRA for later tax-free withdrawal. It is particularly beneficial when a low tax bracket year is followed by a higher bracket year; this strategy can expand the tax-advantaged resources until times when they could be most needed (see Roth withdrawal limitations[iv]).
Especially since tax planning must go hand in hand with effective investment management, there are several practices that should be considered:
- Generating Excess Cash Balances beyond what may be immediately needed, as long as it is prudent from a tax standpoint, can help create a buffer for potentially greater living expenses in future years.
- Taxable Assets are generally the most advantageous to spend down before deferred, qualified and tax-free assets. These actions need to be carefully orchestrated with investment allocation and estate planning considerations as well.
- Overweighted and Concentrated Asset Holdings can be sold as priority especially from taxable accounts to better align the portfolio with long-term targeted allocations.
- Loss Harvesting can offer guidance for priority liquidations. Investors may be hesitant to sell assets at a loss as they hope for an eventual recovery. It is important they consider that such sales need not mean that the position will be abandoned entirely because it may be added back to the qualified account (so long as wash-sale rules are observed) to regain the exposure and desired portfolio balance.
- Postponing Deferred and Qualified distributions allows tax-deferred growth to continue longer, which can potentially enhance accumulation and portfolio longevity. The result can be greater terminal wealth and portfolio success rates.
- Determining Specific Assets to Liquidate by selling those that might generate the lowest taxable gain or realize a loss, then rebalance the portfolio within deferred and qualified accounts to ensure proper portfolio alignment with target allocation.
- Asset Cultivation when no overweight exists can be done by selling proportionally from all asset classes until the selected account is depleted or spending needs are covered. Once depleted, a similar approach can be used with other accounts.
- Large Tax Deductions, such as medical bills, when they occur, can provide an opportunity to offset additional tax-qualified withdrawals.
- Recommended Withdrawal Rates range from 3-6 percent. However, in low interest rate environments, a growing number of studies suggest that a 4 percent rate may be the only one that can “… avoid depleting the portfolio (prematurely).”[v]
These techniques potentially allow investors to spend and rebalance their portfolios with minimal tax costs. When done properly, studies show that portfolios can save tax erosion to such magnitudes that the benefit can in effect add up to 70 bps (70 percent) of additional annual return.[vi] The greatest benefit, it bears repeating, is realized when taxable and tax-advantaged balances are about the same size and the investor is in a high marginal tax bracket and/or fluctuates between high and low brackets.
Added Value from Different Withdrawal Strategies
Up to 70 bps of value added from optimizing withdrawal strategies without adding investment risk.
These hypothetical data do not represent returns on any particular investment. Each internal rate of return (IRR) is calculated by running the same 10,000 VCMM simulations through three separate models, each designed to replicate the stated withdrawal order strategy listed. Greatest benefits occur when the taxable and tax-advantaged accounts are roughly equal in size and the investor is in a high marginal tax bracket. If an investor has all of his or her assets in one account type (that is, all taxable or all tax-advantaged), or an investor is not currently spending from the portfolio, the value of withdrawal order is 70 bps. The greatest benefits occur when the taxable and tax-advantaged accounts are roughly equal in size and the investor is in a high marginal tax bracket. Source: “Quantifying Vanguard Advisor’s Alpha” by Vanguard research.
You should compare your current and prospective account features, including fees and charges, before making a rollover decision. Distributions that are not properly rolled over to another retirement plan or account may be subject to withholding, income taxes, and if made prior to age 59½, may be subject to a 10 percent penalty tax. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. You should discuss any tax or legal matters with the appropriate professional.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Wells Fargo Financial Network LLC (WFAFN) does not provide tax or legal advice. We strongly recommend an advanced tax and estate planning expert be contacted for further information. Any opinions are those of Mitchell Kauffman and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Wells Fargo Financial Network does not guarantee that the foregoing material is accurate or complete. Prior to making a financial decision, please consult with your financial advisor about your individual situation.
Mitchell Kauffman provides wealth management services to corporate executives, business owners, professionals, independent women, and the affluent. He is one of only five financial advisors from across the U.S. named to Research magazine’s prestigious Advisor Hall of Fame in 2010, and among a select list of 100 over the past 20 years.
Inductees into the Advisor Hall of Fame have passed a rigorous screening, served a minimum of 15 years in the industry, acquired substantial assets under management, demonstrate superior client service, and have earned recognition from their peers and the broader community.
Kauffman’s articles have appeared in national publications, and he is often quoted in the media. He is an Instructor of Financial Planning and Investment Management at the University of California at Santa Barbara and Santa Barbara City College.
For more information, visit www.KauffmanWealthManagment.com or call (866) 467-8981. Kauffman Wealth Management and serves clients from two office locations: 140 South Lake Avenue, Suite 307, Pasadena, CA 91101 and 550 Periwinkle Lane, Santa Barbara, CA 93108 (by appointment only). Investment products and services are offered through Wells Fargo Advisors Financial Network LLC (WFAFN), Member SIPC. Kauffman Wealth Management is a separate entity from WFAFN.
 “Putting A Value On Your Value: Quantifying Vanguard Advisor’s Alpha,” by Francis M. Kinniry Jr., CFA, Colleen M. Jaconetti, CPA, CFP, Michael A. DiJoseph, CFA and Yan Zilbering, Vanguard Research 2014 Pg. 20-21
 “How Annuities Are Taxed,” by Kimberly Lankford, Kiplinger July 10, 2009
 “Charitable Donations from IRA’s,” IRS http://www.irs.gov/Retirement-Plans/Charitable-Donations-from-IRAs
 “IRA FAQs-Rollovers and Roth Conversions,” IRS http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-IRAs-Rollovers-and-Roth-Conversions
 “Why 4% May Be A Sustainable Withdrawal Rate,” by Gregg S. Fisher, FA Advisor Feb. 14, 2014 http://www.fa-mag.com/news/why-4–may-be-a-sustainable-withdrawal-rate-16337.html
 “Spending from a Portfolio: Implications for Withdrawal Order for Taxable Investors,” by Colleen M. Jaconetti, CPA, CFP and Maria A. Bruno, CFP Vanguard Investment Counseling and Research 2008