Final-Spending Phase. This is the phase we all hope to avoid. However, it is occurring with greater frequency as medical advances continue to extend life expectancy, and thus, must be planned for. In this phase, medical and long-term care expenses can be extremely high. And given their tax deductibility, at least under current law, that can provide another period with a very low marginal tax rate—which can create new opportunities for tax-efficient strategies.
Legacy Phase. The legacy phase begins at your death, or, if married, upon the second-to-die. The goal in this phase is not only the tax-efficient transfer of your remaining wealth to heirs or charities, but also preparing your heirs for the assets they will inherit. Chapter 18 covers the estate planning process and Chapter 19 is about preparing your heirs to manage their inheritance and transferring your values.
As you move through the five stages, many strategies can be used to minimize the government’s share of your assets and maximize the growth of your portfolio—entire books have been written on the subject. Here we provide you with examples demonstrating the important role that good financial planning has in giving you the greatest odds of achieving your financial goals. We will begin with an analysis of the efficient tax strategy when faced with the choice of withdrawing from taxable, tax-deferred, and tax-exempt accounts.
Tax-Efficient Withdrawal
Investors who have taxable, tax-deferred and tax-exempt accounts can increase the longevity of their portfolio by withdrawing in the most efficient sequence. And there are also other strategies that can be used as well.
The “conventional wisdom” has been that investors should first take withdrawals from their taxable account, then from their tax-deferred accounts (such as a traditional IRA or 401(k) plan), and finally from their tax-exempt accounts (Roth IRA). With that said, our recommendations are always based on the academic literature. So, we turn to the study Tax-Efficient Withdrawal Strategies, published in the March/April 2015 issue of the Financial Analysts Journal. The authors, Kirsten A. Cook, William Meyer and William Reichenstein, studied this issue to determine if the conventional wisdom was correct. The following is a summary of their findings:
• In general, the conventional wisdom is correct. Withdrawing first from the taxable account (TA), then from the tax-deferred (TDA) and finally from the tax-exempt (TEA), instead of the reverse order, can add about three years to the portfolio’s longevity.
• A key to a tax-efficient withdrawal strategy is to withdraw funds from TDAs in order to minimize the average of the marginal tax rates on these withdrawals.
• Because withdrawals from taxable accounts are usually mostly, if not entirely, tax-free withdrawals of principal, withdrawing first from the TA often results in the retiree being in an unusually low tax bracket before required minimum distributions (RMDs) begin. Withdrawing funds from the TDA or converting funds from the TDA to the TEA during such years if these funds would be taxed at an unusually low rate increases the longevity of the portfolio in a progressive tax rate regime such as the one we live in. This strategy can add about one more year to the portfolio’s longevity.
The bottom line is that under our progressive tax structure, “the goal of minimizing the marginal tax rates on TDA withdrawals can be accomplished by withdrawing funds from the TDA each year so long as these withdrawals are taxed at a low marginal rate and then making additional withdrawals from the taxable account until it’s exhausted. Once the taxable account has been exhausted, the retiree should withdraw funds from the TDA each year so long as these funds are taxed at a low marginal rate and then make additional withdrawals from the TEA.”