A Successful And Secure Retirement—Spend-Down Strategies: Part 1

Ed Note: This is part one of a two-part series and is an excerpt from Your Complete Guide To A Successful And Secure Retirement.

If we live long enough, our financial assets can go through five phases: accumulation, what we at Buckingham Strategic Wealth call “black-out,” spend down, final spending and legacy. The knowledge required to effectively manage financial assets in the accumulation phase is not sufficient to carry clients through the remaining stages. What follows is the knowledge needed to give your clients the greatest chance of achieving life and financial goals as they pass through the various other stages.

Accumulation Phase

The accumulation phase commences when we begin our careers and start to save and invest. For those who forgo college, the accumulation phase will begin in our late teens. For others, such as doctors and lawyers, it might not begin until our late twenties. This phase is the longest one as it typically continues until we stop working full-time. The goal during this phase is to save and invest as early and as much as possible. Chapters 3 through 10 have provided you with the information needed to develop the right strategy. The strategy should include a focus on which tax-advantaged accounts should be used (traditional versus Roth IRA). Chapter 10 provides a detailed discussion on this issue. The strategies learned in this chapter continue to apply throughout your lifetime.

Each of the following phases are part of the decumulation, or withdrawal, phase. The biggest difference in strategies during withdrawal and strategies during accumulation is that there is a much greater emphasis on long-term tax planning during withdrawal. Taxes are often the single largest expense for investors. Thus, to ensure that you have the greatest chance to meet your own goals, we strive to have the IRS take the smallest share of your financial assets. However, this does not necessarily mean paying the least amount of taxes in any particular year. Instead, the focus is on paying the least over your lifetime and possibly beyond.

During accumulation, taxes are dominated by your salary and/or other sources of income. The tax strategies during this phase relate mostly to how much you can save before tax, how much after tax and where you locate the different types of assets. However, planning during spend down presents different opportunities as you go through phases of low and high tax rates. Therefore, we break decumulation into four distinct phases.

Decumulation Phase

Black-Out Phase. The first phase during withdrawal, which doesn’t exist for everyone, is one with low tax rates. It typically begins with your retirement, when you are no longer generating sufficient income to meet your lifestyle needs, but have not yet chosen to receive Social Security or pension benefits. Thus, you may be in a low tax bracket and can draw on your taxable assets (at relatively low tax rates), or tax- free assets, to provide the desired lifestyle.

We call this phase black-out since the structured sources of income (salary, Social Security, required minimum distributions) are absent, or blacked out. During this phase, many retirees celebrate their low taxes after years of paying large amounts with their salaries. However, as we discuss later, this might not be the best strategy.

Spend-Down Phase. The spend-down phase, so called because this is when you start spending down your tax deferred retirement plan accounts, typically begins in the year you turn 70½ and start taking your required minimum distribution (RMD). It is a period when tax rates can jump back up from the low rates of the black-out period as you start receiving income from RMDs as well as Social Security and possibly pension benefits. An individual’s tax rate will often remain at this same high rate for the rest of his or her life. Although, increasingly, people move into one final phase during their lives.

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.”

The authors also note that a retiree may be in an unusually low tax bracket due to large tax-deductible expenses, such as medical costs. They make the following recommendation: “In those years, the retiree will likely be in a low, if not zero, tax bracket. Although forecasting this circumstance presents a financial-planning problem (because no one knows for certain whether they will have such high expense years), it is nevertheless desirable to try to save some TDA balances for this nontrivial possibility.”

The authors also offer a Roth-conversion strategy that can extend longevity. Each year the retiree does a Roth conversion from the TDA to the TEA in an amount that pushes their taxable income to the top of the (then) marginal tax rate of 15 percent (12 percent under the 2018 tax act). At this rate, dividends and long-term capital gains are taxed at 0 percent. The authors estimate that this strategy increases the portfolio’s longevity by about one year.

Finally, the authors demonstrate that the impact on portfolio longevity is greater when returns are higher, when volatility is higher, and when the returns sequences are more favorable (higher returns in the early years).

Summarizing, the authors demonstrate that the most tax-efficient withdrawal strategy can add as much as six years relative to the most inefficient one—quite an improvement considering that there are virtually no costs to implementing the most tax-efficient approach.

The following examples show how to put these concepts into practice. You will note that, in general, they tend to increase income during periods of low taxes—the black-out and final spending phases—while lowering income during the spend-down phase when tax rates tend to be higher.

1. Proper Asset Location Saves Income Taxes Now And In The Future

Bill and Sally started saving right out of college, at age 25, by fully funding their 401(k)s and IRAs, and investing in taxable accounts for additional savings. Bill also inherited $300,000 of equities from his grandfather. They decided on an overall investment plan of 60 percent in equities and 40 percent in fixed income. Understanding the asset location issues discussed in Chapter 10, they placed all of their fixed income investments in their 401(k)s and IRAs, and their equities in the taxable accounts to the extent possible. The equities in the taxable accounts produced mostly capital gain income each year. In addition, they were able to harvest capital losses, to offset capital gains, in years when the stock markets declined.

• After 40 years of fully funding their traditional 401k(s) and IRAs, at age 70½, they had accumulated sizable amounts in the tax-deferred accounts. However, by keeping a large proportion of these accounts in fixed income, the growth of their total portfolio was shifted to the taxable accounts and their RMDs were reduced accordingly. This helped reduce their overall taxable income during the spend-down phase when they were also receiving Social Security.

• When Bill died at age 75, Sally received a step-up in basis on Bill’s taxable account assets, to the value at that time. And when Sally died at age 85, their children received another step-up in basis for all the taxable account investments they inherited. The step-up in basis eliminated the capital gains tax that would have been due on these taxable investments.

• The children also inherited the IRA accounts, and they will pay income tax as they take distributions over their lifetimes. However, the utilization of efficient asset location, tax strategies such as loss harvesting and step-up in basis, managing RMDs and optimal Social Security claiming strategies all contributed to a significant increase in their heir’s inheritance.

2. Minimizing Today’s Tax Bill Isn’t Always The Best Strategy

Steve and Jennifer had high taxable income during their working years. A year ago at age 65, they both retired as they became eligible for Medicare. Jennifer is now receiving Social Security spousal benefits based on Steve’s record. Once Steve is 70, he will claim his maximum Social Security benefit. They have sufficient assets for lifestyle needs, with substantial assets in both tax-deferred IRA accounts and taxable accounts. They also have small Roth IRA accounts.

Their cash flow for spending is coming from Jennifer’s Social Security benefits and funds from the taxable accounts. They bragged about not paying any income tax the first year after retirement. They did not understand they were wasting the low tax brackets and their tax deductions. By deferring taking taxable income now, they were building a tax-trap for later. Indeed, starting at age 70½, they will be required to take greater minimum distributions (RMDs) from tax-deferred accounts, such as traditional IRAs, and pay higher taxes than they would now. Each year, the amount they must withdraw, and report as taxable income, will be based on the value of their account at the beginning of the calendar year and the distribution period per the IRS Distribution Table.

Working with an advisor, they were able to see the tax advantage of converting $1 million of their IRAs to Roth IRAs over the next five years. This causes $200,000 of taxable income each year, using up the lower tax brackets and enabling them to utilize their deductions. This strategy also has the important benefit of reducing the traditional IRA account value. This provides the important benefit of reducing future RMDs at a time when Steve must begin taking his Social Security benefits. With the graduated tax brackets, less income will be taxed at the higher tax brackets in all future years.

Another benefit is that their money will remain in a tax-advantaged account, but all future growth of the Roth IRA accounts will be tax-free as they plan to leave the Roth conversion accounts untouched for many years. On the other hand, allowing the traditional IRA accounts to continue to grow creates higher taxable income in future years. (Note that because Steve and Jennifer are over age 59½, the five-year rule for penalty-free distributions of converted funds won’t apply. But, the five-year rule for tax-free distribution of earnings should be considered.)

By bringing taxable income into the years of the black-out phase, and using up lower tax brackets, Steve and Jennifer have reduced the total amount of taxes they will pay over their lifetimes. The old adage of never paying taxes now that you can defer until later can lead to paying more in taxes over your lifetime.

Our next example is similar in that it also takes advantage of a Roth conversion. However, it has a few other nuances, including: doing a small Roth conversion to start an important clock ticking; doing an IRA withdrawal at year end for tax withholding purposes; and using some of the withdrawals for spending purposes.

3. Roth Conversions To Fill Up Lower Tax Brackets

Jim and Rhonda retired last year with pension income that provides for approximately half of their spending needs. The majority of their retirement funds are in tax-deferred accounts. They will be in the highest tax bracket once they are taking RMDs after age 70½. They are waiting until age 70 to claim Social Security to obtain the largest benefit. At that time, their taxable income will include their pensions, Social Security, and the RMDs.

By letting their investments continue to grow inside the traditional IRAs, their future RMDs also increase. Projections were done to estimate how much they should withdraw from their IRAs annually until they are 70½ to reduce the tax bracket in future years and the total tax over their lifetime. Since they need cash now to support their lifestyle, part of the IRA withdrawal was kept for spending and part was converted to a Roth IRA.

The Roth IRAs will grow tax free if they do not take any distributions for five years from the first conversion. To start the five years running, they did a small $1000 Roth conversion last year while they were still working.

To make their lives simpler, a second IRA withdrawal is being done at the end of the year—with federal and state income taxes being withheld from the IRA distributions for the total estimated tax they will owe each year. This allows them to not worry about making quarterly estimated tax payments.

4. Donate Appreciated Securities, Not Cash

Many people are in their highest tax brackets in the last five years of the accumulation phase. This may occur due to high earnings years or from selling a business. This is a great time to set up and fund a Donor Advised Fund (DAF), for which you receive the charitable deduction upon setup. Community foundations were the first organizations to offer DAFs. Today, financial institutions, such as Schwab, Fidelity and Vanguard, as well as charities, offer DAFs. DAFs vary mostly in terms of their minimum contribution, minimum grant, investment options and fees. Service is also a consideration. For example, a community foundation offers a hands-on connection to local needs and initiatives.

The DAF can be used to fulfill your charitable intentions after the accumulation phase. A DAF can also be used to get children involved each year in the charitable decision-making process, teaching them your family’s values and giving them a reason to get together on a regular basis.

Randy and Katie plan to give $50,000, over a five-year timeframe, to a non-profit for which Katie serves on the board of directors. They have highly appreciated securities in a living trust and were planning on selling investments to raise cash for the contribution. In lieu of donating cash, it was recommended they donate the appreciated securities approximating $50,000 into a DAF. Their tax situation, and this strategy, will allow them to fully deduct the contribution over the next couple years and avoids having to report capital gains on their tax return this year. The DAF will immediately sell the securities they received, reinvest the proceeds appropriately, and at Randy and Katie’s direction each year, forward the cash to the non-profit.

5. Donating Traditional IRA Assets To Charity After 70½

Dan and Kathy are married and both are age 73. They expect to have income of $285,000 from Social Security, required distributions from their IRAs, and more than $50,000 of taxable interest, dividends, and capital gains. Over the last few years, since they started taking their required minimum distributions (RMDs) from their IRA accounts, Dan and Kathy have exceeded the $250,000 threshold for the net investment income tax. Thus, they have had to pay an extra 3.8 percent tax on some of their investment income.

In reviewing the 2018 tax brackets they noted that their marginal tax bracket will go down from 33 percent to 24 percent. However, their only deductions for itemizing would now be $10,000 for state and local taxes, plus about $5,000 that they give annually to charity, for a total of $15,000 of itemized deductions. This amount is less than the new standard deduction. As a result they would no longer itemize. With advice from their advisor, Dan and Kathy decide to use what are called Qualified Charitable Distributions (QCDs) to gift to their charities directly from their IRA accounts. While the charitable donations count towards Dan and Kathy’s RMDs, they are not reported as income on their tax return.

From a tax perspective, this has two benefits. First, not reporting the donations as income has virtually the same benefit as they used to get by reporting the income and then deducting the amount as an itemized deduction. Now they can still claim the standard deduction, allowing them to get the tax benefit for their charitable contributions on top of the standard deduction. The second benefit is that since the $5,000 of QCDs count towards their RMDs, but are not reported as income, $5,000 of their investment income now falls below the Net Investment Income Tax threshold. This saves Dan and Kathy an extra 3.8 percent in tax on that $5,000. Thus, by making $5,000 of QCDs, Dan and Kathy save 27.8 percent in taxes, or $1,390.

Dan, knowing a good thing when he sees it, mentioned QCDs to his brother, Rick, who could also make charitable contributions from his IRA and still get the benefit of the standard deduction. Rick has lower income than Dan and he pays 12 percent on his marginal ordinary income. However, as it turns out, Rick’s investment income from dividends and long-term capital gains straddles the threshold between the 12 percent and 22 percent brackets. Above the threshold, the tax on this income is 15 percent, but below, it is not taxed.

Interestingly, Rick, even at his lower tax bracket, gets almost the same benefit from QCDs as his higher earning brother, Dan. Rick’s QCDs also give him two tax benefits: first, he saves the tax on the donation amount at a 12 percent rate for ordinary income, and second, because this IRA withdrawal does not show up on his tax return, a portion of his investment income in an amount equal to the donation falls from being taxed at 15 percent to 0 percent. Total tax rate savings on the QCD amount is 27 percent, or $1,350 on a $5,000 QCD.

In summary, QCDs are a strategy that everyone who is eligible should consider, no matter what your tax bracket. In most cases, they will reduce ordinary income just as itemized charitable contributions did before the tax law changed in 2018. In some cases, they can give even greater benefits by lowering tax brackets.

Larry E. Swedroe is director of research for Buckingham Strategic Wealth and The BAM Alliance. Kevin Grogan is director of investment strategy for Buckingham Strategic Wealth and The BAM Alliance.