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.