[Editor's Note: This is the second in a two-part article on retirement withdrawal strategies. The first article can be found here.]

Last month, we outlined a retirement income framework that helps advisors add more value to clients’ accounts than they could receive from standard strategies pervasive in our industry.

We showed that, by recommending a dynamic withdrawal strategy addressing multiple stages of retirement, with a separate target for each phase, advisors could get more in after-tax wealth than they would from strategies recommended by leading financial planning software such as eMoney and MoneyGuidePro—garnering an additional $1 million-plus of after-tax wealth for a retired household with a $4.5 million portfolio.

This framework, which we call a dynamic withdrawal strategy using an optimal withdrawal level, is a new methodology for advising clients in or near retirement. Just as clients’ working lives take various twists and turns, so do their retirement years. A dynamic withdrawal strategy allows an advisor to address elements of retirement that all clients face as well as unexpected issues that may surface, where changing withdrawal levels will result in more income for clients in retirement.

By having a separate target for each phase of retirement, the strategy adds value because it exploits the rising and falling pattern of marginal tax rates in retirement that comes from the taxation of Social Security benefits and income-based Medicare premiums (known as income-related monthly adjustment amounts, or IRMAAs). For example, the strategy may recommend that retirees delay household Social Security benefits until they are age 70 and make Roth conversions in these early retirement years when the household’s marginal tax rates are the same as its tax bracket. The marginal tax rates paid on these Roth conversions may be 0% to 22%. Then, once Social Security begins, the household might make withdrawals from tax-deferred accounts, such as 401(k)s, up to the top of the 15% tax bracket, which is scheduled to return in 2026, and use tax-free Roth account withdrawals to meet the rest of its spending needs.

This strategy adds value because the early-year Roth conversions made at marginal tax rates of 0% to 22% allow the household to avoid additional withdrawals from tax-deferred accounts in 2026 and later, which would have been subject to marginal tax rates of 46.25% because of the taxation of Social Security benefits. In addition, the early-year Roth conversions may reduce the household’s lifetime IRMAAs. By contrast, the “conventional wisdom” withdrawal strategies recommended by eMoney and Money Guide Pro and the “proportional” withdrawal strategies recommended by Fidelity and Schwab ignore the rising and falling pattern of marginal tax rates. Thus, with rare exception, they fail to maximize the value of financial accounts in retiree households.

In this second article, we will summarize two cases that illustrate the substantial value that an advisor can add to clients’ accounts by recommending a dynamic withdrawal strategy. Furthermore, we show that adding an asset-location strategy can add significantly more value.

Comparing Approaches
Let’s start by examining the five withdrawal approaches we went over last month:

Conventional wisdom. In this strategy, we withdraw for spending one account at a time: taxable accounts first, then tax-deferred accounts and then tax-exempt accounts.

Proportional. In this strategy, each year we create ratios of the client’s taxable, tax-deferred, and tax-exempt accounts to the total value of all savings. Withdrawals are made each year based on these ratios.

Multiple accounts using average tax rates. Here we withdraw from both taxable accounts and tax-deferred accounts to cover spending, assuming an average tax rate every year. The system finds the best average tax rate and uses it each year to determine the right amounts to withdraw from all accounts.

Multiple accounts to tax bracket. Here we withdraw from tax-deferred accounts and then other accounts each year to cover spending, while hitting the top of a chosen tax bracket.

Optimal withdrawal level (OWL) approach. This is where we use a multi-phase withdrawal strategy, where each phase adopts a different withdrawal strategy and a different target threshold.

In addition, we present a rebalancing approach that uses an asset-location strategy, which can add significantly more value to clients’ accounts.

In the base scenario, we assume the household rebalances each account to the target asset allocation every year. We then calculate the extra value that is available by rebalancing at the household level using asset location. This asset-location strategy allocates stocks to taxable accounts and then to Roth accounts to the degree possible, while attaining the portfolio’s target asset allocation. Note: This strategy maintains the same pre-tax risk level.

Next, we calculate the total value of each strategy, where “total value” is the sum of lifetime spending, which requires after-tax dollars, plus the after-tax value of funds inherited by heirs, where the remaining tax-deferred account balances are reduced by 25% to reflect an estimate of their embedded tax liability.

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