The government gets “t” of each dollar withdrawn from the TDA or converted from a TDA to a Roth, where “t” is the marginal tax rate. The objective is to look for opportunities to withdraw funds from TDAs to minimize the average marginal tax rate. In our 2015 article, we describe three strategies that improve upon the conventional wisdom strategy for this retiree.
New Strategies
In one of the more optimal strategies, for the first 19 years this retiree withdraws $47,750 annually from the TDA to fill the top of the 15% tax bracket plus additional funds from the taxable account. The $47,750 is the sum of standard deduction for someone 65 or older of $7,600, personal exemption of $3,900, and taxable income at top of 15% tax bracket of $36,250. In years 20 and beyond, the retiree withdraws $47,750 from the TDA to fill the top of the 15% tax bracket plus additional funds from the Roth. This strategy offers 1.22 more years of portfolio longevity than the conventional strategy. That comes from a) shifting some TDA withdrawals from years nine through 24 (taxed at 25%) to years one through eight to fill up tax brackets of 15% and lower and b) shifting TDA withdrawals to years 26 and beyond to fill up the 0% through 15% brackets.
Two additional withdrawal strategies rely on converting funds from the TDA to a Roth. In one, the retiree converts $47,750 from the TDA to the Roth at the beginning of years one through six, and withdraws additional funds from taxable accounts to meet her spending needs.
After the taxable account has been exhausted, she withdraws $47,750 annually from the TDA and additional funds from the Roth to meet her spending needs. This allows the portfolio to last 35.51 years, which is 1.14 years longer than our prior strategy. After the year six distribution, this second strategy has $377,144 more in the Roth and $377,144 less in the taxable account than our previous strategy did. Because funds in a Roth grow tax-free, while funds in the taxable account grow at an after-tax rate of return, this new strategy allows the portfolio to last longer.
Our third strategy examines the impact of a Roth conversion with recharacterization on portfolio longevity. This strategy as modeled in the 2015 article has the retiree convert two separate $47,750 amounts from the TDA to Roths at the beginning of years one through 27.
In one Roth, she holds U.S. stocks. In the other, she holds one-year bonds. At the end of each year, the retiree keeps funds in the higher-valued Roth and recharacterizes funds in the lower-valued Roth. To understand why this recharacterization option is valuable, suppose the Roth containing $47,750 of stocks at the beginning of 2013 was worth $63,116 at year end as it would have been if the funds were invested in the Vanguard 500 Index Admiral shares. This third strategy allows the retiree to avoid ever paying taxes on the $15,366 appreciation. In contrast, if stocks lose value, then the funds are recharacterized and the retiree is in the same position with respect to this stock investment as if she never converted these funds to a Roth. Meanwhile, she keeps the modest return on one-year bonds that were converted to the Roth, and the $47,750 beginning-of-year conversion value fills the top of the 15% tax bracket. This strategy allows the portfolio to last 36.17 years, 0.66 years longer than the second strategy. In short, it adds more than three years of additional longevity compared to the conventional wisdom (which, we should point out, is already considered a tax-efficient withdrawal strategy).
Conclusion
The best way to view TDAs is that they are a partnership with the government. The government effectively own “t” of the current principal, where t denotes the marginal tax rate in the withdrawal year. A tax-efficient withdrawal strategy requires a retiree to time withdrawals of funds from TDAs and conversions of funds from TDAs to Roths such that she minimizes the average marginal tax rate. In contrast, someone following the conventional wisdom strategy will generally be in relatively low tax brackets in years when funds are being withdrawn from the taxable account, in relatively high tax brackets in years when funds are being withdrawn from TDAs, and in the 0% bracket when funds are being withdrawn from Roths. In this article, we presented three withdrawal strategies that improve upon the conventional wisdom. In the most efficient strategy, this retiree was able to extend the longevity of her portfolio by more than three years compared to the conventional wisdom.
In our next article, we will discuss the taxation of Social Security benefits, and how this should affect the way individuals withdraw funds from their financial portfolio to maximize their portfolio’s longevity.
William Reichenstein, Ph.d., CFA is professor of investment management at Baylor University and Principal at Incomesolver.com. William Meyer, is founder and managing principal of Incomesolver.com. Reichenstein will address some of the issues in this article at Financial Advisor’s Inside Retirement conference in Dallas on May 12.