How to Manage Taxes and Withdrawals in Retirement

Once you decide on the appropriate retirement spending range, the next question is how to implement a strategy to reach your goals.  Many retirees hold money in a variety of different accounts and deciding how to withdraw cash from these various account types can help increase the longevity of your assets, both by helping you to manage your tax liability and by not depleting tax-deferred or tax-free money too quickly.  Therefore, we would like to present three questions we use to help investors implement a tax liability management and withdrawal order strategy, which can help them maintain a comfortable level of spending while also being mindful of not running out of money.

Question 1: Are you 70 ½ and therefore subject to Required Minimum Distribution (RMD) rules?

If yes, then the first source of cash flow is your RMD, which will be taxed as ordinary income since contributions to accounts such as 401(k)’s was deposited pre-tax.  If no, or if you need additional cash flow above your RMD, please ask yourself the following question.

Question 2: Do you have taxable investment accounts (e.g., brokerage account or trust account)?

If yes, then you will want to use cash flow from the investments in your taxable accounts (e.g., dividends) first since this money will be taxed anyway.  If you still need more spending money, you should consider selling assets with low capital gains or even those with losses in order to take advantage of lower long-term capital gains rates and possibly to use losses to offset gains elsewhere.  If you do not have taxable investment accounts or need additional cash flow please ask yourself the following question.

Question 3: Do you anticipate your future tax rate to be higher or lower than your current tax rate?

If you expect your tax rate will increase throughout retirement (e.g., due to RMD’s increasing annual income), it is best to begin taking distributions from tax-deferred accounts such as IRA’s before you take distributions from any tax-free accounts such as Roth’s.  Alternately, if you anticipate your tax rate to decrease during retirement (e.g., no longer receiving part-time income) then it is best to reverse the order and take distributions from your tax-free accounts first followed by distributions from your tax deferred accounts when your tax rate declines. 

We believe that answering these three basic questions can help those in or approaching retirement to begin to create a more strategic plan for maintaining their standard of living while also extending the longevity of their assets.  The ultimate goal of our retirement spending implementation strategy is to delay depleting assets that can grow tax-deferred or tax-free while using assets that will be taxed, either through ongoing distributions or through sales, to help fund spending needs.  By doing this, we can target maximizing the total value of your assets while minimizing tax liabilities.      

We also understand that each client’s situation is unique and sometimes there are other considerations that take precedent, such as estate planning.  Further, we also remind clients that there are additional tax planning strategies to consider, including charitable contributions, management of RMD’s prior to age 70 ½ and Roth conversions.  Given all these variables, we believe it is important for investors approaching retirement or in retirement to specify what goals matter to them, decide on the appropriate retirement spending strategy and work with their team of advisors, accountants and attorneys to draft and continually revise a retirement plan that fits their life goals.

Turning Retirement Assets into Retirement Spending

We believe one of the most important questions a client approaching retirement age should be asking is how am I going to turn my accumulated assets into a sustainable cash flow that will support me throughout retirement?  Typically, retirement spending strategies fall into two divergent camps, those for retirees who want to maintain a stable level of spending and those for retirees who do not want to run out of money.  However, in our experience, most retirees want some combination of these two strategies, maintaining a comfortable lifestyle while not running out of money.

The trouble with budgeting based on a traditional retirement spending strategy is that each requires a non-optimal trade-off.  If you want to maintain your level of spending throughout retirement, you increase the chance you will run out of money.  However, if you worry too much about running out of money by, for example, withdrawing a certain percentage from your portfolio each year, your spending volatility will be tied to the movement and uncertainty of the market – not an ideal strategy in our opinion.  To help retirees keep their spending within a comfortable range while not depleting assets too quickly, we recommend using a range-bound spending strategy, which we outline with an example below.

At retirement, a couple has a $1 million portfolio and receives an annual Social Security benefit of $40,000.  Our couple would like to spend $80,000 per year in order to maintain their lifestyle, so they will use a 4% (or $40,000) annual withdrawal rate from their portfolio.  Before they begin their spending strategy, the couple needs to decide how much fluctuation above or below their targeted $40,000 withdrawal amount is comfortable for them.  By allowing for a range around their ideal spending target, the couple gives themselves an opportunity to limit the volatility in their year-to-year cash flow while also being aware of asset depletion that can be caused by market uncertainty.

Let’s assume that this couple is comfortable with a 3% range around their annual withdrawal target.  Therefore, this couple will accept annual withdrawals as low as $38,800 and as high as $41,200.  During the first year of retirement, the couple withdraws $40,000 from their portfolio and experiences a 2% loss due to a market downturn, leaving their portfolio value at the end of year one at $940,800[1].  Starting year 2 of retirement, the couple uses the $940,800 balance and 4% withdrawal rate to arrive at a withdrawal amount of $37,632.  However, this amount is lower than the couple’s desired floor of $38,800 so the couple increases their withdrawal amount for year 2 to $38,800.  Similarly, if the couple had experienced a portfolio increase in year one of 10%, their second year withdrawal would be calculated at $42,240 but given their limit of $41,200, the couple would lower their withdrawal to match this ceiling.  By using a predetermined range, the couple is able to limit the decrease to their annual spending if the market moves down but hold some money in reserve if the market increases.  This dynamic adjustment to annual withdrawals can help stabilize annual spending while increasing the longevity of the portfolio.     

While there is no right answer as to how to set the withdrawal range, we suggest that those who are more concerned about spending stability set a narrow range while those who are more concerned with running out of money set a range with a wider floor and lower ceiling (e.g., 4% lower limit and 2% upper limit).  It is also important to review your spending range every one-to-three years to make sure it is appropriate as your retirement progresses.  Moving forward, our final article in this series will focus on a corresponding strategy for increasing portfolio longevity, implementing a tax efficient withdrawal strategy.  

[1] In this example, we assume that the full withdrawal is made at the beginning of each year. 

Total Return Investment Approach

The traditional retirement strategy relied on building an income-based portfolio that uses a combination of dividends and interest to help meet the spending needs of a retiree.  This approach leads to a portfolio that is constructed based on the yield available in the market from various investment holdings (e.g., dividend-paying stocks and government bonds).  The trouble with using an income-based approach is that it ignores what we believe are more important factors when creating a personalized spending strategy: your goals, your time horizon and your risk tolerance.

In order to build a spending strategy that puts your needs and desires first, Stratus proposes that investors think about moving from an income-based strategy to a total-return strategy.  The total-return approach relies not only on income produced from the portfolio’s assets, but also on the capital appreciation of a retiree’s holdings.  Further, we believe that this more holistic strategy helps an investor to control risk through proper diversification, to create a goals-based withdrawal plan and to build a more tax efficient portfolio, all of which can potentially increase the longevity of their assets.

Diversification is the process of spreading your assets across a wide variety of investments so that each holding is not subject to the same risks.  The power of diversification is that by varying the allocation to more risky (e.g., stocks) and less risky (e.g., bonds) assets, we can adjust the risk tolerance to match that of the individual retiree.  Unlike an income-based approach, we can select investments based on their long-term risk and expected return characteristics as opposed to being limited to holding assets with higher yields, which typically causes a portfolio to be concentrated in fewer market sectors. 

By holding a greater number of securities, an investor has a greater chance to participate in upside from any individual asset.  This allows an investor pursuing a total return approach to have greater retirement spending flexibility.  For example, if an investor needs $80,000 to pay expenses in a year but the assets in their portfolio only produce $60,000 in income, how will the investor make up the shortfall?  A total-return investor would sell assets that had appreciated to create the necessary $20,000 while not adversely impacting the overall portfolio value whereas an income-based investor would not spend more than the portfolio earned, thus creating a scenario where the retiree may have to get by on a tight budget.

To help increase the chances that a portfolio can provide for a lifetime of goals-based spending, an investor should also consider the tax implications of their portfolio holdings.  As currently written, tax laws favor gains from long-term holdings and an investor looking to optimize their withdrawals would be wise to consider the impact of taxes on their spending strategy.  The total-return investor can use strategies such as rebalancing and asset location to help retain more money for their lifetime spending needs.     

Taken together, the process of reducing volatility through diversification, having more flexibility over year-to-year spending and paying less money in taxes can potentially increase the longevity of a retiree’s portfolio.  For these reasons, we encourage investors to consider talking with a financial professional about the benefits of a total-return strategy.  By focusing on cash flow, whether from capital gains or from income, as opposed to income-only, we believe the total return approach is a more effective way for our clients to live retirement on their own terms.  Moving forward, we will continue our discussion of retirement spending in our next newsletter, which will discuss how investors can build a more personalized spending strategy to help them meet their retirement goals.

Saving for Retirement versus Spending in Retirement

For the majority of investors, a big goal of our working lives is to save for retirement.  To help us out, there are numerous tax-deferred and tax-free investment products to suit the needs of different investors – from 401(k)’s to Cash Balance plans to Life Insurance and Annuities.  If we are lucky, our employer may even provide a matching contribution to our retirement account, which allows us to accelerate our rate of savings.  On top of our contributions, we also have the option to invest in a range of different products to help us grow our retirement savings. 

The savings strategies described in the previous paragraph should be fairly familiar to most people.  In fact, the majority of the financial information we receive involves how to save enough for retirement.  However, it is rare that we find specific information that focuses on how to spend our hard-earned savings once we are retired.  This can create a conundrum for investors from both a qualitative and quantitative perspective.  For example, how do I match my ongoing cash outflows (e.g., utilities, property taxes, mortgage, etc.) now that I don’t have a regular paycheck?  Further, what is the appropriate amount to withdraw each year so that I don’t end up over or under-spending?  Our goal over the next four newsletters is to provide you with a framework to help analyze and implement a personalized retirement spending strategy.

This month, we want to focus on a few of the psychological factors that affect retirement spending decisions.  This is an important topic because without understanding our preconceived biases, it can be difficult to come up with a strategy that best fits your needs.  The first mental bias that can affect our retirement spending is our mental definition of income.  When preparing to retire, the biggest concern for many investors is that they will not receive a regular paycheck.  It is completely understandable for someone who has spent 30-plus years receiving a biweekly cash inflow to be worried about navigating without this regular deposit.  However, this can lead to spending paralysis because we are fearful that we will deplete our asset base too quickly.  To counter this fear, many investors will look for products with a high yield or dividend.  In their minds, if they are producing income through interest and/or dividend payments, they are replicating the income they were so used to receiving during their working years[i]

A second, and complementary bias, is that many investors target a specific amount of savings they believe will be necessary to support their goals throughout retirement.  This target then becomes the anchor to which all future decisions are tied.  If the market has a bad year and the portfolio balance is lower than the target savings amount, how does the investor justify removing money from their portfolio?  In another scenario, what happens if the annual withdrawals needed to cover living expenses decrease the portfolio balance below the targeted savings level?

While these concerns are understandable, we believe that they lead to a portfolio that may actually create more risk due to the concentration of assets within a few, potentially more volatile, market sectors.  Over our next three newsletters, we will discuss how investors can pivot toward a total return investment approach that may better align their risk tolerance with their goals, how investors can build a more personalized spending strategy and finally, how investors can create a tax efficient withdrawal strategy to help maximize spending throughout their retirement.     

[i] In previous periods, when interest rates were much higher, using bond interest to create retirement “income” was part of a solid investment strategy.  However, given the low interest rates on most high quality bonds, it is much trickier to construct a safe bond income strategy in our current environment. 

How the Department of Labor's Fiduciary Rule Impacts You

While financial regulation is a topic that most of us are not thrilled to read about, the implications of the Department of Labor’s (DOL) Fiduciary Rule are important to understand because it could have a significant impact on the management and administration of retirement plan assets.  Since workplace retirement plan assets tend to be the largest investment holding of most Americans, we want to share our thoughts on the Fiduciary Rule so investors will be better informed when they have a discussion with their financial advisor or digest marketing material from financial services firms. 

Before we walk through the requirements of the new rule, we believe that it is important for investors to know that there is no uniform definition of a financial advisor.  We think this is important because different service providers are held to different standards of care and investors will need to perform some basic due diligence regarding the standard of care their financial professional is required to uphold. 

Currently, financial service professionals are held to two primary standards of care: a suitability standard and a fiduciary standard.  A suitability standard requires that the financial professional recommends products that are “suitable” given a client’s current situation.  While there are many solid professionals that work under a suitability standard, we believe that these service providers have inherent conflicts of interests because they are able to sell products that benefit both the client and the financial professional.  For example, many annuity, insurance and mutual fund selling arrangements are set up so that the financial professional who sells the product also receives an ongoing stream of revenue so long as the client holds the asset in their portfolio.

The second primary standard of care is the fiduciary standard.  Firms that operate under this standard, including Stratus, are required to put the interests of their clients’ ahead of their own personal interests.  While this may not sound drastically different from the suitability standard, firms and financial professionals held to a fiduciary standard typically charge transparent, asset-based or flat fees for their work and do not receive compensation for selling specific products.  In our opinion, this independence allows fiduciaries to select products solely based on the unique needs of their clients’ as opposed to having inherent conflicts of interest based on selling agreements with specific product providers.

We believe it is important to understand the difference between a suitability and a fiduciary standard because the DOL has proposed regulation that would require all financial professionals working with retirement accounts to be held to a fiduciary standard.  Stratus supports these new regulations because we believe that the interests of investors are more important than the interests of the financial services industry.  However, this regulation is by no means assured of being enacted.  Two weeks ago, President Trump asked the DOL to conduct a review of the fiduciary rule to reassess the costs and benefits to investors.  Further, multiple financial services associations and lobbyists filed a suit against the DOL to try and stop the pending regulation based on unreasonable costs to consumers[i].

At Stratus, we are left to wonder why any financial service professional or financial service firm would want to operate under a standard that was not in the best interest of their clients.  However, given the antipathy toward the new DOL regulation from the Trump administration, the financial trade associations and the large financial service firms, we encourage all investors to discuss with their financial professional which standard of care they are held to when making recommendations.

[i] A federal judge in Texas issued a ruling in early February that the DOL had conducted a reasonable analysis of the costs and benefits to consumers if the new regulation was enacted.  However, as of Monday, February 13, it appears that the DOL will be delaying the Fiduciary rule by 180 days to seek further public comment.