One of the ways a qualified financial advisor can add value for their clients is by ensuring that, after the accumulation phase of the investor lifecycle has concluded, withdrawals are made in the most tax-efficient manner. Investors who have taxable, tax-deferred and tax-exempt accounts can increase the longevity of their portfolio by withdrawing funds in the most efficient sequence. And there may be other appropriate tax strategies for an advisor to apply as well.
The “conventional wisdom” has been that investors are best served by first taking withdrawals from taxable accounts, then from tax-deferred accounts (such as a traditional IRA or 401(k) plan), and finally from tax-exempt accounts (such as a Roth IRA). Kirsten Cook, William Meyer and William Reichenstein — authors of the study Tax-Efficient Withdrawal Strategies, which appeared in the March/April issue of Financial Analysts Journal — studied this assumption to determine if the conventional wisdom was correct. What they discovered may be of particular interest to investors nearing retirement. The following is a summary of their findings:
- The conventional wisdom, in general, is correct. Withdrawing first from the taxable account (TA), then from the tax-deferred account (TDA), and finally from the tax-exempt account (TEA), instead of the reverse order, can add approximately three years to the portfolio’s longevity.
- Under a flat tax structure, withdrawals should be made from the taxable account (TA) until it has been exhausted. However, the order of withdrawals from a tax-deferred account (TDA) and a tax-exempt account (TEA) would be irrelevant.
- A key element of a tax-efficient withdrawal strategy is to withdraw funds from TDAs in such a way that the investor minimizes 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 a retiree ending up 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 years when 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 another year to a portfolio’s longevity.
The takeaway from these findings 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. Their recommendation is: “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 completes a Roth conversion from the TDA to the TEA in an amount that pushes the marginal tax rate to 15 percent. They estimate that this strategy increases the portfolio’s longevity by about one year.
However, for even greater tax efficiency, the authors suggest a strategy that calls for creating two Roth-conversion accounts of equal amounts. At the end of the year, the retiree re-characterizes the account with the lower valuation. Taxes are due only on the one conversion that wasn’t re-characterized.
Based on their return assumptions, the authors estimated that this would extend the longevity of the portfolio about two-thirds of a year. Given a sufficient level of funds, even more than two conversion accounts could be set up. All the accounts except for the one with the highest valuation could be re-characterized at the end of the year.
Finally, the authors demonstrate that the impact a tax-efficient approach can have 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).
In summary, the authors show that the most tax-efficient withdrawal strategy can add as much as six years to portfolio longevity, as least relative to the most inefficient strategy. That’s quite an improvement, considering that there are virtually no costs to implementing the most tax-efficient approach