Tax Strategies: Tax-Efficient Retirement Withdrawals
One of the greatest challenges investors face in retirement is finding the most tax-advantaged withdrawal method to meet planned and unplanned expenditures. After no and low capital gain assets have been consumed, what assets should be withdrawn next? Conventional wisdom suggests selling taxable long-term capital gain assets first, followed by tax-deferred retirement plan assets and finally, Roth IRA assets. The idea behind this is that selling capital gain assets results in less taxes than using traditional retirement account assets. Roth IRA assets are used last so that they compound their returns tax-free for as long as possible.
However, there are instances in which this conventional wisdom is wrong. Optimal tax-efficient withdrawal strategies are affected by current and future capital gain and ordinary income tax brackets, estate tax rules, longevity, and even the desire to leave an estate behind for the next generation. State income tax rates should also be considered. However, for simplicity, the following discussion considers only federal tax rates and brackets. In most cases, adding state taxes does not change the conclusions.
WESCAP Group has developed analytic tools that assist in developing tax efficient withdrawal strategies. Some examples and methodologies are discussed below.
Maximize Low-Tax-Bracket Ordinary Income
For individuals with relatively low ordinary income, it could be prudent to take advantage of the low tax bracket by strategically withdrawing from the tax-deferred retirement plan accounts. For example, if you are in the 12% federal tax bracket and $15,000 away from the next higher tax bracket, it might be best to withdraw $15,000 from your retirement accounts at this low tax rate.
At age 70.5, retirement plan Required Minimum Distributions (RMDs) may push you into a higher tax bracket. Taking out retirement plan money pre-RMD at a lower tax bracket thus can reduce aggregate cumulative taxes.
For a useful look at the “bracket filling” strategy, see below:
Take Advantage of Zero-Federal-Tax Capital Gain Tax Bracket
Similar to the above example, individuals with low ordinary income may be able to take capital gains on their taxable assets without owing any tax whatsoever. For those in the 10% or 12% ordinary income tax brackets ($39,475 for single filers and $78,950 for those married filing jointly), long-term capital gains are not taxed. As a result, you may find that selling capital gain assets in moderation results in no federal tax, thus making it a superior way to fund current and pending expenditures.
Long-Term Federal Capital Gain of 15% Tax versus use of Roth IRA and other Retirement Plan assets
After the zero-tax capital gain tax rate comes the 15% maximum federal long-term capital gains tax rate (up to $434,550 for single filers and $488,850 for those married filing jointly). It often makes sense to sell these capital gain assets rather than use tax-deferred retirement account assets that may have tax rates of 35% or more.
However, one needs to consider that most capital gains are “forgiven” at death via the cost basis step-up feature built into the estate tax code. This can change the optimal withdrawal strategy dramatically.
For example, with an older husband and younger wife, the best strategy might be to use retirement account and Roth IRA account assets before selling and using capital gain assets. If a $200,000 asset has a $150,000 capital gain associated with it, it might be best to wait a few years and have the capital gain eliminated with the estate cost-basis step-up provision. Therefore, before the step-up event, using the Roth IRA and possibly the regular retirement accounts (if not pushed into a yet higher tax bracket) might be best.
Hence, longevity estimates are often needed to determine the best strategy. Of course, actual longevity will only be known after the fact. Let’s say that WESCAP’s analysis shows that one spouse could to live to age 75 and the best strategy in this case is to use the capital gain assets first as that will save $50,000 in long-term costs for the surviving spouse. However, let’s also assume that there is an equal chance of the first spouse living to age 85 and in this case using the capital gain assets first will cost $100,000 relative to using the Roth IRA first. The various outcomes of this example are shown below, along with a 50-50 Roth/capital gain choice and a 2/3-1/3 Roth/capital gain choice.
| Relative Benefit or cost to use first | |||||
| Roth IRA | Cap’l gain | 50-50 mix | 2/3 Roth | ||
| 50% chance to live | |||||
| to age 75 | -50000 | 50000 | 0 | -16667 | |
| to age 85 | 100000 | -100000 | 0 | 33333 | |
| Expected value | 25000 | -25000 | 0 | 8333 | |
| Max cost if wrong | -50000 | -100000 | 0 | -16667 | |
| Exp value/max cost | 50% | -25% | 0% | 50% |
The highest expected value choice is to use the Roth IRA first due to its
larger age 85 benefit. The average
expected advantage of this choice is $25,000 (50% x $100000 + 50% x -$50000). Therefore, in this example, if maximizing the
potential outcome is desired, then using the Roth IRA is the best choice.
However, we can also look at minimizing the cost of making the wrong choice (minimizing the maximum cost or “mini-max” solution). If we stick with using the Roth IRA first to fund expenditures, the cost is $50,000 if the life expectancy ends up being 75 and not 85. To minimize the cost of being wrong, using the Roth IRA for 50% of needed withdrawals and selling capital gain assets for the other 50% minimizes the cost of selecting the wrong strategy.
Lastly, since the Roth IRA strategy maximum benefit is twice that of the capital gain asset strategy, we can employ a 2/3 Roth and 1/3 capital gain assets strategy. It still has a positive $8,333 expected value and a maximum cost of being wrong of $16,667. This puts the expected value to maximum cost ratio at 50%, which is the same as the 100% Roth only strategy, but with much less maximum cost if wrong. As a result, someone could validly choose this hybrid approach as the most appealing compromise.
Borrow Money
In addition to the approaches discussed already, another choice is to borrow funds to meet future expenditures. Borrowing money does not trigger ordinary income or capital gains and does not reduce the tax-free compounding of returns advantage of Roth IRAs. The loan interest rate is a critical factor, but so long as the interest rate is lower than the long-term portfolio return, this can be the best alternative. Borrowing methods can include: Home equity line of credit (HELOC), mortgage refinance, 401k borrowing ($50,000 max.), and margin loan for taxable portfolio accounts.
Conclusion
There is no completely right or wrong choice as to how to best fund expenditures when dealing with the uncertainties of life expectancies, rates of returns and tax rates, and all of the foregoing calculations are based on our understanding of current tax rates and laws. Nevertheless, detailed analysis, projections and comparisons can reveal the benefits and costs of different cash flow funding choices. These can add clarity and assist in making good choices that not only enhance long-term finances, but can also enhance one’s long-term sense of security and well-being.
Please contact WESCAP Group for a more in-depth review of your own retirement withdrawal strategy.