Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success (The Retirement Researcher Guide Series)

by Wade Pfau

To be precise, a 1.3 percent fixed real return is all that is needed to make the 4 percent rule work for 30 years. The further amplifying effects of sequence risk on investment volatility made it seem like the compounded return was only 1.3 percent for retirees that year, instead of the actual 4.2 percent. Sequence risk amplified investment volatility, because the 30-year retirement could not rely on the average market return earned over the 30 years. The early part of the 1966

Intermediate-term government bonds do provide the sweet spot in terms of risk/return tradeoffs to support the highest worst-case withdrawal rates.

Higher-yielding dividend stocks have historically provided about the same total return as lower dividend stocks before considering taxes.

First, switching to higher-yielding, longer-term bonds leaves investors more exposed to capital losses if interest rates increase. Long-term bond prices are more volatile. With current low yields, a small increase in interest rates will result in capital losses that cancel out any higher interest

investing for income is not necessarily superior to the total portfolio returns approach that backs the 4 percent rule.

Thus, an important mechanism for managing sequence risk is to allow spending to fluctuate over time. Reducing spending in the event of a market decline provides a release valve for sequence-of-return risk that can allow the initial withdrawal rate to increase.

Help? There are four general ways to manage sequence of returns and

By not claiming until 70, the eight-year loss of Social Security benefits sums to $168,000, which would also be its present value with a 0 percent real interest rate. We could view that $168,000 as the approximate premium to buy a deferred income annuity with inflation-adjusted annual income of $16,200 beginning at age 70. The implied payout rate on the “annuity” provided by delaying Social Security is 9.64 percent.

Social Security delay provides a higher payout rate and stronger inflation protection than commercially available annuities. Delaying Social Security should be the first step for anyone considering annuities as part of their retirement income plan. Commercial annuities do not beat the implied payout

on delaying Social Security.

Because supplements should be treated more as a lifetime commitment, you may wish to work with an independent broker to review your options and save time.

Even though health expenses can be expected to rise, perhaps at around 5 to 7 percent annually, those increases may be more than offset by declines in other categories, relative to an overall assumption that all expense categories in retirement stay fixed in inflation-adjusted terms. Constant inflation-adjusted spending is a simplifying and conservative assumption that can more than handle the issue of health expense growth in retirement. In other words, you have taken care of this aspect of health spending risk already if you use a simplified assumption that your overall retirement budget will grow with consumer price inflation. If your budget does incorporate reduced spending in other categories with

Understand that using only Medicare Parts A, B, and D can lead to significant exposure to uncapped medical expenses if you experience costly health events.

In taxable accounts, the basic idea for annuities is that distributions representing return of premium are not taxed, but distributions representing any interest or gains through market growth or mortality credits are taxed. Taxation occurs at the point of distribution rather than when interest is earned, which allows for continued tax deferral for the underlying annuity assets until distributions are made.

An ideal financial plan for these advocates would involve having just enough saved in qualified retirement plans such as a 401(k) that required minimum distributions do not push these taxable income amounts above the level of standard deductions, then perhaps have some funds in taxable investment accounts from which taxable long-term gains can be drawn without pushing the tax rate out of the 12 percent level (which keeps the tax rate on long-term capital gains at zero), and then taking other income as distributions from Roth accounts or policy loans from life insurance. One could potentially fund a quite sizable amount of spending power in retirement without having to pay any federal income taxes.

an individual owns multiple IRAs, this person may determine the RMD for the combined account balances and then take the distribution from only one of the accounts if desired.

About aggregating IRAs, this means only traditional IRAs, not inherited IRAs or Roth IRAs. Also,

QCDs allow for up to $100,000 from the IRA to be distributed directly to a charity without any tax consequences. QCDs are even allowed for amounts that would otherwise need to be distributed as RMDs. The SECURE Act now allows for contributions to IRAs for those still working past age 70.5, and the QCD annual limit is reduced by the accumulated contributions made to traditional IRAs after 70.5.

The benefits for this strategy are significant – even though there is no tax deduction, the amount of the donation does not count as income but does count as that year’s RMD. For non-QCD donations, even if the donation could be itemized, it shows up in the adjusted gross income because it is a below-the-line deduction. This means that it could create vulnerability to the auxiliary taxation issues related to AGI and MAGI (more on these later in the chapter) that are determined before deductions are considered. For those who are not otherwise itemizing, a non-QCD donation would not allow for a tax deduction anyway.

For indirect rollovers from qualified plans, there is a mandatory 20 percent withholding, though this withholding does not apply to indirect rollovers from IRAs. Generally, except for those seeking specific short-term access to the funds, direct rollovers are encouraged to avoid any issues with not completing an indirect rollover within 60 days and making the distribution fully taxable and potentially subject to early withdrawal penalties.

basic guideline around withdrawal order sequencing is to first consider any income you receive from Social Security, pensions, and so forth, as well as any required minimum distributions you must take from qualified retirement plans and other tax-advantaged accounts. Then the order of spend down for covering remaining spending is taxable accounts, then tax-deferred accounts, and then tax-exempt accounts.

Each retiree’s situation is different in this regard, but one threshold that creates a big advantage for strategic management is the divide between the 12 percent and 22 percent tax bracket. That reflects the biggest jump in tax rates, and in 2021 the taxable income levels where this shift happens are $40,525 for singles and $81,050 for joint filers. These thresholds are also quite close to where the tax rate for long-term capital gains and qualified dividends jumps from 0 percent to 15 percent. For singles this happens at $40,400 of taxable income and for married couples filing jointly it is $80,800.

the most counterintuitive outcome relates to how the taxable portion of Social Security benefits can decrease as the Social Security benefit increases for different levels of MAGI and tax-exempt interest. This is because the taxable portion of the benefit is not growing as fast as the benefit in those cases where the 85 percent rate is playing a role.

Social Security taxation creates a case for more than just tax bracket management; it also can add greater after-tax value for delaying Social Security benefits. If one is already retired at age 62, delaying Social Security benefits to 70 could help to provide a foundation for making more Roth conversions before Social Security benefits begin, which could then help keep taxable income lower after age 70 so that Social Security then does not experience as much of the tax torpedo.

Social Security delay frequently complements strategies to support more after-tax spending power.

These tax rates could be even higher if there were long-term capital gains that further get pushed from the 0 percent tax bracket to the 15 percent tax bracket as Social Security becomes taxable. For this to be relevant, the household would need to still be in the 12 percent tax bracket and in a range where a dollar of income is taxing 85 percent of a dollar of Social Security. If this also then pushes $1.85 of long-term capital gains from the 0 percent to the 15 percent tax bracket, then suddenly the marginal tax rate is 49.95 percent. With the tax rates scheduled to return in 2026, the 12 percent tax bracket becomes 15 percent, which then increases the overall marginal tax rate to 55.5 percent for this perfect tax storm. Retirement tax rates will not always be lower in retirement, especially when a dollar of income leads to tax on that income, tax on more of Social Security, and tax on more of long-term capital gains or qualified dividends.

When beneficiaries are adult children receiving assets from their parents, this could end up leading to RMDs taking place during the children’s peak earnings years, which could push up the marginal tax rate paid on the inheritance. For retirees thinking ahead about bequeathing assets, the tax bracket management problem for paying taxes at the lowest rates includes comparing tax rates for the retiree against tax rates for the potential beneficiary. Roth conversions by the retirees may allow for the taxes to be paid at a lower rate. Beneficiaries would then receive Roth assets instead, and though they will

These are appreciated shares with unrealized capital gains of $20,000. By donating these shares instead, this person gets the same $30,000 tax deduction PLUS there is no need to pay capital gains taxes on the $20,000 of gains associated with a later sale of these assets. By donating the appreciated shares, and then using the available cash to repurchase those shares, we have erased $20,000 of taxable capital gains from the investment portfolio.

practice, it can be a real hassle for individuals to donate appreciated shares directly to charities, but a donor advised fund can help facilitate this process. Assuming you itemize your tax return, there are also AGI limitations for how much of a charitable gift is deductible. It is important to work with an accountant when making a large charitable gift to make sure it is structured in such a way that the full tax benefits can be received.

Next, in Exhibit 10.21 we allow for strategic Roth conversions as part of tax-bracket management. The optimal AGI target is $60,000 again, and this increases portfolio longevity by another 0.72 years over the previous strategy. Roth conversion strategies tend to support the same or better outcomes than simple bracket management. For Roth conversions, the early retirement years consist of spending down taxable assets like in the conventional strategy, but also generating more taxable income by converting assets from the tax-deferred account into the Roth account to cover the target. The first four years of retirement witness Roth conversions of more than $50,000 per year. Roth conversions continue until the taxable portfolio depletes. The additional taxes on the conversions are also funded by the taxable account, which depletes it more rapidly. At age