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SWR with taxable portfolio
Old 09-05-2010, 10:48 AM   #1
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SWR with taxable portfolio

My background info: Couple 47/51, 5 kids, possible ER after windfall

Based on 47 years of retirement and the value of the portfolio after paying taxes and retiring our mortgage, the maximum constant spending power FIRECalc SWR with zero failures is 3.5%, and on the surface the corresponding annual withdrawal amount matches our current lifestyle.

My question concerns the treatment of income taxes with respect to consumption. I perceive several possible approaches:

1. All taxes must be paid from the SWR amount. In tax-sheltered portfolios, this amounts to a simple tax on spending and seems likely to be the unspoken assumption of FIRECalc and analyses like the one in http://www.amazon.com/Unveiling-Reti...Myth-Jim-Otar/.

In taxable portfolios on the other hand, income taxes apply to investment results rather than spending. This leads to a counter-intuitive result. In high-return years, taxes will be high, and the portion of the planned annual withdrawal available for non-tax expenses will be reduced. Conversely, in low-return years, more of the withdrawal will be available for consumption.

To take an extreme example, imagine a year in which a taxable $1M portfolio with a $35K SWR experiences a $200K short term capital gain. The taxes on the gain would consume the entire annual withdrawal and then some.

2. Taxes on unearned income must be paid from the portfolio rather than the SWR amount. This policy also creates a large disparity in the experiences of tax-sheltered and taxable portfolio holders. A retiree with a tax-sheltered portfolio would pay ordinary income tax out of withdrawals and would enjoy high investment returns from tax-free compounding.

A retiree with a taxable portfolio would pay no income tax out of withdrawals and would therefore be able to consume more. That retiree's investment returns would be reduced significantly by taxes.

For example, consider a $1M portfolio with a $35K SWR and a $200K short term capital gain. The retiree with the tax-sheltered portfolio winds up with $1,165,000 in the portfolio and spends, say, $28K on consumption and $7K (20%) on income taxes. The retiree with the taxable portfolio pays Federal, state, and local income taxes at a higher rate (say, 35%), winds up with $1.2M - $35K - $70K = $1,095,000 in the portfolio, and spends $35K on consumption.

As an another example, adjust the above scenario by turning the $200K gain into a $200K loss. The retiree with the tax-sheltered portfolio still spends $28K on consumption and $7K on income taxes. The portfolio is worth $765K. The retiree with the taxable portfolio spends $35K on consumption and acquires a $200K carry-forward tax loss to offset future gains. That portfolio is also worth $765K.

3. Reduce the SWR for taxable portfolios to provide for withdrawals equivalent to the after-tax portion of the amount available from an identical tax-sheltered portfolio. In our example, the SWR for a taxable portfolio would be 2.8% in order to provide the spendable $28K available to the retiree with the tax-sheltered portfolio.

4. Use precise financial calculations to normalize the two scenarios and establish a mathematical relationship among FIRECalc, tax-sheltered, and taxable SWRs.

Clearly option 1 doesn't work for taxable accounts, and options 2 and 3 are just simple stabs in the dark. Has anyone worked on option 4? Are there any rules of thumb to account for the differences between taxable and tax-sheltered scenarios? And (for extra credit ) what about SWRs for Roth portfolios, which enjoy the best of both worlds?
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Old 09-05-2010, 12:46 PM   #2
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If you have a large taxable portfolio and modest withdrawals you should be paying hardly any taxes as at all. And taxes are part of the sustained withdrawal rate, so if you withdraw 4% and your income taxes are 25% of that, then you get to spend 3%.

I don't see how taxes could be 25%. When I was in the 33% income tax bracket, taxes were just 15% of our income since some income is taxed at 0% (i.e. tax-free), some at 10%, some at 15%, some at .... You get the idea. Now that we are semi-retired and in the 25% tax bracket, taxes are about 8% of AGI.

You need to invest your taxable portfolio very tax efficiently. Here is a great article on how to do that: https://www.savantcapital.com/upload...rs/zerotax.pdf

You could have income of $200K and pay about $10K in taxes. In your example, I don't know why you would have $200K short-term cap gains. That's insane and you would not be investing properly and tax-efficiently. First, return-of-capital is tax-free. Second, you should judiciously practice tax-loss harvesting to build up capital loss carryovers. Third, you should only realize long-term capital gains and should never have realized short-term capital gains. Fourth, you may wish to consider municipal bonds, but frankly I don't see how someone in a low tax bracket would benefit from tax-exempt bonds. Your fixed income like bonds, CDs, money markets etc should be held in tax-advantaged accounts like 401(k), 403(b), and IRAs.
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Old 09-05-2010, 12:52 PM   #3
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For more help with creating a very tax-efficient diversified, passively-managed index portfolio, you cannot do better than to visit Bogleheads Investing Advice and Info

For help on how to sequence withdrawals and from which accounts in order minimize taxes then visit www.i-orp.com
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Old 09-05-2010, 01:16 PM   #4
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And while you are in a low tax bracket, I don't see why you wouldn't be converting some of your 401(k) or rollover IRA to a Roth IRA ... a little bit each year ... use your taxable account to pay the taxes.

William Reichenstein is the guy that writes about different accounts having different tax costs. Unless you have more than $5 million in assets or spend more than about $150K a year, I don't think it will even matter.
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Old 09-05-2010, 02:05 PM   #5
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Thanks very much for your comments and for the references to in-depth material on this topic. I will read those links with great interest.

To summarize, I think you're saying that instead of adjusting the SWR, people with a preponderance of savings in taxable accounts generally just invest differently.
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Old 09-05-2010, 02:18 PM   #6
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As an aside, a 0% failure rate at any SWR may be mathematically possible but realistically implausible. My guess is that a 10% failure rate per FireCalc would be acceptable to most here.

One of the reasons is that FC assumes you continue your losing ways til the day you die; realistically most of us would adjust expenses down, reduce inflation adjustments in low years, annuitize parts of our holdings etc. in the event we sensed serious danger. A 10% failure rate really means several years of warning signs which would alert you to the dangers.

Otar uses the warning sign of a total portfolio losing value over a trailing 4 year period, for example. He says you should annuitize at that point but the main message is not to blindly continue plan A in the face of mean storm clouds gathering.
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Old 09-05-2010, 02:26 PM   #7
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Quote:
Originally Posted by Marc1962 View Post
To summarize, I think you're saying that instead of adjusting the SWR, people with a preponderance of savings in taxable accounts generally just invest differently.
Most of the SWR assumptions derive from the math of the stock market's annual returns, which would involve mostly interest & dividend taxes. ERs do have capital gains, but the majority of them are long-term cap gains taxed at much lower rates than you're examining.

Your examples are correct, but most of us don't invest actively enough to book that much in short-term cap gains. Every year that I've been ER'd, my trading activity has declined. Last year I only had three trades in a taxable account, and this year I've had four sales during the spring runup. Without that runup I'd have no trades.

I've also sold some covered-call options this year, but that income's not enough to move the SWR needle. In your six-figure case you might want to fence off 25-30% of your trading gains for those cap-gains taxes before deciding how much of your portfolio is available for your SWR (which would include the rest of your taxes).

Frankly, if you're booking $200K short-term cap gains every year, then why are you looking at SWR so closely?
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Old 09-05-2010, 02:44 PM   #8
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To summarize, I think you're saying that instead of adjusting the SWR, people with a preponderance of savings in taxable accounts generally just invest differently.
No, I'm not saying that. Everybody should invest tax-efficiently. Even if you have only a Roth IRA and a 401(k), you should decide which assets might be better in the Roth. And anybody with taxable accounts should only put tax-efficient investments in those accounts whether the amount is $1,000, $10 million or anywhere in-between.
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Old 09-05-2010, 05:00 PM   #9
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Your tax bill is the sum of taxes on withdrawals plus taxes on rebalancing. Withdrawals are regular and predictable and the taxes they generate can be planned. The tax cost of rebalancing can be highly variable in any year but for longer periods you can project your rebalancing and subsequent tax liability, and provide for that amount.

IOW, your yearly SWR calculation should include the average tax cost of rebalancing plus the yearly tax liability for distributions. Your yearly budget should include both amounts but allow for the rebalancing component to be variable. Differences in yearly tax liability from rebalancing are not over/under budget, they just point to greater or less future tax liability.

If you choose to transact outside of normal rebalancing, tax liability needs to be included in the decision process and funded within the transaction.

FIRE with a taxable portfolio requires a careful focus on tax management and the Boglehead link provided by LOL is a very good source. The general availability of ETFs and passive funds has also made it much easier to manage tax liability in a taxable acount.
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Old 09-05-2010, 05:21 PM   #10
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My portfolio is almost entirely taxable accounts, invested all in mutual funds - equity funds and bond funds. I usually rebalance no more than once a year.

For my personal planning purposes, I estimate that taxes will take 0.5% of my portfolio. So if I were using 4% as my SWR, I would conclude that I usually have 3.5% left over for my living expenses.

Averaged over many years, I have found that the taxes on my portfolio do average to about 0.5%. I am told this seems high. I often pay AMT (26-28%) plus sometimes my portfolio throws off a lot of distributions, so I sometimes find myself in higher tax brackets than others might for some of my income. However, even in those years at least half of the distributions from my portfolio are taxed at capital gains rates - sometimes a much higher percentage. My short term capital gains are always very low.

Year-to-year my income taxes as % of my portfolio do vary widely - 0% or even negative (tax loss harvesting) to as high as 1.1% of portfolio in a year with particularly large distributions payouts.

So far I have been able to pay my portfolio income taxes and still stay within my annual SWR as I don't spend as much annually as my portfolio can theoretically support.

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Old 09-05-2010, 05:35 PM   #11
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Frankly, if you're booking $200K short-term cap gains every year, then why are you looking at SWR so closely?
I'm not - it was just an example to illustrate a general principle. Here's another, slightly more realistic example that doesn't involve short-term capital gains:

Our absurdly undiversified retiree living by a 3.5% SWR has $1M in a taxable account invested 100% in WIN, which is providing an 8.4% dividend today. He wants to spend $35K minus income taxes, but his taxes are based on his $84K dividend, not his $35K withdrawal. Under current rules, those taxes are $84K * 0.15 or $12.6K, which is a full 36% of his annual withdrawal. My original question amounted to this: Should he increase his withdrawal to cover a portion of the $12.6K?

I do understand that he shouldn't be invested 100% in a single company. The example is just an illustration. And I think I now understand from the comments here that if the retiree is dumb enough to wind up with more taxable income than he wants to spend in a given year, he should bite the bullet and pay the excess taxes out of his SWR-sized withdrawal.
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Old 09-05-2010, 05:40 PM   #12
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And I think I now understand from the comments here that if the retiree is dumb enough to wind up with more taxable income than he wants to spend in a given year, he should bite the bullet and pay the excess taxes out of his SWR-sized withdrawal.
You're very perceptive.
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Old 09-05-2010, 05:47 PM   #13
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Michael and Audrey, thanks for sharing - I understand now that I should plan to pay all of the taxes out of the SWR-based withdrawal.

I perceive this to be a significant burden, perhaps because my 47-year planning horizon requires the ratio between annual spending and portfolio size to be large. Audrey's 1.1% peak tax rate would amount to 32% of my withdrawal that year.

I will study carefully the links you all have recommended, as it seems that executing well in this regard is important.
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Old 09-05-2010, 05:56 PM   #14
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Suppose you have a $2 million taxable portfolio. If 100% equities, you would get about 2% in qualified dividends taxed at 15% and maybe going up next year. But in your situation, probably the first $50,000 or so of income is tax free because you are married and have kids, so all of that dividend income is tax-free. You also get a tax credit for college expenses.

If the taxable portfolio had some fixed income (highly recommended! ), then you could use tax-exempt bonds if in a high tax bracket or regular taxable bonds if in a low tax bracket or even a mix of them. Anyways, in your situation you can have a lot of income before you would have to pay any taxes. Have you used TurboTax yet to run some "what if's"?
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Old 09-05-2010, 06:05 PM   #15
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I perceive this to be a significant burden, perhaps because my 47-year planning horizon requires the ratio between annual spending and portfolio size to be large. Audrey's 1.1% peak tax rate would amount to 32% of my withdrawal that year.
That was an outlier year, even though it was a bit shocking at the time. Many years were 0.4 to 0.6%. And like I said, I have had a couple of negative to 0 tax years to make up for it.

I tend to front-load X-years living expenses in a cash account outside of my long-term portfolio, so year-to-year variations in what I am able to withdraw don't affect me that much. This is basically a buffer that helps smooth out variations between years. You might consider this as part of your strategy.

I retired at 39, and so had a long time horizon FWIW. I can still live within 3% withdrawal rate including 0.5% for taxes (so 2.5% assumed for living expenses). So if some year it went above that 0.6%, it wouldn't seem like such a burden. And, as I mentioned, I still don't usually spend all of that anyway, so I tend to have left over from prior years to help occasional increases in portfolio expenses.

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Old 09-05-2010, 06:22 PM   #16
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My portfolio is almost entirely taxable accounts, invested all in mutual funds - equity funds and bond funds. I usually rebalance no more than once a year.

For my personal planning purposes, I estimate that taxes will take 0.5% of my portfolio. So if I were using 4% as my SWR, I would conclude that I usually have 3.5% left over for my living expenses.

Averaged over many years, I have found that the taxes on my portfolio do average to about 0.5%. I am told this seems high. I often pay AMT (26-28%) plus sometimes my portfolio throws off a lot of distributions, so I sometimes find myself in higher tax brackets than others might for some of my income. However, even in those years at least half of the distributions from my portfolio are taxed at capital gains rates - sometimes a much higher percentage. My short term capital gains are always very low.

Year-to-year my income taxes as % of my portfolio do vary widely - 0% or even negative (tax loss harvesting) to as high as 1.1% of portfolio in a year with particularly large distributions payouts.



Audrey
IMHO 0.5% isn't high - and it's also close to what I plan for. I am below that now but only due to aggressive tax loss harvesting. I don't see how you can get it much lower and still rebalance, and wouldn't want to plan on a lower rate.

My tax rate was higher during my first years of FIRE but I had no passive investments and bought & sold excessively. ETFs and passive funds have really lowered the year end distributions and more discipline in asset allocation has been very beneficial.

1.1% sounds like a lot but if is the product of rebalancing after a year of high returns it isn't, and it is offset by another year of zero portfolio growth and no taxes.

Unnecessary short term capital gains, though, are deadly. edited to add: so is market timing.
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