Marc1962
Recycles dryer sheets
My background info: http://www.early-retirement.org/forums/f26/couple-47-51-5-kids-possible-er-after-windfall-51856.html
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-Retirement-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?
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-Retirement-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?