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Withdrawal Rates and Taxes
Old 10-30-2009, 10:14 AM   #1
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Withdrawal Rates and Taxes

A question for the group....

I am analyzing my assets to determine what I should utilize to fund my 2010 living expenses. As this is my first full year of retirement I want to get it right. I'm quite comfortable that my withdrawal rate will be right around 3% of total assets (not including house NAV).

The question is do you include estimated tax payments that will need to be paid during the year on things such as dividends, interests and capital gain in your total living expenses when determining a safe withdrawal rate?

I have seen articles that suggest that a safe withdrawal rate of 3% to 4% does not include taxes due that year and is really related to just actual living expenses. But if taxes are an expense that need to be paid during the year why wouldn't they be included?

That being said I guess you wouldn't be paying the taxes on the gains if your investments weren't growing.

I am not of the age where I am having to take required monthly withdrawals from any retirement accounts.

Your feedback is appreciated.
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Old 10-30-2009, 10:35 AM   #2
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i think the answer behind the theory of a SWR is that the taxes due are in that SWR but i think there are exceptions. for instance, if you own a valuable asset that has a large capitol gain in it and you sell it i think you dont include that tax in your SWR, rather it is a more akin to a cost of selling. and another example, if you are making TIRA to roth conversions i think you dont include that tax owed in your SWR.

i personally however have split my finances into 2 pieces, an income producing/growth piece and a spending piece. and i let the income producing/growth piece pay all the taxes incurred by that function. it also pays my spending piece a particular amount each month and if i dont spend all of that amount it accumulates in that spending piece for emergencies or big ticket items or the like. but the spending piece only pays taxes associated with said spending (to include the RE taxes on the place where i live). however i didnt use a SWR to determine the amount sent to the spending piece (even though i can calculate the WR after the fact if i want to)
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Old 10-30-2009, 10:43 AM   #3
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Taxes are generally treated like any other expense in estimating your annual SWR. Just like food, mortgage, entertainment, etc. you should plan on taxes being covered by your SWR.

If you living expenses are $40k per year not including taxes and your overall taxes are 20% of that number, you would need to withdraw $50K per year as your SWR. This assumes that your SWR is coming from tax-deferred accounts. Kind of makes you appreciate your post-tax savings which do not need to to be adjusted to cover taxes, other than their earnings over the year.
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Old 10-30-2009, 10:47 AM   #4
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Thanks JDW.

Another question if that is the case...

Why wouldn't I take those assets that are generating the income, sell them and pay off my house (single largest monthly expense for me) thereby lowering my monthly expenses and eliminating some of the income those assets are generating?
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Old 10-30-2009, 10:49 AM   #5
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Unfortuantely this income is coming all from taxable accounts. Can't draw on retirement accounts for another 7.5 years.
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Old 10-30-2009, 11:06 AM   #6
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Thanks JDW.

Another question if that is the case...

Why wouldn't I take those assets that are generating the income, sell them and pay off my house (single largest monthly expense for me) thereby lowering my monthly expenses and eliminating some of the income those assets are generating?
there have been multiple threads on whether to pay off your mortgage or not. there are arguments on both sides but since you asked me i will tell you that i do not have a mortgage on the place i live. i used a cost to rent analysis and my income producing/growth piece determined that it paid to buy this place mortgage free. in doing such that piece lowered the amount sent to my spending piece (which was in essence income for the income producing piece).
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Old 10-30-2009, 11:08 AM   #7
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Unfortuantely this income is coming all from taxable accounts. Can't draw on retirement accounts for another 7.5 years.
well you can if you really want to (72t) but i dont see why it is unfortunate.
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Old 10-30-2009, 11:24 AM   #8
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well you can if you really want to (72t) but i dont see why it is unfortunate.
I have a tax problem already. Doing a 72t would just increase it as it would just add more to my taxable income.

Unfortunately was probably a bad choice of words in this case. Having a tax problem is probably a fortunate position to be in. Just trying to figure a way to keep the withdrawals in an acceptable range.
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Old 10-30-2009, 11:28 AM   #9
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The question is do you include estimated tax payments that will need to be paid during the year on things such as dividends, interests and capital gain in your total living expenses when determining a safe withdrawal rate?
That withdrawal rate always includes the taxes on the portfolio that you are using for income (as income is generated or assets sold for withdrawal) as well as taxes on any other investment transactions within the portfolio.

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Old 10-30-2009, 11:31 AM   #10
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i think the answer behind the theory of a SWR is that the taxes due are in that SWR but i think there are exceptions. for instance, if you own a valuable asset that has a large capitol gain in it and you sell it i think you dont include that tax in your SWR, rather it is a more akin to a cost of selling. and another example, if you are making TIRA to roth conversions i think you dont include that tax owed in your SWR.

i personally however have split my finances into 2 pieces, an income producing/growth piece and a spending piece. and i let the income producing/growth piece pay all the taxes incurred by that function. it also pays my spending piece a particular amount each month and if i dont spend all of that amount it accumulates in that spending piece for emergencies or big ticket items or the like. but the spending piece only pays taxes associated with said spending (to include the RE taxes on the place where i live). however i didnt use a SWR to determine the amount sent to the spending piece (even though i can calculate the WR after the fact if i want to)
JDW,

I do like your idea of setting up the separate buckets and using one to produce the growth and income and also pay the taxes on the gains and the other to live off.

I guess that is what I am trying to ultimately achieve. The problem remains that given the tax rate is so much higher than the withdrawal rate of 3% that overall my expenses are going to be closer to 5% when you figure in the taxes.

Guess its time to move some of the income producing assets into something that throws off less in yearly dividends and ST gains for something a bit more growth oriented and more tax efficient.
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Old 10-30-2009, 11:40 AM   #11
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i think the answer behind the theory of a SWR is that the taxes due are in that SWR but i think there are exceptions. for instance, if you own a valuable asset that has a large capitol gain in it and you sell it i think you dont include that tax in your SWR, rather it is a more akin to a cost of selling. and another example, if you are making TIRA to roth conversions i think you dont include that tax owed in your SWR.
Good point.

However, SWR studies do not take these exceptions into account. They assume that you only sell as much stock/bonds as you need to meet your SWR and rebalancing needs. Taxes are included in expenses supported by the SWR.

Additional taxes on transactions like IRA to ROTH IRA transfers and mandatory withdrawals from an IRA are not factored into SWR studies. So, treating those taxes as being outside your SWR, will increase the risk of retirement ruin.

That said, I'd think it foolish to stick to any of these methodologies blindly. Just be aware of what the SWR studies encompass and what they don't.
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Old 10-30-2009, 11:53 AM   #12
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I've assumed when you figure your withdrawal needs to plug into any such models, you have to count all of the expenses, including taxes.

So, for example, if your expenses for food, shelter, medical, etc. are $20k/year, but your portfolio is throwing off taxable $60k per year, and as a result, you have to pay $15k in taxes, that means you have to plan for $35k/year expenses.

This also means that your tax expense will increase not at the rate of your "personal" CPI inflation but at the rate of your projected (portfolio minus withdrawals) growth... plus if you get pushed into higher/lower tax brackets, that would affect the tax expense too.
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Old 10-30-2009, 12:36 PM   #13
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Additional taxes on transactions like IRA to ROTH IRA transfers and mandatory withdrawals from an IRA are not factored into SWR studies. So, treating those taxes as being outside your SWR, will increase the risk of retirement ruin.
i am not so sure that it will. if you are doing a conversion you must think your tax rate will either go up or stay the same in the future. if that holds true you will have more after tax money in the future if you do the conversion so that should actually help your retirement. and if the MRD in the future is going to be more than you need for youe expenses WD then maybe you should look into doing a TIRA to roth conversion before that point so that your MRD will be lower.
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Old 10-30-2009, 12:58 PM   #14
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So, for example, if your expenses for food, shelter, medical, etc. are $20k/year, but your portfolio is throwing off taxable $60k per year, and as a result, you have to pay $15k in taxes, that means you have to plan for $35k/year expenses.
or if those numbers are very consistant then you could look at your portfolio as earning an after tax $45K per year (in other words have your portfolio cover the expenses (i.e. taxes) of producing that income) and your WD (for spending purposes) would be $20K which means your portfolio increased in value, just from the income, by $25K. this is what i do because my income producing/growth piece throws off alot of taxable income. and before anyone asks, i am invested this way because even after paying the taxes the return is very good, so in essence i am just discounting the gross return i am getting by the tax i am paying to get my net (after tax) return.

i think most of the retired on this forum would try to limit the taxable income production of their portfolio to the amount of their withdraw (including taxes)
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Old 10-30-2009, 08:48 PM   #15
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i am not so sure that it will. if you are doing a conversion you must think your tax rate will either go up or stay the same in the future. if that holds true you will have more after tax money in the future if you do the conversion so that should actually help your retirement.
Your logic for wanting to do the transfer is correct. And, if your assumption holds, you will pay less in taxes.

However, it is not CERTAIN that you will come out ahead using this move. The amount in the ROTH IRA will be lower - by the amount that you pay in taxes - than if left in the T-IRA. So, your gains are from a lower base. How you end up will depend on the performance of your portfolio, number of years before mandatory withdrawals hit, and the difference in tax rates.

I plan to move money from T-IRAs to ROTH starting this year. I'll go to the max in the 15% bracket & will l try to use money from my SWR to pay the taxes, but if they're not sufficient, I'll pay from the taxable portfolio. I'm hoping to come out ahead, but we'll see.
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Old 10-30-2009, 09:07 PM   #16
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I'm amused by all the examples of 20% to 25% of income paid in taxes. I never paid that much when AGI was around $200K or so. Now in semi-retirement, tax rate will be about 5 to 7% of income.

So to address the topic: Yes, you include taxes you pay in your expenses and it comes out of your sustained withdrawal rate of 3% to 4%. To figure out your tax rate, use a copy of TurboTax and plug in your numbers. You may be pleasantly surprised that your tax rate may be 0% because (a) return of capital in a taxable account is tax-free, (b) you have a capital loss carryover from previous years (tax-loss harvesting), (c) you have a net capital loss this year (tax-loss harvesting), (d) qualified dividends are taxed at preferable rate as low as 0%, and (e) etc.

So run your numbers. if your tax rate is low enough, consider converting some traditional or rollover IRA money to a Roth IRA.
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Old 10-31-2009, 12:25 AM   #17
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However, it is not CERTAIN that you will come out ahead using this move. The amount in the ROTH IRA will be lower - by the amount that you pay in taxes - than if left in the T-IRA. So, your gains are from a lower base. How you end up will depend on the performance of your portfolio, number of years before mandatory withdrawals hit, and the difference in tax rates.
if you pay the taxes with non ira money and you get the same invest returns whether you kept the TIRA or convert to a roth and your future tax rate is >= your current tax rate you will come out ahead doing the conversion, period.

for example you have a $20,000 TIRA lets assume a 100% rate of return and a 25% tax bracket. you have 2 choices, convert or dont convert.

1) converting: when you convert you must pay the taxes and that will cost you $5,000 which you pay from assets outside the ira which means now you have $20,000 in your roth. fast forward... you have gotten your 100% return and you now have $40,000 in after tax money.

2) dont convert: you leave the $20,000 in your TIRA and you still have the $5,000 outside your ira. fast forward... you have gotten your 100% return and now you have $40,000 in your TIRA and $10,000 ($5,000 that you started with and $5,000 of taxable gain) outside your ira before taxes. after taxes the $40,000 ira becomes $30,000 and the $5,000 of gain outside the ira becomes $3,750. so adding it all up you get $30,000 +$5,000 +$3,750 = $38,750 in after tax money.

obviously converting produces a higher total and unless you change my initial assumptions (if you pay the taxes with non ira money and you get the same invest returns whether you kept the TIRA or convert to a roth and your future tax rate is >= your current tax rate), it will be this way no matter what the rate of return is or what the tax rates are (unless you use 0, after all it is simple math). in fact it will even work if the future tax rate is just a little bit lower than the current tax rate. if you dont believe me run some examples for your self but remember not to violate my initial assumptions.
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Old 10-31-2009, 12:38 AM   #18
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So to address the topic: Yes, you include taxes you pay in your expenses and it comes out of your sustained withdrawal rate of 3% to 4%. To figure out your tax rate, use a copy of TurboTax and plug in your numbers. You may be pleasantly surprised that your tax rate may be 0% because (a) return of capital in a taxable account is tax-free, (b) you have a capital loss carryover from previous years (tax-loss harvesting), (c) you have a net capital loss this year (tax-loss harvesting), (d) qualified dividends are taxed at preferable rate as low as 0%, and (e) etc.
what if someone had $1,000,000 in liquid assets (portfolio). thus at a 4% "SWR" he should pull a $40k "SWD" and out of that pay the taxes. well what if he is in an investment that yields 16% in taxable income (i.e. $160,000 on his portfolio). well if he is single and has no meaningful deductions his federal income taxes for that year would be about $36k which would leave him $4k to live on after he paid his taxes out of his $40k "SWD". obviously if he did this he would be living below the poverty level and yet he made, after fed taxes, a $124k gain that year. in this case taking the income taxes out of the "SWR" makes no sense at all but taking a WD of some percentage (or whatever method arrived at) out of the now $1,124,000 after tax liquid assets is what needs to be done and if it is on the order of 4% (~$45k) i dont see how that has weakened his retirement position since his portfolio is still up almost 10% after taxes and after the WD. so to me it makes more sense to look at this situation as earning an ~12% after tax return and treat it that way from a WD standpoint
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Old 10-31-2009, 01:43 AM   #19
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what if someone had $1,000,000 in liquid assets (portfolio). thus at a 4% "SWR" he should pull a $40k "SWD" and out of that pay the taxes. well what if he is in an investment that yields 16% in taxable income (i.e. $160,000 on his portfolio). well if he is single and has no meaningful deductions his federal income taxes for that year would be about $36k which would leave him $4k to live on after he paid his taxes out of his $40k "SWD". obviously if he did this he would be living below the poverty level and yet he made, after fed taxes, a $124k gain that year. in this case taking the income taxes out of the "SWR" makes no sense at all but taking a WD of some percentage (or whatever method arrived at) out of the now $1,124,000 after tax liquid assets is what needs to be done and if it is on the order of 4% (~$45k) i dont see how that has weakened his retirement position since his portfolio is still up almost 10% after taxes and after the WD. so to me it makes more sense to look at this situation as earning an ~12% after tax return and treat it that way from a WD standpoint
That would be a very tax-inefficient portfolio, wouldn't it? If you have a $1M portfolio, why not invest it in a mixture of bonds and stocks producing, as an aggregate, an income roughly equivalent to what you need. Let's say you need $40K a year, and let's say your portfolio produces $40K a year in passive income (4% yield). Let's also assume that half that income is qualified dividends and half is ordinary dividends. HR Block says you would owe $0 in federal income taxes even if you are single. That means you get to spend 100% of your SWR on yourself. If the portfolio had a total return exceeding 4% for the year, the excess gain would remain unrealized and untaxed.
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Old 10-31-2009, 01:57 AM   #20
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That would be a very tax-inefficient portfolio, wouldn't it? If you have a $1M portfolio, why not invest it in a mixture of bonds and stocks producing, as an aggregate, an income roughly equivalent to what you need. Let's say you need $40K a year, and let's say your portfolio produces $40K a year in passive income (4% yield). Let's also assume that half that income is qualified dividends and half is ordinary dividends. HR Block says you would owe $0 in federal income taxes even if you are single. That means you get to spend 100% of your SWR on yourself. If the portfolio had a total return exceeding 4% for the year, the excess gain would remain unrealized and untaxed.
you are kidding right? you would pass up $160K in income that is all taxable for a $40k income that isnt? you havent thought this thru

and based on http://www.moneychimp.com/features/tax_brackets.htm
you wud still owe taxes (only about $1k)

but the real point is you would give up an over $80k increase in after tax income to have an income that wasnt taxed i wudnt
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