Counting large tax bills in SWR

[RunningBum]

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Originally Posted by jebmke I agree with your statement but I consider this method inferior. It tends to treat the future taxes (at least mentally) as a foregone conclusion rather than an expense to be managed.

I know there is disagreement on this and CPAs might cringe at this method, but for some of us it makes perfect sense. I used to have a large potential net worth in unexercised stock options, and it was better to think of it in terms of how much it would be in post-tax dollars. From there it started making sense to think of everything in post-tax dollars.

If I convert 100K from a tIRA to a Roth and paid 20K out of pocket in fed/state taxes now rather than probably the same 20% later if I'd have taken tIRA distributions later, I really didn't change my financial state even though I now have 20K less in my account totals to show for it. I find this method is good for treating tIRA, Roth IRA, and taxable accounts with cap gains (or losses) on the same ground.

Also, while I'm mindful of managing taxes, I don't want to make choices just to limit my tax expense to some budget. I can't keep all my cap gains under the 15% bracket. If I have reason to sell something and take a large cap gain at 15% one year, I'm going to do it. Rather than have an uneven budget skewed by the occasional sale, I just keep the cap gains and conversion taxes out of my expense budget and instead treat them as a future liability on my balance sheet. I calculate my withdrawal rate on my assets minus the future tax liabilities.

I honestly don't see how this method is inferior. I may be able to manage some of my capital gains to be taxed at 5% (state only) rather than 20%, but I view the 20% reduction as being conservative. I can't be 100% accurate on that tax liability, but neither could I be 100% accurate in budgeting the future tax as an expense either, if I treated it that way. Just because I mentally and on paper took 20% off those gains doesn't mean I won't try to do better with managing it. I mean, if I'm house shopping I may plan on 300K for a house, but if I find one that suits me well for 250K I'm not going to pass on it because it's under budget, or insist on paying 300K because that was my foregone conclusion of what I'd spend.

[mpeirce]

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Originally Posted by RunningBum I know there is disagreement on this and CPAs might cringe at this method, but for some of us it makes perfect sense. I used to have a large potential net worth in unexercised stock options, and it was better to think of it in terms of how much it would be in post-tax dollars. From there it started making sense to think of everything in post-tax dollars.

This is exactly how I came to my thinking as well.

If one does have large unexercised stock options, it's very important to think in terms of after taxes on these. Non qualified stock options (the kind I had) are taxed at regular tax rates. If you hope to FIRE, you need to exercise these before leaving the company. Roughly half of the value of those options goes to taxes (depending on your state and how big they are) so if you think about the entire amount as your "worth" your in for a big surprise.

And once going through that exercise, you realize that: that $100K in one account isn't really worth the same as the $100K in that other account because, say, one has no accumulated CGs and the there does. Likewise, I like to keep in mind that IRA money is only accessible after a (possible large) tax bite, vs that money sitting in a CD which isn't.

Neither view is absolutely "best", but one viewpoint might make sense based on your situation.

[jebmke]

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Originally Posted by RunningBum I know there is disagreement on this and CPAs might cringe at this method, but for some of us it makes perfect sense. I used to have a large potential net worth in unexercised stock options, and it was better to think of it in terms of how much it would be in post-tax dollars. From there it started making sense to think of everything in post-tax dollars. If I convert 100K from a tIRA to a Roth and paid 20K out of pocket in fed/state taxes now rather than probably the same 20% later if I'd have taken tIRA distributions later, I really didn't change my financial state even though I now have 20K less in my account totals to show for it. I find this method is good for treating tIRA, Roth IRA, and taxable accounts with cap gains (or losses) on the same ground. Also, while I'm mindful of managing taxes, I don't want to make choices just to limit my tax expense to some budget. I can't keep all my cap gains under the 15% bracket. If I have reason to sell something and take a large cap gain at 15% one year, I'm going to do it. Rather than have an uneven budget skewed by the occasional sale, I just keep the cap gains and conversion taxes out of my expense budget and instead treat them as a future liability on my balance sheet. I calculate my withdrawal rate on my assets minus the future tax liabilities. I honestly don't see how this method is inferior. I may be able to manage some of my capital gains to be taxed at 5% (state only) rather than 20%, but I view the 20% reduction as being conservative. I can't be 100% accurate on that tax liability, but neither could I be 100% accurate in budgeting the future tax as an expense either, if I treated it that way. Just because I mentally and on paper took 20% off those gains doesn't mean I won't try to do better with managing it. I mean, if I'm house shopping I may plan on 300K for a house, but if I find one that suits me well for 250K I'm not going to pass on it because it's under budget, or insist on paying 300K because that was my foregone conclusion of what I'd spend.

I don't think it is inherently inferior except to the extent that it lulls some (maybe not you) to just view the taxes as not within their control.

I had a different approach on my NQ options -- I ignored them entirely until it became time to start converting them to cash. My situation was a bit tricky because I was an insider and had limited ability to just dump them. But, when it came time to liquidate large blocks, I also transferred from our taxable account, appreciated shares equal to about 15 years of our normal charitable donations to a DAF. I was able to shift the deduction from a 15-25% rate to a 35%+ rate and drive the after-tax yield from the NQ exercise up.

I do agree that you can't always (and shouldn't always) manage finances just for tax purposes. But I can tell you from having prepared over 1000 tax returns over the past few years that many people have this perception that taxes are inevitable and not controllable. When I explained tax loss harvesting to a couple of seasoned tax preparers in 2009 they looked at me as if I had invented the wheel.

[audreyh1]

I built my retirement portfolio as I divested company stock, and always calculated my potential SWR on the after tax amount I had set aside in that portfolio. This solved the initial capital gains taxes on a lump sum problem.

Once you divest company stock and build an investment portfolio for annual withdrawal, it should be no problem to keep the income taxes of the portfolio well below 1% of the portfolio, and thus below the SWR.

[RunningBum]

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Originally Posted by Ed_The_Gypsy Safe Withdrawal Rate applies to the survival of the portfolio, not how you spend it (i.e., pay taxes, eat, etc). IIRC, the beginning asset allocation is more important than rebalancing. In taxable accounts, I can imagine a good case for not rebalancing. Better to just take the dividends as they come and sell a little stock when it grows out of balance.

That's all rebalancing is. If stocks have a big run you might have to sell more than just a little stock, but probably not too much if you don't defer rebalancing. Actually most of my rebalancing is done by taking my living expenses out of the asset class that is overweight.

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Taxable accounts have always been a headache for me. Taxable events sold me on buy-and-hold.

Maybe this is an advantage to my method. I treat taxes as a given, not a headache. I also buy and hold, but now that I'm FIRE'd I'm having to take some out to live on and I don't have any qualms about taking the tax hit since I've already accounted for it, both on paper and mentally. I will try to limit the taxes by selecting which shares to sell but I won't throw my AA further out of balance by choosing to sell a depressed asset class just to limit the current tax hit.

[marko]

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Originally Posted by RunningBum Just remember if you aren't going to include those taxes as part of your yearly expenses, you ought to reduce your net worth by the future tax liability when calculating your SWR, or how much to pull out yearly based on a SWR. You do have to account for the taxes one way or another.

The way I look at it is that during our working days, whenever we're asked how much we made (legal, accountants etc) we gave them our pre-tax amount. I never said: " I make $X after taxes".

So I view my SWR to include taxes just the same as if it were a salary. Gotta pay the taxes and spend the rest.

[RunningBum]

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Originally Posted by jebmke I don't think it is inherently inferior except to the extent that it lulls some (maybe not you) to just view the taxes as not within their control.

OK, that makes sense too, though I think people who aren't very tax savvy probably don't manage taxes well no matter which method they use. I get the impression that some people will try to minimize taxes for the current year even if it means that deferred income will push them into a higher bracket in later years. Just in this thread we had someone essentially say not to sell a stock high, but instead wait until it drops and THEN sell it. Unless you are talking about exchanging it with a different stock that tracks the same, you should ALWAYS want to sell high, damn the taxes.

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I had a different approach on my NQ options -- I ignored them entirely until it became time to start converting them to cash. ...

I've heard others take that approach too. In my case the future options were probably 90% or more of my net worth so they were the key to my FIRE. It'd have been like ignoring an elephant. As the options are highly volatile, it probably makes sense for the rest of the portfolio to be a bit more conservative.

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I do agree that you can't always (and shouldn't always) manage finances just for tax purposes. But I can tell you from having prepared over 1000 tax returns over the past few years that many people have this perception that taxes are inevitable and not controllable. When I explained tax loss harvesting to a couple of seasoned tax preparers in 2009 they looked at me as if I had invented the wheel.

That's pretty funny (and said) that even tax preparers didn't understand the tax loss harvesting concept. I hope by "preparers" you aren't meaning someone who would actually advise people on managing taxes.

[RunningBum]

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Originally Posted by audreyh1 I built my retirement portfolio as I divested company stock, and always calculated my potential SWR on the after tax amount I had set aside in that portfolio. This solved the initial capital gains taxes on a lump sum problem. Once you divest company stock and build an investment portfolio for annual withdrawal, it should be no problem to keep the income taxes of the portfolio well below 1% of the portfolio, and thus below the SWR.

Once I started with the tax liability method, I've seen no advantage to switching even though my taxes are more predictable now. Roth conversions can still make them somewhat variable. For a couple reasons I won't bother to detail I've been converting to the 25% bracket for a couple of years, and probably starting next year I'll drop it to 15%.

[RunningBum]

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Originally Posted by marko The way I look at it is that during our working days, whenever we're asked how much we made (legal, accountants etc) we gave them our pre-tax amount. I never said: " I make $X after taxes". So I view my SWR to include taxes just the same as if it were a salary. Gotta pay the taxes and spend the rest.

Sure, but how did you do your own budget? I always added up my mortgage, utilities, food, etc and set that against my take home pay--not my gross pay before taxes. Nor did I include income and SS taxes as expense items in my home budget.