Effect of taxes on withdraw rate

[jIMOh]

This idea came from another thread in this forum. Hoping the examples can help suggest how much to estimate in taxes for planning purposes and to make sure my math is accurate for my own planning purposes.

Example 1: Income need is 60k. Taxes married filing jointly. All money is in tax deferred accounts. Portfolio value is $1.5 M.

Taxes owed on 66k would be:

Exemptions $10,900 (standard exemption) plus 2 personal exemptions ($7000) is $17,900.
66k-17.9k=$48.1k Taxes owed on $48.1k is $6412.

5512/66000=8.3% taxes paid
66k/1500k is a 4.4% SWR.
$6412 taxes owed.

Example 2 Income needed is 60k. Portfolio value of 1.5 M. This portfolio is divided among taxable accounts which produce dividends ($750,000 with a 3% yield) and tax deferred account worth $750,000.

Taxes:
$750,000 yields 3% ($22,500). Taxes on this are 5% ($1125)
Tax deferred $750,000 has balance withdrawn (43000 withdrawn, 17900 exemptions, $2962 taxes paid)

Income: $22500+43000=$65500
Taxes paid: $1125+$2962=$4087

4087/65500=6.2% taxes paid
65.5/1500=4.3% SWR
$2962 taxes paid (half the first example).

Example 3: Income needed is 60k. Portfolio value of 1.5 M. This portfolio is mostly in a taxable account ($1.4 M) which produce dividends with a 3% yield, with the balance ($100k) in a tax deferred account.

Yield is 3%* $1.4 M=$42000.
Taxes owed is $2100 on the dividends.

Balance of needed income (20k) is from the tax deferred accounts. The standard exemption and personal exemptions ($17,900) make this effectively tax free. I have $21 taxes owed (10% of $2100).

Income is $42000+$20000=$62000
Taxes owed are $2100+$21=$2121
62/1500=4.1% SWR
2121/62000=3.4% taxes paid

Do I see the trend right-

As the amount from dividends and taxable accounts increase, the taxes owed and withdraw rates actually DECREASE? Or is there something obvious I am missing?

Thx

[OAG]

Pray (or hope) the tax rate for qualifying dividends survive the 5% rate into 2010 and beyond. If that happens then more dividends works better. I think there are more than a few on this board that have tax engineered a large amount of income from dividends.

[statsman]

I think what you are finding makes sense, but what is missing is that some of the balance in the taxable account is likely to have had taxes paid on it before capital gains/losses (assuming no inheritance, gifting, etc.).

[pksublime]

Yeah, but don't forget to throw in a Roth account too.

[FIREd]

I am of the opinion that tax diversification is an important aspect of financial planning. Right now we have about half our money in tax-deferred accounts and about half in taxable accounts (and a small chunk in Roths). Since we really have no idea what the tax code will look like by the time we retire I think it was better to keep our options open.

[jIMOh]

Quote:

Originally Posted by pksublime Yeah, but don't forget to throw in a Roth account too.

I was trying to keep the examples simple based on modifying only 2 variables. Adding a Roth to all 3 examples would decrease the SWR for each example, but example 3 would still have lowest SWR.

[jIMOh]

Quote:

Originally Posted by OAG Pray (or hope) the tax rate for qualifying dividends survive the 5% rate into 2010 and beyond. If that happens then more dividends works better. I think there are more than a few on this board that have tax engineered a large amount of income from dividends.

What were dividends taxed at before the Bush tax cuts?

[OAG]

20% Long Term. Marginal Rate for Short Term.

[FIRE'd@51]

Actually, the tax on qualified dividends (and LT gains) which fall into the the two lowest brackets (10% and 15%) is taxed at 0% through 2010. This year, for a married couple filing jointly, the 15% bracket tops out at 65.1K of taxable income (after deductions and exemptions). So, in your examples, the tax rate on qualified dividends is 0% (it was 5% in 2007). Adding back the 10.9K standard deduction and 7K for two exemptions means you could actually have AGI of 83K in qualified dividends (or 65.1K in qualified dividends and 17.9K of ordinary income) and owe no federal tax.

As was mentioned above, the Bush tax cuts will sunset after 2010; possibly sooner if they are repealed by Obama and a Democratic Congress. McCain says he wants to extend them, and therefore, would likely veto any attempt to repeal them before 2011. Obama says he will end the Bush tax cuts for those earning more than 250K. As far as I know, he has never made it clear whether he will keep the 0% rate on the two lower brackets. If he doesn't, he will be raising taxes on the middle class, which he says he won't do. Perhaps one of the many Obama supporters on this board can clarify this for us.

[clifp]

Quote:

Originally Posted by jIMOh What were dividends taxed at before the Bush tax cuts?

The same as interest i.e. ordinary income which at the top rate was ~39.6%. At some point there was a modest (IIRC $200) exemption for dividends, but I am not sure when that disappeared from our tax code.

The 20% rate was under Clinton the top rate for long term capital gains, but not dividends.

I wonder if there is a job? tax code historian... Google isn't all that helpful.

[Nords]

Quote:

Originally Posted by clifp I wonder if there is a job? tax code historian... Google isn't all that helpful.

How would they maintain the will to live long enough to ER?!?

[jclarksnakes]

How would the curriculum look for a degree in tax code history? Maybe one or two classes covering the dawn of man to the very beginnings of US income taxes and then a bazillion REALLY boring classes covering everything since. The last 47 classes would be so confusing that faculty and students would all need psychotropic medications.
Jeff

[jIMOh]

Quote:

Originally Posted by jclarksnakes How would the curriculum look for a degree in tax code history? Maybe one or two classes covering the dawn of man to the very beginnings of US income taxes and then a bazillion REALLY boring classes covering everything since. The last 47 classes would be so confusing that faculty and students would all need psychotropic medications. Jeff

Obviously most spending/withdraw calculators cannot take this into account when planning.

Sounds like there are 3-4 things which could/will? happen:

1) dividend rate for people in 25% bracket+ will probably go up (tax the rich)
2) dividend rate for people in 10 and 15% brackets may change to what they were before (this would be taxing the poor and middle class).
3) There is a huge tax risk when planning withdraw rates- I would assume the higher the needed income, the more this risk rears its head (my example used 60k income need and showed withdraw rate approaching 4%, with 80k income need (and $2 M in assets) I assume the SWR changed even more in above examples).
4) The worst case is to put the dividend funds back into tax deferred or tax free accounts and move other assets into taxable accounts if the new dividend rates are unfavorable.

[bamsphd]

Quote:

Originally Posted by jIMOh As the amount from dividends and taxable accounts increase, the taxes owed and withdraw rates actually DECREASE?

Yes.

Because of taxes, we all know that
$1,000,000 in a Roth IRA is better than
$1,000,000 in a taxable account, which is better than
$1,000,000 in a traditional IRA.

You seem to just be using a few examples which demonstrate this reality.

[rmark]

“Adjusting Withdrawal Rates for Taxes and Expenses” by Pye, Journal of Financial Planning April 2001