Withdrawal Rates and Taxes

[RockyMtn]

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.

 

[jdw_fire]

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)

 

[Rich_by_the_Bay]

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.

 

[RockyMtn]

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?

 

[RockyMtn]

Unfortuantely this income is coming all from taxable accounts. Can't draw on retirement accounts for another 7.5 years.

 

[jdw_fire]

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).

 

[jdw_fire]

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.

 

[RockyMtn]

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.

 

[audreyh1]

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.

Audrey

 

[RockyMtn]

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.

 

[walkinwood]

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.

 

[smjsl]

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.

 

[jdw_fire]

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.

 

[jdw_fire]

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)

 

[walkinwood]

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.

 

[LOL!]

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.

 

[jdw_fire]

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.

 

[jdw_fire]

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

 

[FIREd]

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.

 

[jdw_fire]

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

 

[clifp]

JDW

I think your example is very unrealistic, I can say in my 10 years of being retired with taxable assets roughly twice the level you talked about I never got close to 40K taxes even as single guy with minimal deductions. Most investment/pension/social security income is taxed at favorable rates, I think LOL 5-7% rates is much closer to what I have experienced and is huge drop from when I was working.

 

[teejayevans]

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.

I'd like to know how HR block figure that out...this is why you don't
go to H&R Block...the tax would actually be around $1180.

Try another tax tool (TurboTax has a online tax estimator or download TaxAct).
TJ

 

[LOL!]

jdw_fire, many folks here have more than a million dollars in liquid taxable assets. They don't pay taxes at the average rates that you suggest because they have some understanding of the tax laws.

I could pull all the money out of my taxable portfolio on Monday and owe no income taxes. You may be amazed by that, but you shouldn't be. It's all about how you set your portfolio up to be tax efficient. Put your tax-inefficient assets in your tax-sheltered accounts and use tax-efficient investments in your taxable account. Just because they are tax-efficient, does not mean you are not getting the portfolio return that you expect for such an asset allocation. You are, however, not paying the taxes that someone who doesn't understand asset location would be.

I'd rather have $160K in gains that I paid $0 in taxes on than $160K in gains that I paid $40K in taxes on. Once again, turbo-tax can help you understand all this.

 

[RockyMtn]

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 Tax Brackets (Federal Income Tax Rates) 2000 through 2009
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

JDW has hit the nail on the head (at least in my situation). Depending on the types of gain the tax man is going to cometh no matter what. Yes you can minimize them as LOL says using tax loss harvesting, capital loss carryovers, etc. but that is not always available or still doesn't necessarily offset the entire gain 100%.

In the end I would rather pay the taxes and have the higher growth of the portfolio than be a slave to a SWR.

 

[jdw_fire]

JDW

I think your example is very unrealistic, I can say in my 10 years of being retired with taxable assets roughly twice the level you talked about I never got close to 40K taxes even as single guy with minimal deductions. Most investment/pension/social security income is taxed at favorable rates, I think LOL 5-7% rates is much closer to what I have experienced and is huge drop from when I was working.

and just what were your AGI and deductions? if you dont make that kind of income then you wont be paying that kind of taxes. i am not saying it is common for retired people on this board to pay that kind of taxes but then they arent making that kind of money either (and of course it makes a difference how you get that income, whether it is tax favored (like LTCG and dividends) or not favored (like interest or STCG)). just becauase you arent making that kind of income doesnt mean someone else isnt. remember the high interest rates of the early '80s? if someone investing a million back then was concerned about investing in the stock market so s/he invested in bonds (and other loan type instruments) s/he could have been pulling down 16% interest on the million and thus been paying that amount in taxes (especially since tax rates were higher). and just because you dont get that kind of a taxable return on your money now doesnt mean nobody does.

yes i picked an extreme example (16% taxable income) to make my point but that doesnt mean it is invalid, instead it just shows off my point. what if you were getting 12% instead of 16%? using the standard 4% rule and paying taxes out of it would still only leave you with ~$15,500 after fed income taxes for your yearly living expenses when actually you netted over $100k in income after said taxes (and i didnt even say anything about state income taxes). or what if in the future tax rates go up, then you wouldnt even have to make a 12% taxable yield. or if again in the future LTCG are taxed at the same rate as all other income, then just selling some property could do the trick.

but even if you dont have that kind of taxable income, look at the point i am making. all i am saying is that sometimes (under some circumstances) paying your income taxes out of your "SWD" doesnt really make sense. and those times are when you have a very high taxable income (or if tax rates go up). so then now comes the question, if that is true, at what level of taxable income does it start making sense to pay your income taxes out of the "SWD"? at very low levels of taxable income (my examples here are any of the posters here who have proudly posted that they pay $0 in fed income taxes) it doesnt matter since the taxes are so low or nonexistant. so it must be those "middle" incomers. but by doing such the need to minimize taxes kind of dictates to them how they will invest (eg. for LTCGs instead of income) and that is all well and good if that is how you want to invest in the first place but maybe it is more appropriate to invest for total, after tax return, even if it produces a large taxable income. sooo maybe it is more appropriate for you to treat your portfolio as a machine that provides you with an after tax amount of money (meaning that the taxes are paid from inside the machine) and in operating that machine you try to maximize your after tax return on the assets in said machine. and then, to make you feel more comfortable about your retirement assets lasting your lifetime you can always lower your after tax "SWR" that you take out of your machine.