Safe withdrawal rate questions

[jhecht]

I apologize if these questions have been covered before, but I was trying to understand this concept and had a few questions.

First, how do taxes come into the equation? Do you assume that you are paying taxes due on investment income/cap. gains out of the 4 percent withdrawn, or out of the accounts themselves (i.e., is this factored into the return on the investments themselves)?

Second, I had read somewhere that you could potentially increase the safe withdrawal rate (maybe to around 4.8 percent) by devoting more of your portfolio to inflation protected instruments (TIPS?). Is that considered to be accurate, particularly with interest rates on such bonds at a lower level? (I understand that, in any event, this strategy would reduce the expected value of your portfolio at the end of the period).

Finally, it would be interesting to get an intuitive feel for how the safe withdrawal rate works in a simplified example that controlled for inflation, e.g., through a TIPS type portfolio, and limited risk. Does anyone have a sense for what a safe withdrawal rate would be if, for example, you were 100 percent invested in TIPS at current interest rates?

Thanks for any help.

 

[kaudrey]

Hi,

Well, I haven't really thought about an all TIPS portfolio, but on the first part - I count taxes as part of my spending.

Taxes are a line item part of my projected expenses and have to "covered" by the money I plan to withdraw, just like food and travel expenses.

 

[retire@40]

First, how do taxes come into the equation? Do you assume that you are paying taxes due on investment income/cap. gains out of the 4 percent withdrawn, or out of the accounts themselves (i.e., is this factored into the return on the investments themselves)?

Income taxes are just like any other expense. You have to include income tax expense in your SWR.

 

[audreyh1]

First, how do taxes come into the equation? Do you assume that you are paying taxes due on investment income/cap. gains out of the 4 percent withdrawn, or out of the accounts themselves (i.e., is this factored into the return on the investments themselves)?

Yes, unfortunately, all taxes incurred by the investments, or by withdrawals from tax-deferred investments must be paid out of that 4%, so in reality you have something less than 4% to actually live on.

Audrey

 

[mickeyd]

Welcome jhecht,

First, how do taxes come into the equation?

I am still about a year from entering into my distribution phase, but I consider all expenses and taxes (all taxes) as a large part of the formula. For example if I am withdrawing 4% from my stash, all of my taxes (income, property etc) would be paid from whatever money that the 4% represented.

I had read somewhere that you could potentially increase the safe withdrawal rate (maybe to around 4.8 percent) by devoting more of your portfolio to inflation protected instruments (TIPS?).

Do you have a link to that TIPS story? I would probably disagree that any single one asset class would, by itself, would prompt me to make such a change. Remember that TIPS is a bit more volatile than some other bond allocations, as many Vanguard TIPS fund investors are finding out.

Does anyone have a sense for what a safe withdrawal rate would be if, for example, you were 100 percent invested in TIPS at current interest rates?

I do not believe that investing in 100% of anything would work unless you had unlimited funds and non-variable expenses.

 

[FIRE'd@51]

Second, I had read somewhere that you could potentially increase the safe withdrawal rate (maybe to around 4.8 percent) by devoting more of your portfolio to inflation protected instruments (TIPS?). Is that considered to be accurate, particularly with interest rates on such bonds at a lower level? (I understand that, in any event, this strategy would reduce the expected value of your portfolio at the end of the period).

You can prove this number to yourself using a financial calculator. It is calculated just like a fixed-rate self-amortizing mortgage but using 2.5% for the YTM of a 30-year TIPS.

Present Value = 100

Future Value = 0 (note that this reduces the ending value of the portfolio to zero)

Interest rate = 2.5%

Number of periods = 30

The result is Payment = 4.78 which implies a nearly 4.8% SWR

Today the YTM on a 30-year TIPS is closer to 2.2%, so the SWR would be about 4.6%.

More importantly, the withdrawal of principal from a TIPS portfolio is logistically difficult, because the price of a TIPS moves around a lot (similar to an ordinary bond) as the level of real interest rates change. What we really need is an interest-only TIPS, which would be created by selling off the maturity payment of a regular TIPS. To the best of my knowledge, no broker-dealer has separated TIPS this way yet, but if/when they do, it would be just the product you (and others) are looking for.

 

[JohnEyles]

You can prove this number to yourself using a financial calculator. It is calculated just like a fixed-rate self-amortizing mortgage but using 2.5% for the YTM of a 30-year TIPS.
...
The result is Payment = 4.78 which implies a nearly 4.8% SWR

...

More importantly, the withdrawal of principal from a TIPS portfolio is logistically difficult ...

In a massive TIPS thread a month or two ago, I posted a spreadsheet (or rather a
printout of a spreadsheet) which showed how this return-of-principal might be done.
The basic idea was to a have a ladder of five 5-yr TIPS. Each year, one would mature.
You would take your WR from the interest paid during the previous year on all 5 TIPS,
supplemented as ncecessary with some fairly small proportion of the proceeds from
that year's maturing TIPS. The remaining money would be invested into a new 5-yr
TIPS.

Worked nicely, as expected. A WR of 4% could be sustained for about 35 years assuming
coupons of 2.5%, and this held up over a rather wide range of inflation numbers. Of
course, the assumption that you can always roll the money from the maturing TIPS
into one with 2.5% coupon is a rather massive one. OTOH, if coupons > 2.5% become
avaliable, as someone here said, "back up the truck".

My forum-searching kung-fu is not strong enough to find that old thread.

 

[rmark]

The 4% is based on past U.S. market returns, before investing costs and taxes.