The traditional approach for managing the imbedded tax liability in retirement assets is fairly straightforward:
1) Access taxable accounts (such as a taxable savings account).
2) Access partially tax-deferred assets (e.g., stock held outside a qualified plan).
3) Access tax deferred accounts (an IRA, annuity or qualified retirement plan).
This approach is based on the premise that continued income tax deferral creates greater economic benefit for the individual.
But is the traditional approach always best? And, does the optimal tax distribution plan change if the client wants to maximize assets available to future generations?
Let’s take a hypothetical case. Assume a husband, age 65, and wife, age 63, have $25,000 in taxable investments, $250,000 in capital or equity investments (with a tax basis of $50,000), and $450,000 in an individual retirement plan. Both are retired, but the wife plans to work 2 more years for $25,000 a year. The couple seeks $75,000 of after-tax income (including Social Security) in year one of retirement, to increase each year by the rate of inflation. For ease of comparison, assume a constant 7% investment return for all asset classes. All current tax law rules, including scheduled tax rates changes and required minimum distributions for the IRA, apply. The target retirement income and Social Security benefits will grow by 2.8% a year.
The couple wants to maximize the assets left for their 2 children, and so is seeking the optimal income distribution strategy. The tables show 3 scenarios for the couple, where Social Security for the older spouse commences at 1) age 62; 2) age 67; and 3) age 70. The comparison focuses on the traditional distribution strategy described above versus a pro rata distribution strategy, where the couple receives proportionate distributions from all accounts, regardless of tax status.
Table 1, the age 62 analysis, assumes Social Security payments begin when the husband reaches age 62 (or 3 years before the start of the distribution modeling). Here, pro-rata withdrawals from currently taxable and tax-deferred assets result in a slightly longer asset duration. This shows that it is possible for an alternative withdrawal strategy to result in equal or greater asset longevity relative to that produced using the traditional approach.
Would the traditional strategy be optimal if the couple died prematurely? If both die within 20 years of retirement, the pro-rata withdrawal strategy maximizes the net after-tax amount for heirs. Given that this strategy is also slightly better for asset longevity than the traditional strategy, the financial planner should suggest a pro-rata withdrawal from all asset classes rather than the traditional distribution approach.
Note: Once the couple’s assets have been depleted, Social Security provides only 35% of the target income. Of course, it is not optimal to be left with an asset that only provides for 35% of expected retirement needs; we will look at ways to increase this percentage later.
Table 2 shows what happens if the start of Social Security payments is deferred until age 67. Here, the traditional distribution strategy is optimal.
The delay in start date also extends the duration of the assets, from approximately 19 years to 23 years. This is likely because the delay in benefits both increases the amount of Social Security benefit and reduces the income tax paid on those benefits because the wife continues to work (Social Security benefits are taxable over certain income thresholds). It is also possible that the delay forces use of assets that are temporarily subject to lower tax rates (i.e., the lower rates on capital gains which are in effect through 2009) to meet the required annual target income.
When considering assets available for heirs in event that both die within 20 years of retirement (or when the husband is age 85), the traditional distribution leaves the greatest after-tax amount for the couple’s heirs. However, if the couple dies within 15 years (when the husband is age 80), the pro-rata strategy is slightly preferable.
This makes the right choice for the couple less clear. If the goal is to maximize asset duration without regard to whether the approach will maximize after-tax assets for heirs, then the traditional strategy is optimal. However, if the couple is concerned about leaving the maximum amount for heirs and also about their own health, more modeling may be required to determine the best strategy.
Delaying the start of Social Security payments until age 67 also leaves the couple in a better position relative to their income target, once the assets are depleted.