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November 15, 2022 at 11:34 AM
What You Need to Know
- A new academic analysis challenges the conventional wisdom advocated by many CPAs to defer taxes for as long as possible.
- Tax efficiency can deliver up to several years of additional portfolio longevity while improving estate plan efficiency.
In early November, the CFP Board’s Center for Financial Planning announced the recipients of its 2022 Best Papers Awards, presented during the center’s sixth annual Academic Research Colloquium.
As in past years, the 2022 Colloquium brought together respected researchers from around the world to present their work on investments, psychology, behavioral finance and other financial planning-related fields.
Among the paper authors earning recognition at the 2022 event were James DiLellio, of the Pepperdine Graziadio Business School, and Andreas Simon, of the University of Southern California. The pair were recognized for their presentation of a paper called “Seeking Tax Alpha in Retirement Income.”
According to DiLellio and Simon, financial advisors and their clients can generate a meaningful amount of “tax alpha” by rethinking the retirement income planning process. In a discussion with ThinkAdvisor about their results, the pair said one clear takeaway from their paper is the need to rethink the so-called “common rule” retirement account withdrawal strategy.
A better approach, they explain, involves deeper consideration of the client’s ability or desire to bequeath assets to the next generation and greater attention being paid to the heir’s anticipated future tax burden. By taking a smarter approach, the pair show, advisors and their clients can extend the lifetime of a given portfolio by several years.
How the Common Rule Falls Short
As defined in the paper, the common rule withdrawal strategy is both commonly employed by financial advisors and relatively straightforward to follow.
The common rule approach first suggests that clients draw required minimum distributions from tax‐deferred accounts, when applicable, each year, and then any unmet income needs are subsequently sourced from taxable account funds until these are exhausted. Finally, tax‐deferred account withdrawals are made until these accounts are exhausted and the portfolio closes.
As DiLellio and Simon note, this approach does lead to some degree of tax efficiency, which helps to account for its popularity. However, the common rule approach is suboptimal for many individuals, the researchers warn, and the main reason for this is that it does not consider the various situations in which it may make sense to pay taxes earlier than is strictly necessary.
A More Tailored Income Approach
The paper suggests the actual optimal strategy for a given individual will depend on the relationship between the retiree’s net worth (including the present value of annuities) and the retiree’s desired retirement income and estate goals. While tax optimization matters for all clients, the pair explain, those with excess assets and ambitious inheritance goals have the most to gain.
