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Retirement Planning > Spending in Retirement > Required Minimum Distributions

Delaying Taxes in Retirement Isn’t Always Best, Award-Winning Paper Shows

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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.

At a high level, DiLellio and Simon explain, portfolio longevity can be extended by more tax‐efficient planning that includes knowledge about the heir’s tax rate. In basic terms, the optimization model suggests many individuals will see greater portfolio longevity if they plan to draw income from their tax‐deferred accounts up to the heir’s tax rate before then turning to using taxable account funds.

According to DiLellio and Simon, a key insight in their findings is that portfolio longevity tends to increase if one defies conventional wisdom to always defer taxes until future years. Among the most effective approaches to possibly extending portfolio longevity, they explain, is careful Roth conversions during either pre-retirement or early retirement years.

“Our results demonstrate that withdrawing from the tax‐deferred account earlier than the RMDs suggest can provide real benefits,” the pair writes. “We show that these results are mostly generalizable across several varying conditions.”

Industry Implications

According to DiLellio and Simon, large financial institutions such as Fidelity and Vanguard currently provide retirement income planning tools that rely solely on the common rule withdrawal strategy.

“Our findings suggest that their enterprise applications should not be entirely discarded due to their heuristic benefits,” the pair writes. “Instead, results from the common rule strategy can be used to guide the next level of optimization that has a substantial benefit to tax‐efficient retirement plans.”

According to the analysis, some fintech firms, including Personal Capital, Betterment and others, are beginning to move in this direction.

“Ultimately, our findings challenge the conventional wisdom advocated by many CPAs to defer taxes for as long as possible,” DiLellio says. “We show the value of strategically paying some taxes earlier to avoid large taxes later due to RMDs or switching tax filing from married to single. Lastly, we show that tax alpha or the additional pre‐tax return realized by an optimal strategy is usually most sensitive to future tax rates, and least sensitive to the rate of return for the stock market.”

According to DiLellio and Simon, this final finding suggests simulation of stock returns is likely unnecessary to quantify the tax alpha available from more individualized planning.


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