Making the Most of One s Nest Egg: Optimal Tax-wise Planning of Withdrawals from Retirement Accounts* INFORMS New York Metro Wednesday, December 12, 2007 Lewis Coopersmith, Ph. D. Associate Professor, Rider University Coopersmith Associates LLC *A manuscript has been prepared for publication with Alan R. Sumutka, CPA
Outline Motivation For DSS Development New Process For Planning Retirement Withdrawals The Optimization Model Results for Typical Scenarios Future Development
Motivation For DSS Development When I asked about planning my retirement income, my financial advisor recommended Conventional Wisdom (CW). However Considering federal taxes, CW does not always make sense The other piece of the puzzle is tax efficiency. You re probably familiar with the conventional wisdom: Draw down your taxable accounts first; then turn to tax-deferred accounts, like IRAs In this way, tax-deferred assets get more time to grow. But the sequence isn t always that simple * *Ruffenach, Glenn. 2005. Before You Open That Nest Egg The Wall Street Journal. December 12, 2005 R1.
Motivation For DSS Development Complicating Tax Issues Tax deductions and exemptions may offset taxes owed on taxdeferred withdrawals Delaying tax-deferred withdrawals may result in higher tax brackets when satisfying federal required minimum distributions (RMDs) after age 70.
Motivation For DSS Development More Complicating Issues Many different retirement accounts: Annuities may restrict how funds are withdrawn. Some retirement funds may have rates of return (RORs) less than taxable investments.
Motivation For DSS Development Still More Complicating Issues My financial advisor recommended selecting withdrawal rate with high sustainability probability Makes more sense to plan withdrawals based on my living expenses. Annual updating of withdrawal plans should reduce concern for sustainability!
Motivation For DSS Development Yet Still More Complicating Issues But what about tax impact Determine an acceptable withdrawal rate first then we can apply an average tax rate and see what s left for you to live on But makes more sense to figure out what s needed to live on then plan withdrawals for low tax impact.
DSS Objective Provide decision support for retirees and their wealth managers in planning retirement withdrawals. Use mathematical optimization to Determine amount to withdraw from each wealth source Assure satisfaction of before-tax expense specifications. Federal RMD constraints. Compute approximate federal income taxes as an integral part of the modeling process to maximize final accumulated wealth.
New Process For Planning Retirement Withdrawals* Fixed Data: Age, Account Values, Tax info, etc. Data Optimization Model Discretionary Data: Before-tax Expenses, Average Account RORs YES NO Feasible Solution? YES Re-evaluate Before-tax Expenses? RORs? OPTIONAL: Risk Analyses OPTIMAL PLAN (Account Withdrawals) NO Implement PLAN Selected From OPTIMAL PLANS *There is a patent pending on this process.
The Optimization Model Data Fixed over all scenarios: Retiree age, RMD coefficients, tax exemptions*, federal tax brackets* and tax rates. Social Security* initial amount, start year. Planning related dependent on lifestyle choices and investment portfolio distribution: Interest/ROR rate per account. Before-tax (federal) expenses. Sub-totaled tax-deductions. *cost of living adjustments are applied for each year during the planning horizon.
The Optimization Model Income Sources User specified: Social Security. Pensions, estimated earned income (for future development). Model determined withdrawals: Taxable savings and investments. Tax-deferred fixed annuities (fixed-term or lifetime). Non-annuity tax-deferred savings. traditional IRAs, 401(k) plans, etc. Tax-free savings (for future development). Roth IRAs, municipal bonds.
The Optimization Model Objective Function Maximize accumulated wealth at the end of the planning horizon. Other possible objectives: Maximize final taxable savings. Maximize before-tax expenses, given desired final wealth
The Optimization Model Constraints Withdraw no greater than available amount. Meet before-tax expenses. Satisfy federal RMDs. Others: To assure correct estimation of taxes For prototype model with a 25 year horizon and 3 account types, Number of constraints = 297
The Optimization Model Variables Model Determined Values Account withdrawals. Transfers from tax-deferred accounts to taxable savings.* Taxes For prototype model with a 25 year horizon and 3 account types, Number of variables = 300 *Other types of transfers can be considered in future model updates.
Results for Typical Scenarios Data A couple: Husband age 65, Wife age 63. Planning 25 years of retirement. Current retirement portfolio: $1,000,000 split - 1. Taxable savings investments: $100,000 average ROR: 5.5%. 2. Tax-deferred annuities: $300,000 average ROR of 5.0%. Withdrawals must be converted to either 10-year annuities or lifetime annuities. 3. Non-annuity tax-deferred: $600,000 average ROR of 7.5%.
Results for Typical Scenarios Current* Before-tax Expenses Item Annual Amount Household $40,800 Personal Care $7,200 Transportation $4,800 Leisure $11,800 Miscellaneous $4,800 Total $69,400 Itemized deductions: $20,800. *Husband s age 65
Results for Typical Scenarios Assumptions Withdrawals proportional to internal asset allocation of that account. Example: If account is 40% bonds/60% equities, a $1000 withdrawal will be $400 from bonds and $600 from equities. Social Security: 85% taxable. Excess* non-annuity tax-deferred withdrawals made at year-end and deposited in taxable savings. *(e.g., RMD more than amount needed to meet specified before-tax expenses)
Mortgage payments end Results for Typical Scenarios Baseline Data: Tabular Results ($000) Cash Needs Cash Sources/ Withdrawals Tax-Deferred Specified Beginning at age 70, some of the Total Age of Before-Tax Approx. Federal Cash-flow Social Taxable non-annuity account Total is withdrawn Remaining Husband Expenses Income Taxes (incl Fed Taxes) Security Savings Annuity due to Non-Annuity federal RMD Account Value [1] 66 $71.0 $1.6 $72.6 $16.0 $30.6 $26.0 $- $822.4 67 $72.7 $2.9 $75.6 $16.5 $23.0 $36.1 $- $773.2 68 $74.5 $3.9 $78.4 $25.5 $16.4 $36.5 $- $809.8 69 Most $76.3 of the annuity $3.8 account $80.1 is $26.2 $17.4 $36.5 $- $850.7 70 converted $77.9 into 10-year $8.1 annuities $86.0 and $27.0 $22.3 $36.7 $29.2 $888.8 71 exhausted $79.8 by the $8.5 second $88.3 year. $27.8 $23.8 $36.7 $31.4 $928.0 72 $81.8 $9.5 $91.3 $28.7 $22.7 $39.9 $33.7 $946.6 73 $83.9 $10.0 $93.9 $29.5 $24.4 $40.0 $36.2 $990.6 74 $86.1 $10.5 $96.6 $30.4 $26.2 $40.0 $38.9 $1,035.8 75 $88.3 $11.1 $99.4 $31.3 $28.1 $40.0 $41.7 $1,082.0 76 $89.7 $7.6 $97.3 $32.3 $51.0 $14.0 $44.8 $1,107.2 77 $92.0 $6.5 $98.5 $33.2 $61.5 $3.8 $47.9 $1,123.4 78 $94.4 $6.9 $101.3 $34.2 $63.5 $3.6 $51.4 $1,138.7 79 $96.9 $7.4 $104.3 $35.2 $65.5 $3.6 $54.9 $1,153.4 80 $99.5 $8.0 $107.5 $36.3 $54.9 $3.5 $58.6 $1,166.8 81 [2] $96.3 $8.6 $104.9 $37.4 $45.6 $3.4 $62.4 $1,185.0 82 $88.1 $8.8 $96.9 $38.5 $43.9 $0.2 $66.5 $1,211.1 83 $90.9 $9.4 $100.3 $39.7 $52.3 $0.2 $70.9 $1,236.7 84 $93.8 $10.1 $103.8 $40.9 $62.7 $0.2 $75.5 $1,261.7 85 $96.8 $10.7 $107.5 $42.1 $65.2 $0.2 $79.9 $1,285.6 86 $99.0 $11.5 $110.4 $43.3 $66.8 $0.3 $84.5 $1,309.4 87 $102.1 $12.3 $114.4 $44.6 $69.5 $0.3 $89.3 $1,331.8 88 $105.5 $13.1 $118.6 $46.0 $72.3 $0.3 $94.2 $1,352.4 89 $108.9 $14.0 $122.9 $47.4 $75.2 $0.3 $99.4 $1,371.0 90 $112.4 $14.8 $127.2 $48.8 $77.8 $0.6 $103.7 $1,388.7 Low taxes due, in part, to itemized tax deductions and exemptions in the range $27,000 43,000 over the 25 year horizon.
Annual Withdrawal ($000) Total Account Value ($000) Results for Typical Scenarios Baseline Data: Graphic Results $250 $1,600 $200 $150 $100 For ages 66-79 and from 84-90, total cash flow comes from Social Security, 5- year annuities and taxable savings. $1,400 $1,200 $1,000 $800 $600 $50 $- During ages 80-83, some of RMD withdrawal is used to satisfy the total cash-flow. 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 Age of Husband $400 $200 $- Social Security Non-Annuity Deferred Withdrawals Total Cash-Flow (incl Fed Taxes) 10-Year Annuity Withdrawals Total Account Value (Right Axis) Taxable Savings Withdrawals Specified Before-Tax Expenses
Results for Typical Scenarios Baseline Data: Wealth Planning Implications Limited use of non-annuity deferred savings before age 80 suggests redistributing this portfolio for greater ROR in early years, even with higher volatility. New plan: Re-distribute to target RORs of 8.5% for ages 66-73, 7.5% for ages 74-80 and a lower risk 6.5% for ages 81-90. New optimal plan result: final total account value of $1,448,755 4.3% higher than initial plan.
Results for Typical Scenarios Conventional Wisdom Vs. Baseline Conventional Wisdom (CW) Policy: Withdraw retirement income from taxable savings first, then from taxdeferred accounts. Tax-deferred withdrawn: 10-year annuity first. Then non-annuity.
Final Wealth ($000) After 25 Years % Improvement Optimal over CW Results for Typical Scenarios CW Vs. Baseline: Graphic Results $3,000 $2,500 $2,000 $1,500 $1,000 $500 $- $312 14.7% CW Exhausted Year 25 $612 Advantages of optimal policy over CW increase as initial wealth varies either above or below a level that could be considered in line with expense needs. 8.3% $900 $1,160 5.6% $1,389 $1,601 $1,810 4.3% 3.9% 5.9% Initial Total Wealth $2,014 $2,212 7.5% 7.8% $2,408 8.1% 8.8% $10 CW. Two plans are similar: optimal 0% $750K $800K $850K $900K $950K $1000K $1050K $1100K $1150K $1200K $1250K Optimal Conventional Wisdom % Improvement NOTE: If lifetime (right axis) annuities substitute for 10-year annuities in CW, final wealth of optimum is 16% higher! 20% 10% Optimal results slightly better than plan starts drawing 10-year annuity year earlier than CW.
Results for Typical Scenarios CW Vs. Baseline: Wealth Planning Implications For retirees with relatively low savings: Optimal planning improves chances that initially specified before-tax expenses will be sustainable. For retirees who have more than enough to meet basic needs: Optimal planning provides wealth managers greater leverage to work with retirees to better manage account portfolios to enhance quality of life.
Results for Typical Scenarios Baseline plus Car Purchases How does model smooth tax burden for occasional large expense needs? Consider car purchases every 5 years at ages 70, 75 and 80 for $20,000, $25,000 and $30,000
Annual Withdrawals ($000) Total Account Value ($000) Results for Typical Scenarios Baseline + Cars: Graphic Results $250 $1,400 Age 70 Cash-flow $106,400: $200 -Social security ($27,000) -Taxable savings ($32,100) -Annuity payment ($39,400) -Part of the $150 RMD ($7,900) for nonannuity tax-deferred savings Age 75 Cash-flow $124,000: -No contribution from RMD for nonannuity tax-deferred savings $1,200 $1,000 $800 $100 $600 $400 $50 At age 80, withdrawals from non-annuity taxdeferred savings at ages 79 (~$5,000>RMD) $200 and 80 contribute most of the cash needed for the car. $- 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 Age of Husband Social Security Non-Annuity Deferred Withdrawals Total Account Value (Right Axis) 10-Year Annuity Withdrawals Specified Before-Tax Expenses Taxable Savings Withdrawals Total Cash-Flow (incl Fed Taxes $-
Results for Typical Scenarios Baseline + Cars: Wealth Planning Implications Occasional need for large withdrawals is expected, but planning for them in an optimal tax-wise manner is complex. Optimal planning takes out guesswork! Automatically provides withdrawal policy with significant financial benefits.
Future Development Evaluate impact of adding other income sources: tax-free savings (e.g., Roth IRAs, municipal bonds). capital gains. Use optimal planning to analyze Age to start Social Security. Need for long-term care insurance. Use optimal planning as part of ROR simulation to assess sustainability risk.