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Tax planning is weaved throughout our Retire With Purpose planning framework because at one point or another, it impacts all areas of your retirement plan. Here, past podcast guest, Wade Pfau, highlights how to strategize the withdrawal order between your three tax buckets (taxable, tax-deferred, tax-exempt) by utilizing two different distribution methods: The adjusted gross income (AGI) threshold strategy versus the incremental average tax rate method.READ THE ARTICLE
The study: Both of these options are compared on the sample client: A couple with $3.2 million in assets, age 60, recently retired, with the objective to build a financial plan that covers spending goals through age 95, while maximizing an after-tax surplus of wealth. Additionally, the case study assumes a fixed portfolio of five percent (including 2.5 percent inflation), along with a portfolio mix of 60 percent stocks, 40 percent bonds and a dividend yield of 2.5 percent (matching inflation).
AGI results: The AGI threshold strategy involves “filling up” specific income (or AGI) thresholds with Roth conversions to see which income thresholds provide the best outcome. It utilizes varied income thresholds over time, but can also “create computational problems, as there are limitless variations of income thresholds to use at any age.” With the couple of focus here, the AGI threshold produces a legacy of $907,208; however, it doesn’t lend well to Roth conversions over the long-term due to higher IRA distributions covering spending needs and can increase taxes once the taxable account is depleted.
Incremental average tax rate results: On the other hand, the incremental average tax rate involves “continuing to draw from the tax-deferred account while the average tax rate on just the incremental disbursals stays below a targeted level.” It also considers the impact of ordinary income marginal tax rates, taxable Social Security, future Medicare premiums and additional net investment income/ Medicare surtaxes. With this method, the couple ends up with a legacy of $912,008, are more likely to avoid the Social Security “tax torpedo” at age 70, maintain lower taxes after age 72 and overall, are provided with greater financial benefit through the “frontloading” of taxes.
Maintain an evolutionary strategy: You simply can’t follow ancient retirement guidance; It might ignore the current environment, as well as the latest research.