If you’re like most pre-retirees, retirement planning starts by asking if you’ll have enough income during your retirement. If it appears you’ll generate adequate income, the focus shifts to tax and investment techniques that will maximize this income. In other words, “given my income, how can I retain more of it?” However, if you’re upper middle-income or affluent, your retirement planning is best addressed by using a different approach. The better retirement planning method for this demographic is to create an efficient retirement drawdown strategy. Instead of starting with income, focus in its place on how to efficiently decumulate or “drawdown” your assets and benefits.
Retirement Drawdown Goals
There are three basic financial goals most affluent consumers share in creating their drawdown strategies:
– Retirees target a monthly cash flow during retirement years to maintain their desired standard of living. This cash flow may derive from principal or interest in an investment, an employer benefit program, or a government program. Whatever the source, the measure is after-tax cash flow. So, whether you withdraw $10,000 after-tax monthly income from a Roth IRA or $13,000 from a taxable IRA, your target is to have $10,000 after-tax cash in hand.
– Maximizing returns on capital remains crucial. Because you may be in retirement 30 years or more, you’ll want your decumulating investments to generate income and/or capital gain. The more return these assets generate, the slower the pace of decumulation.
– Making full use of retirement benefits is a goal among all income groups. Whether the benefit is from an employer (e.g. a pension plan) or the government (e.g. Social Security), retirees see these benefits as earned. With affluent retirees, however, there are typically more challenges and opportunities with the timing of the receipt of these benefits. Taking too early may lessen your longevity protection; taking too much may cause waste due to unnecessary taxation. If you can maximize the timing and taxation of benefits to create additional after-tax cash flow, you can slow the pace of decumulation of your other retirement assets.
Key Drawdown Strategies
How can you accomplish these financial goals with your drawdown strategies? There are three basic ways to maximize efficiencies.
1. Tax efficiency in withdrawals is a primary strategy, and typically one that becomes increasingly important the greater your wealth. The techniques are numerous and varied. For example, it may involve timing of Roth IRA versus IRA withdrawals to limit taxes, directing IRA funds to a charity to save on required minimum distributions (RMDs), and avoiding the Social Security tax torpedo through delayed filing. It often encompasses targeting taxable withdrawals to stay under income thresholds
for Medicare Part B, the net investment income (NII) surtax, and qualified business income (QBI) deduction. In sophisticated planning, it entails calculating how much of an IRA to convert to a Roth IRA to stay just under your next marginal tax bracket.
2. Portfolio efficiency during decumulation is also crucial. This involves the juggling of three factors in such a way as to maximize the overall after-tax efficiency of retirement capital: the tax status of accounts, the tax status of assets, and the growth potential of assets.
Here’s how it works. Some assets are tax efficient (e.g. tax-exempt bonds), and some are tax inefficient (e.g. REITs, mutual funds). At the same time, some retirement accounts are tax-free (e.g. Roth IRAs), while others are tax-deferred (e.g. IRAs), and yet others are after-tax (e.g. saving and investments). Finally, some assets have growth potential (e.g. stocks) while others do not (e.g. CDs, money markets). Portfolio efficiency involves locating the right kind of asset in the right account to leverage these attributes.
For example, you might place higher expected return assets in your tax-free account while locating lower expected return assets in your tax-deferred accounts. This helps avoid taxation on potentially high yielding assets. In other cases, you may put your least tax efficient assets in your tax-deferred accounts while keeping your tax efficient assets in your taxable accounts. This helps delay taxes on higher taxed assets.
3. An efficient order of withdrawals is a lifetime aspect of drawdown strategies. It’s not just a matter of setting up your withdrawal schedule on the date you retire and then going on autopilot. The ordering of withdrawals is where efficiency can be maximized.
Here’s how a typical order of withdrawal strategy might work. At retirement, you start withdrawing from your IRA until your taxable income is a few dollars below your next marginal tax bracket. Any additional needed cash flow would then come from your after-tax assets, such as your investments. Once you reach age 70, you generate part of your income by filing for Social Security, and this cash flow lessens the withdrawals you need to take from your other accounts. Finally, upon reaching age 70 ½, you begin to withdraw from your Roth IRA funds in order to minimize the tax burden of RMDs.
What’s the Secret?
You may look at your personal situation and be wondering how you can possibly sort through these strategies and come up with the right drawdown approach. The myriad ideas are a witch’s brew of confusing and seemingly contradictory tactics. Is there a secret drawdown strategy?
Despite the challenges, it is possible to create a workable drawdown strategy. It doesn’t involve secrets. It just calls for some work and a lot of planning. The following steps can help get you where you want to be with retirement drawdown strategies.
1. Accept that there is no one right strategy. The fact is that withdrawal strategies are not only complex, but also inexact. If you don’t believe this, Google the question “what is the maximum retirement income withdrawal rate?” A quick scan will provide you with opinions that range from 3.5% to over 8% of retirement capital. The reality is that every individual’s profile is unique, and the best you can do is come up with a strategy that maximizes the efficiency of your withdrawals.
2. Adjust and adapt your strategy. Getting to retirement involves enough shocks and deviations; but retirement itself has its own set of surprises. Drawdowns will need to be adjusted to account for returns on investments, changes in taxes and, most importantly, your personal fluctuations in needed cash flow. Your drawdown plan should be monitored and tweaked on an ongoing basis.
3. Get some help. With affluence comes complexity, and you’ll likely find that taking a DIY approach to determining your drawdown strategy isn’t efficient or even plausible. Consider the example of just one tactic used in the drawdown process: arranging your income to stay under key thresholds. For the NII surtax, the threshold is based on “marginal adjusted gross income;” for QBI it’s measured by “taxable income;” and to avoid the Social Security tax torpedo, it involves a “base amount” calculation unique to Social Security. There are experts who can help you with these complexities, as well as investing, portfolio management, and benefit maximization. In most cases, the expense for this kind of expertise is worth it in order to maximize the efficiency of your drawdowns.
4. Be informed. Outside experts, while beneficial, won’t be effective unless they understand your personal situation. And you won’t be able to explain your situation unless you are informed. In theory, you can gather up your benefit statements, brokerage accounts, and tax returns and hand them over to your advisor to sort through. In reality, this still leaves your advisor in the dark. Only you know your goals, your longevity prospects, your income needs, and your expected retirement outcomes. The more you learn about retirement planning as well as drawdown strategies, the more likely you are to succeed in retirement.
Retirement income drawdown strategies is an increasingly important topic for upper middle-income and affluent Americans. With wealthy individuals, tax efficient drawdown strategies are also important, but there are added challenges and opportunities. For example, a multi-millionaire may intentionally pay a 37% income tax on a withdrawal in order to avoid a 40% gift tax on that same amount.
My next post will look at the added complexities of creating effective drawdown strategies for the wealthy.