Editor’s note: Across the gamut of our 2023 articles explaining tax law changes, the bewildering economy, and how to be a better advisor, these Members’ Choice runner-up articles equipped you for powerful performance. These just missed a spot in our annual Top 10 list, but were still among the most popular articles of the year.
Everyday we need to be thinking about tax-efficient investing and how our investment decisions can create additional savings on behalf of our clients. Of course, many advisors are aware and practicing tax-loss trading, rebalancing and capital gain harvesting. But there is more to tax efficiency than the obvious, particularly for those clients who have accumulated a fair amount of wealth and want to leave a legacy.
This is where retirement distribution planning comes into play, which is one of the trickiest things for advisors to tackle. But for certain clients, mastering this area can mean millions of dollars of additional wealth for those clients and their families. And with that increased wealth comes loyalty and additional assets for you.
The importance of tax alpha in retirement
In early November 2022, 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. James DiLellio, PhD of the Pepperdine Graziadio Business School, and Andreas Simon, of the University of Southern California received recognition for their paper titled “Seeking Tax Alpha in Retirement Income,” in which they discuss the results of a study focusing precisely on this topic of creating additional tax savings (Download the full paper). By making better decisions when withdrawing from portfolios in early retirement, investors are increasing portfolio size and longevity. The study has received a fair amount of positive coverage in the Wall Street Journal and ThinkAdvisor.
Sadly, this concept of tax alpha in retirement is nothing new. According to a recent Wall Street Journal article, for the better part of a decade, research has shown that “blending withdrawals often can be more effective. That means pulling funds—say, beginning in your early 60s—from both taxable accounts and tax-deferred accounts, a so-called proportional approach. In doing so, you can chip away at IRA balances, as well as future taxes, a decade or so before RMDs kick in.” Despite a general consensus that there should be more flexibility in approaching retirement distributions, this concept has been largely ignored outside of academia, probably because clients aren’t aware enough to ask for it and the work is complex and non-scalable.
What is tax alpha and how is it created?
To address some of these practical challenges, the authors behind the study also created a retirement income calculator (along with the extensive white paper and presentation discussed further below) modeling optimal decisions for tax-efficient retirement income. The authors propose a simple heuristic to determine what retirement income strategy is optimal, quantifying a .5%–.8% annual return benefit.
The bottom line is that it is often optimal to pay taxes “early,” which is contrary to the “common rule” (which is what most CPAs and tax preparers advocate to their clients). The common rule is a withdrawal sequence where RMDs are drawn first, then you withdraw from your taxable account until depleted, then tax-deferred accounts and finally tax-exempt accounts.
As DiLellio and Simon note in the ThinkAdvisor interview, “the common rule 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.”
DiLellio and Simon suggest 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. 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.
Their study further suggests that there are strategic benefits to paying taxes earlier, particularly for a retiree and spouse with a large age difference, thereby limiting the widow’s penalty, about which we have written so much. The author also advocates that we should avoid large income “spikes,” and therefore the best way to avoid the “jump up” in income is to draw down earlier in retirement.
Review of case studies demonstrating tax alpha
The key with the optimal withdrawal strategy is instead of withdrawing money in the strict order stated above as part of the common rule, investors should mix these accounts. By changing the withdrawal sequence, an investor can increase portfolio longevity (through the reduction of the widow’s penalty) or preserve more money for heirs.
In a case study, the authors show us that a retiree increases portfolio longevity from 30 years to 35 years by ignoring the common rule and instead relying upon a “modified approach” where the client withdraws from the IRA earlier in retirement, at about $109,000 in the first year. By doing this, the portfolio lasts from age 90 to age 95, earning an extra 90 basis points a year in tax alpha. In essence, because the tax liability is more front-loaded for the modified conventional approach, the investor is able to avoid that widow’s penalty.
The authors also present a second case study, focused on creating a larger inheritance for heirs. The married couple is closer in age, and they are looking to spend $150,000 a year at a 25% marginal rate. They have a 60/40 portfolio and some pension income. By using the optimal withdrawal strategy instead of the common rule (which draws down taxable accounts first), the client is able to leave over $280,000 more at the end of their lives, adding tax alpha of .55% a year. The common rule is less tax efficient because the widow is filing taxes as single in those later years. In this case study, not only is the client withdrawing from the traditional IRA early on, but also taking a few small Roth IRA distributions to keep the tax rate a little lower.
In its recent article, the Wall Street Journal had similar findings, stating:
For example, a seminal study in the Journal of Financial Planning compared 15 methods of withdrawing funds from a $2 million portfolio with a 70-20-10 mix of, respectively, tax-deferred, taxable and tax-free assets. The authors found that, over the course of a 30-year retirement, a couple would pay about $225,000 less in taxes by tapping the tax-deferred account first (up to the level of one’s taxable deduction) and then tapping a taxable account, compared with withdrawing funds in the traditional manner.
The calculators and running the numbers
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. Although those calculators are a good starting point, they do not go far enough and can create misleading results.
The author’s calculator focuses on one of two things in its modeling: portfolio longevity and creating an inheritance for heirs. The calculator also focuses on rising tax rates and how they affect the recommendations, a critical component. The more taxes go up in the future, the more opportunity for tax alpha, and the authors deem that a more critical factor than portfolio construction or future returns.
When you run the calculator, you get the common rule results and you can see the potential tax alpha and extended portfolio longevity. For a one-year subscription, the cost is $99.95 per year, whereas IncomeSolver is closer to $1000.
However, it appears as if IncomeSolver has built out additional functions that would be useful to an advisor, and at this time Income Solve is still our preferred calculator as it addresses all of these distribution needs: RMDs, taxable accounts and Roth conversions. We will be following up in additional articles about how best to approach creating tax alpha with the tools that are available to us.
In short, tax alpha is a critical service to offer clients, particularly high-net-worth clients who have plenty of money and are thinking about intergenerational planning. This is a nascent area, with the tools being developed as we speak. A savvy advisor should accept the current imperfections and focus on building out this area of their practice, as it will only become more and more important going forward.
Update: An earlier version of this article suggested that using both calculators might create the optimal recommendations. However, since the initial writing, the author has made further review and determined that IncomeSolver is the calculator of choice. See also the author’s comments in the feedback section below.