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Which Accounts Should I Spend from Each Year in Retirement?

A reader writes in, asking:

“Sometime in one of your posts, would you expound upon the pros and cons of prioritizing your spending from taxable vs. tax-deferred accounts during retirement, factoring in how one’s heirs will fare inheriting whatever is left over from either type of account?”

With regard to general planning about which account(s) to spend from per year, it’s easiest to start with a simplified analysis in which we assume that:

  • You’ll be spending all of the money during your lifetime, and
  • You have only Roth and tax-deferred accounts.

If all you have are tax-deferred and Roth accounts, the question for each dollar you need to spend is: how does my current marginal tax rate (i.e., the tax rate I would pay on this dollar, if I took it from tax-deferred) compare to the marginal tax rate I expect to face later in retirement?

  • If your current marginal tax rate is lower than the one you expect in the future, this dollar should come from tax-deferred.
  • If your current marginal tax rate is higher than the marginal tax rate you expect to face in the future, this dollar should come from Roth.

One key point here is that marginal tax rate is not necessarily the same thing as tax bracket. It’s quite common for retirees to have a marginal tax rate that’s higher than their tax bracket, because their income is at a point where additional income not only causes the normal amount of income tax, it also causes their eligibility for some particular tax break to decline. (Most commonly: It causes more of their Social Security benefits to be taxable.)

For many people, this means spending largely from tax-deferred accounts in the early years of retirement before Social Security kicks in, then spending from a mix of Roth and tax-deferred each year after that. (A common exception: Early retirees purchasing insurance on one of the ACA-established exchanges may want to prioritize Roth spending in the early years — to maximize subsidies — until they qualify for Medicare.)

What If You’ll Be Leaving Money to Heirs?

If you’re confident that you won’t be spending all of your money during your lifetime, the question changes. Instead of asking how your current marginal tax rate compares to your future marginal tax rate, we want to look at how your marginal tax rate compares to the marginal tax rate your heirs would have when they are taking the money out of the account (which, in most cases for IRAs, would start as soon as they inherit it, because they’d have to take RMDs over their lifetime).

In many cases, this suggests that prioritizing spending from tax-deferred makes sense, because it’s common for your marginal tax rate while retired to be lower than the marginal tax rate your heirs would have when they inherit the money, which would likely be while they’re in the late (i.e., peak earning) stages of their careers. But, as with anything related to tax planning, this varies from one family to another. Some families may find that the heirs would be better off inheriting a larger tax-deferred account than a smaller Roth account because the heirs have chosen a lower-paying career (thereby making their marginal tax rate lower).

What If You Have Taxable Accounts?

If you have significant assets in taxable accounts, the situation again depends on how much you expect to be leaving to heirs. In the case in which you expect to spend most or all of your assets, spending first from taxable accounts often makes sense in order to preserve your tax-advantaged retirement accounts. If, however, you expect to leave a large portion of the portfolio to heirs, and you have assets with large unrealized capital gains, it often makes sense to avoid liquidating those assets, so that your heirs can inherit them with a stepped-up cost basis — thereby allowing your family to avoid taxation on the gain completely.

Two Caveats

Caveat number one: I’m assuming with all of the above that the estate tax is not a concern. If estate taxes are a concern, the analysis changes somewhat, as it becomes relatively more advantageous to spend from tax-deferred accounts to minimize the size of the taxable estate. Of course, with the exemption where it is these days ($5.34 million in 2014 for single taxpayers, twice that for married couples), most people don’t have to worry about this.

Caveat number two: The approach presented above is very generalized. That is, any given person is likely to have factors affecting the decision in addition to the factors mentioned above. So, if you want the best analysis, meeting with a tax professional who can look at your personal situation is the best bet.

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Investing Blog Roundup: Safety-First Retirement Planning

When it comes to retirement planning, there are two broad schools of thought about how to cover your expenses. One method is to continue using a portfolio that looks much like the portfolio somebody would use during their accumulation stage (i.e., stocks, bonds, and mutual funds), albeit with a more conservative allocation. The other school of thought – the “safety first” method — relies on a different set of tools, such as bond ladders and annuities.

Elizabeth O’Brien of MarketWatch has more on the topic:

Other Money-Related Articles

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Are Dividends More Important Than Price Appreciation?

A reader writes in, asking:

“I’ve read that dividends account for the vast majority of the return of the stock market over history. I’m confused by the article you linked to last week about not being a dividend investor, given that dividends are so much more powerful than price growth.”

It’s true that, without dividends, you’d experience only a small portion of the market’s overall return over an extended period. But the idea that dividends are more powerful than price appreciation is a significant misunderstanding. (Unfortunately, I’ve seen this misunderstanding intentionally encouraged in the effort to sell products – dividend investing books, newsletters, etc.)

To explain, let’s look at an example of compound growth.

  • $1,000 compounded at 4% for 30 years gives you an ending value of $3,243.
  • $1,000 compounded at 5% for 30 years gives you an ending value of $4,322 (i.e., $1,079 more than you’d have with a 4% growth rate).
  • $1,000 compounded at 6% for 30 years gives you an ending value of $5,743 (i.e., $1,421 more than you’d have with a 5% growth rate).
  • $1,000 compounded at 7% for 30 years gives you an ending value of $7,612 (i.e., $1,869 more than you’d have with a 6% growth rate).
  • $1,000 compounded at 8% for 30 years gives you an ending value of $10,063 (i.e., $2,451 more than you’d have with a 7% growth rate).

The key pattern to notice here is that each additional 1% of return adds more to the ending value than was added by the previous 1% of return. This is just how the math works. Another important observation — which is simply another result of the same mathematical concept — is that, if you cut the return in half (e.g., compounding at 4% rather than 8%), you’ll experience less than half of the growth in value.

So, that last percentage of return — the eighth percentage point – added the most to ending value. But there’s nothing particularly unique about that eighth percent of return. That is, if we removed whatever it was that caused that eighth percent of return (such that you’d be left with a 7% growth rate), that would would have exactly the same effect as removing the cause of, say, the second percent of return. In either case, you end up with a 7% annual growth rate, and you end up with the same $7,612 ending value.

How This Applies to Dividends

The effects we’ve noticed above are amplified when we look at longer periods of time. And this is how people will sometimes come up with impressive-sounding factoids to convince you that dividends are more important than price appreciation.

For example, according to my 2012 edition of the Ibbotson Classic Yearbook — I haven’t purchased a copy for the last couple of years — from 1925-2011:

  • Large-cap stocks in the U.S. earned a total return (before adjusting for inflation) of 9.66%, of which
  • 5.42% came from price appreciation, and
  • 4.24% came from dividends.

Over a period this long (87 years), the difference between a 5.42% return (from price appreciation only) and a 9.66% return is staggering. If you had only experienced the price appreciation, you’d have just 3.24% of the ending wealth that you’d have if you’d gotten the total 9.66% return.

But the key point here is that if you had somehow earned just the 4.24% return from dividends (and had experienced no price appreciation), you’d have even less money.

In other words, factoids like the above can show us that it is important to reinvest dividends rather than spending them (if you’re in the accumulation stage, trying to grow your portfolio, that is). But they do not tell us that dividends are more important than price appreciation.

Investing Blog Roundup: Is Long-Term Care Insurance Likely to Be Beneficial?

One of the toughest questions about retirement planning is the question of long-term care insurance. The available policies have an assortment of drawbacks, and they’re expensive. On the flip side, needing to pay for an extended period of long-term care out of pocket would decimate many people’s savings.

This week, a new paper from two professors and two researchers at the Center for Retirement Research at Boston College takes a look at what percentage of people are likely to benefit from purchasing such insurance:

Investing Articles

Other Money-Related Articles

Thanks for reading!

Why Bother with Social Security Break-Even Calculations?

Broadly speaking, there are two general ways to assess the Social Security decision:

  • You can look at it as an insurance question (i.e., do I want to buy insurance against longevity risk), or
  • You can do a break-even analysis (i.e., how long do I have to live before I come out ahead as a result of delaying benefits).

An argument I’m seeing more and more often in financial publications is that it’s a mistake to even bother with a break-even analysis and that people should instead look at the question solely from the insurance perspective.

From the insurance perspective, delaying Social Security is automatically a good move because it creates an ideal alignment of outcomes. That is, it works out well in scenarios in which you live to be quite old. And those live-a-long-time scenarios are the ones that are the most financially scary. Conversely, delaying Social Security works out poorly in situations in which you die early in retirement, but those are the situations in which you are unlikely to run out of money anyway. I agree that this is an important point to consider in your Social Security planning.

But I still think break-even analysis is useful — for two reasons.

Firstly, just because something reduces risk doesn’t mean it’s a good deal. For example, most financial experts don’t recommend purchasing an extended warranty when you buy a new TV. Yes, it reduces a risk (specifically, the risk of having to replace your TV within the particular extended warranty time frame), but the degree of risk reduction is too small relative to the cost.

As it turns out, delaying Social Security is usually a good deal (especially for the higher-earning spouse in a married couple). But there’s no way to know that until you do the math yourself or read somebody else’s analysis.

A second reason is that, for some people, the reduction in longevity risk isn’t terribly important (or, at least, it isn’t their only concern).

For example, if your standard of living is already quite safe (e.g., because your spouse has a government pension that satisfies your desired spending level or because your portfolio is large enough to satisfy your desired spending level with a super low withdrawal rate), you have no need for longevity insurance. As a result, your goal with Social Security planning should simply be to maximize the total dollars at your disposal during your lifetime. And for those purposes, break-even analysis is a very useful tool.

And many people are somewhere in the middle. They are concerned about maintaining their living standard, but they’re also interested in leaving money to heirs. So it makes sense to look at the question from both perspectives.

 

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Investing Blog Roundup: Dividend Stock Investing

One of the more common strategies for active stock selection is to be a dividend investor — buying stocks with favorable dividend characteristics (e.g., high yield, stability of dividends, or high rate of dividend growth). This week blogger Darrow Kirkpatrick gave what I found to be a very balanced discussion of the pros and cons of such a strategy. In the end, Kirkpatrick comes to the same conclusion that I have.

Investing Articles

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