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I have a special treat for my readers today.
I have none other than the brains behind FI Physician, David Graham, MD, back fulfilling his promise of writing the highly anticipated sequel to his incredible first guest post on this site, “Planning The Next Life: How To Leave Money To Your Heirs.”
But don’t take my word for it.
Another brilliant analytical mind that I highly respect, and who is known throughout the physician blogger community, Gasem, had this to say in the comments to that original post:
That is high praise indeed, especially given the source.
Anyway I will now turn the reigns of the site over to the very capable hands of FI Physician.
XRAYVSN challenged me to answer a question about de-accumulation.
He wants to know:
“What would be the difference in drawdown approach if 1) you want to leave heirs the best tax advantaged inherited money vs 2) maximize the money you receive during your lifetime (goal of leaving $0 at death).”
This post is part two of a two-part series.
Part 1 addressed how to leave money to your children.
Part 2 addresses strategies to squeeze every last dollar from the nest egg.
In addition, if you don’t want to spend it all, let’s look at ways to optimize giving.
There are only 4 things you can do with money: spend it, give it away, invest it, or leverage it.
Let’s spend some money first then look at giving it away!
What’s the Maximal Withdrawal Rate from a $1M Portfolio?
Usually, we talk about the 4% safe withdrawal rule of thumb in de-accumulation.
If you have a $1M portfolio, it is generally safe to withdraw 4% the first year and adjust that dollar amount for inflation.
In figure 1, you can see a 4% ($3333 a month) withdrawal rate in light green vs a 6.68% ($5567 a month) rate in dark green.
This assumes a couple with a 60/40 portfolio returning 7%/3.5% for stocks and bonds respectively, as well as social security with $2000 a month primary insurance amount and 2% inflation.
In this situation, you can get 2.68% more per year, or $2234 a month ($26,804 a year) out of a nest egg over 30 years, leaving you with zero at the end.
Of course, returns are not continuous.
Sequence of Return Risk could devastate the 6.68% withdrawal rate anytime in the first 15 years of retirement.
Can We Squeeze Even More Money Out?
If you did take this higher withdrawal rate, taxes are a huge consideration.
Early retirement is the best time to manage your taxes, and taxes are often a retiree’s largest expense.
Let’s look at the tax implications of a high withdrawal rate.
Tax Implications in Retirement and How to Save More Money by Lowering Taxes.
Please remember that taxation of the different types of income depends on the source.
Brokerage accounts have capital gains, qualified dividends, and interest income.
IRAs are always-taxable.
Roths are always tax-free.
Figure 2 is busy but makes many important points. Stick with me here.
On the top, see the key tax components of income with a high withdrawal rate.
Initially, you sell funds from your brokerage account (blue) and receive dividends and interest income from your brokerage account (light blue).
The brokerage accounts runs dry quickly given the high spending rate, and then you are forced to take money from your IRA (orange) at age 67.
When you hit social security at 70, 85% of social security payments (lime green) are included into taxable income!
This phenomenon, where you pay extra taxes on your social security because you simultaneously draw always-taxable money from your IRA is called the Tax Torpedo.
Later, at age 77 when the IRA is decimated, the taxable amount of social security becomes zero when you spend from the Roth (blue).
Before we move on to a more optimal tax strategy, note that at peak you need almost $100,000 a year in withdrawals since you are paying taxes on both the IRA and Social Security at the same time.
Optimize Taxes in Early Retirement.
If you pay less in taxes, you get to spend the money you save!
Usually, you want to spend from your brokerage account first so you give time for your tax-deferred (IRA) and tax-free (Roth) accounts to grow.
More important, however, is utilizing your 10 and 12% tax brackets to pay less in taxes over time.
Back to Figure 2: on the bottom you take income from your IRA first (orange).
Note during this time you also receive dividends and interest from your brokerage account (light blue), but do not sell and recognize capital gains (darker blue not seen).
The total income needed here is about $60,000 a year compared to $100,000 at the peak in the top graph.
Now, this is where the magic happens.
When you turn 70, you don’t have any IRA left!
You are not forced to pay taxes on tax-deferred income.
This has several implications.
First, Social Security (lime green) is taxed minimally as there is negligible income from the brokerage account (light blue).
Second, you pay low and diminishing taxes between ages 70-80.
Finally, you pay no taxes after 80 when only the Roth remains.
The bottom line: you save over $70,000 in taxes during your lifetime and wind up with an additional $70,000 at the end (data not shown).
This extra $140,000 during your life is a 14% return on your original $1M nest egg: not a bad return for understanding tax planning!
So, if you want to spend as much as possible in retirement, be as tax efficient as possible especially during your tax planning window.
The Tax Planning Window.
The elephant in the room is the pre-tax IRA.
The goal: convert this always-taxable reservoir into income while paying the least in tax.
Brokerage accounts are taxed favorably through capital gains and qualified dividends.
Roth accounts provide tax free income.
IRA income is always taxed as ordinary income.
The order you withdraw from these accounts is of vital importance during your tax planning window.
After you retire and have no income from work, and before you are forced to take social security and required minimum distributions at age 70, you have a few years with unfettered access to your standard deduction and the 10 and 12% tax brackets.
You must use these brackets!
There are several ways to do so.
How to Utilize Low Tax Brackets in the Tax Planning Window.
In this case, partial Roth conversions don’t make sense.
In fact, if your goal is spending or giving, don’t bother with Roth accounts at all!
This is an important lesson.
Roths are best for giving to heirs, but useless to give to charity since you have already paid taxes on the amount!
Spend the Roth accounts in retirement when you need tax-free income (such as to keep surcharges on Medicare or IRMAA away).
Capital Gain Harvesting is an idea.
You can harvest gains up to the 12% tax bracket max and pay 0% capital gain tax.
But the ideal solution here is to get rid of the elephant in the room, the IRA.
Recognize the income at 10 or 12% tax rate before you are forced into taking social security and suffer the tax torpedo.
What if You Want to Give Away as Much as Possible?
Giving is more difficult since the Tax Cut and Jobs Act increased the standard deduction and limited SALT deductions.
You must be a bit more creative, especially in retirement when you are no longer earning income.
You can lump donations every other year, or better yet consider a donor advised fund (DAF).
Combine a DAF with a tax-generating event such as Capital Gain Harvesting or Roth conversions for maximal effect.
In general, don’t give cash.
With cash, you can get up to a 60% deduction on your AGI, which is nice.
It is better, however, to give appreciated assets such as stocks, real estate or other assets.
You get up to a 30% deduction on your AGI with appreciated assets.
Just as important, you don’t have to pay taxes on the appreciation.
Never give Roth money as you have already paid taxes!
Perhaps, the best money to give is from your IRA.
How to Give From Your IRA.
Since the income in your IRA is always-taxable, you can forgo paying taxes if you give your IRA to charity.
Options include beneficiary forms, QCDs, or, if you need income, a CRUT.
IRA Beneficiary Forms.
Remember, IRAs pass outside of wills and probate via a beneficiary form.
Spouses have the most options for inherited IRAs.
They can make the IRA their own, or take RMDs on their or their spouse’s life expectancy.
Other designated beneficiaries have less options.
To be a designated beneficiary, you must have a pulse.
If this is the case, you can take it over 5 years or stretch it over your remaining life expectancy.
The SECURE act may take away the stretch, forcing out the always-taxable income to your heirs over 5 or 10 years.
Follow this issue closely if you are planning on leaving a stretch IRA to non-spouses.
Charities can be beneficiaries as well.
They don’t pay taxes on this money, however, so they can just take the entire amount out in a lump sum and use it.
If you leave your spouse as primary beneficiary and a charity as a contingent, you give your spouse the ability to disclaim the IRA and give it to charity if he or she doesn’t need the money.
Qualified Charitable Distributions.
Qualified charitable distributions (QCDs) are a great way to get rid of unneeded RMDs.
First off, you must use RMDs rather than non-RMD distributions so you can only do this once you are 70 and a half years old.
Do a trustee-to-trustee transfer of the distribution and you need not report the distribution as income.
Do be careful around tax time, however, as the 1099 from your IRA does not specify that the distribution went to charity or to your bank account.
Make sure your CPA knows not to include the distribution as income.
The reason for QCDs: If you take the distribution and then donate it, you may get no tax benefit due to the large standard deduction!
Instead, give the money away before it is recognized as income.
But what if you need the income?
Charitable Gifts with Income.
You can give your IRA to charity and still benefit from the income during your lifetime.
Many charities and universities are more than happy to help you donate.
They can set you up in a pooled income fund, a gift annuity, a foundation, or a charitable remainder uni-trust (CRUT).
Discussion of pros and cons of each of these are beyond the scope of this piece, but let’s look quickly at a CRUT.
CRUT for Income.
When you donate your IRA into a CRUT, you will not pay taxes and the full amount of the donation will go into an irrevocable trust that is then invested for tax-free growth.
The income you receive from the trust is actuarily set up in advance.
You must plan on leaving at least 10% of the gift to charity, and you get a current write off on the present value of that future gift.
Typically, you can get 5-8% of your donation back as income every year.
Meanwhile, the full donation is in trust and grows tax-free.
Let’s look at giving away the IRA at retirement to a CRUT with a 6% payout.
With the IRA CRUT, income from the payments are fully taxable.
The donation stems from an always-taxable account, so the income retains the same tax nature.
On top of figure 3 is a drawdown comparison for a portfolio with and without a 6% IRA CRUT.
In light green, note this is the 6.68% withdrawal rate we looked at above.
In dark green, note the decrease in portfolio value when you fund the CRUT.
Over time, the slope is less due to the income from the CRUT.
On the bottom: the key tax components of the CRUT.
Compare this with figure 2.
In blue, note the income from the CRUT as a component of taxable income stays stable over time.
In green, qualified dividends and interest provide the rest of the income until age 70.
At age 70 there is a bump, which serves as a good reminder.
Taxation of social security is based upon your tax return from two years prior, so you must plan in advance.
After 70, taxation from social security and from capital gains on the brokerage account slowly increase over time.
Note that you don’t really have more money with a CRUT than if you invest your IRA over time.
You do, however, decrease market risk, tax risk, and longevity risk with such a play.
Spending money, or even giving it away, is hard work!
If you understand taxation in the tax planning window, you have a leg up.
Every dollar you don’t pay in taxes you get to spend or give away.
Always-taxable IRA accounts are the trickiest to plan.
Give them to charity if you can.
If you must, leave them to heirs.
Tax-deferred growth is wonderful, but eventually the tax bill comes due.
Thank you David for such a high yield, incredibly informative post.
For those readers who agree with me that David has a gifted mind in this arena, please check out his blog where you can find other topics that are well worth your time reading.
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Wow. That was very thorough and informative. Thanks.
David is really an incredible talent regarding stuff like this. I wish I had an analytical mind like this but alas it was not meant to be. Thanks for stopping by VP and glad you found some info you can use. Have a great one!
Thanks for hosting another post XRAYVSN. I have a lot of fun putting together pieces like this that take a deep dive into a topic.
I did want to point out that I made an error in the text. Social Security is taxed the same year (as part of your “combined income.”). It is IRMAA that is applied depending on your prior-prior year 1040. Sorry for the mistake!
About IRMAA https://www.fiphysician.com/irmaa-2020-high-income-retirees-avoid-the-cliff/