Control the things you can control. We’ve all heard the mantra when it comes to personal financial planning, and it usually refers to the accumulation side of a retirement plan—factors such as investment cost, contribution amounts and timing.
But a growing body of research points to an under-utilized point of control on the decumulation side of a plan: tax-efficient withdrawal strategies.
Conventional wisdom holds that retirees should spend first from taxable accounts until they are exhausted, then move on to tax-deferred accounts, and finally on to exempt sources.
But in some cases, advisors have the opportunity to add significant alpha for clients by constructing plans that draw simultaneously from taxable and tax-deferred accounts.
“Going from one type of account to the next and then to the next is not as smart as taking from multiple accounts simultaneously,” argues William Meyer, co-founder of Social Security Solutions, a leading benefit optimization service. Meyer and his partner William Reichenstein, a professor of investment management at Baylor University, have argued this point recently in several retirement journals.
Reichenstein and Meyer acknowledge that an initial focus on taxable accounts makes sense because they are least tax-efficient. But they are also strong advocates for delayed Social Security claiming in the early years of retirement. That means clients would be in a lower tax bracket—a good time to start withdrawals from tax-deferred accounts. If the tax-deferred account is large enough, accelerating the strategy with Roth conversions can also make sense.
These strategies reduce total required minimum distributions (RMDs) later on, when Social Security income is flowing and tax brackets may be higher. That reduces the tax burden substantially, and can help keep your clients out of the Medicare high-income surcharge zone.
It’s an especially valuable strategy if tax rates rise. “The results of this approach become even more powerful if that happens,” Meyer says.
The math is inarguable, but execution can be complex. They involve sifting through the intricacies of client taxes, Social Security strategies and Medicare premiums, which can rise sharply for high-income retirees. One move can have an adverse effect on other components. “It can be like a Rubik’s cube,” Meyer says. “I solve the green side—and suddenly it creates problems with the yellow side.”
For the past 10 years Meyer and Reichenstein have been developing software to make tax-efficient drawdown plans easier to design and manage. Recently, they unveiled their solution, Income Solver.
An advisor plugs in client data on income needs and expenses, detailed account information and optimal Social Security claiming strategies. From there, it’s possible to compare different strategies for a drawdown sequence, illustrating the approaches that are likely to be most efficient.
Typically, these scenarios begin with an assumption that Social Security claiming will be delayed to boost monthly lifetime income. If the client isn’t working, that leaves an income gap in the early years of retirement, which is a good time to draw down or convert deferred assets and get those taxes out of the way. This can have the benefit of reducing or even eliminating required minimum distributions in the out years, so managing tax brackets, and helping high-income clients avoid Medicare surcharges, gets easier.
Those surcharges are paid by a relatively small percent of Medicare enrollees, so they are more than likely not your clients—but the ranks will grow in the years ahead. Surcharges will impact 25 percent of all Medicare beneficiaries by 2036, according to the Kaiser Family Foundation. And last year’s “doc fix” legislation, which overhauls how Medicare pays doctors, will place a heavier cost burden on some high-income households.
Here’s a hypothetical example, generated by Income Solver.
Bill is single, with savings of $600,000: $250,000 in tax-deferred savings, $250,000 in taxable savings, and $100,000 in a Roth IRA. He plans on a modest spending level in retirement of about $30,000 annually. In addition, he has a fixed annuity that will provide $1,000 in income after retirement. His optimal Social Security strategy, the one that pays the most in cumulative lifetime benefits, is for him to begin benefits at age 70, but Bill, who is 62, is ready to retire sooner than that.
Income Solver’s recommended strategy is a series of Roth conversions over time aimed at keeping Bill’s modified adjusted gross income (MAGI) at or below $85,001 each year—the threshold for Medicare high-income surcharges. The combined value of delaying Social Security to age 70 and using Roth conversions increases the total portfolio value by a whopping $960,000.
Eye-popping alpha aside, Income Solver also points to an important new direction in planning.
The profession is preparing to shift into the new fiduciary regulatory regime while also adjusting to the rise of automated robo advisory services. Solutions like Income Solver can help advisors bring value to the table in the emerging environment, because it blends technology with human judgment and insight.
Consider just one of the most important battlegrounds for new business: rollovers from 401(k)s. Under the Department of Labor fiduciary standard, any advice to do a rollover will have to be demonstrably in the best interest of the client.
Pitching a rollover out of a well-constructed, low-cost 401(k) won’t meet this standard if costs double or triple—unless the advisor brings something of value to the table that justifies the recommendation.
The changes present an existential crisis for broker/dealers, who now face the need to transition from selling investment products to offering true advice. It’s not clear yet whether this is a transition they can make successfully, but if it is possible, services like Income Solver will need to be part of the solution.
“The large broker/dealer firms I talk with all want their people to deliver more value to clients, but they say they can’t spend six months teaching them how to use complex software,” says Shuang Chen, co-founder of RightCapital, a one-year-old financial planning software platform that incorporates some tax-efficient drawdown features. “They want something easy to use that adds real value.”
Adds Meyer: “The broker/dealer community is still reeling from the fiduciary rule, and the last thing they want to think about is training their field force to deal with something like taxes. But actually, that is exactly what they should be doing.”
Mark Miller is a journalist and author who writes about trends in retirement and aging. He is a columnist for Reuters and also contributes to Morningstar and the AARP magazine.