Which Accounts Should I Spend from Each Year in Retirement?
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.
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.
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.
Are Dividends More Important Than Price Appreciation?
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.
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.
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.
Why Bother with Social Security Break-Even Calculations?
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.
Is It Important for Your Financial Advisor to Be Local?
Firstly it depends on how comfortable you are with communicating remotely about very important topics/transactions.
For example, I personally prefer written communication rather than in-person communication for important topics. So I’ve never felt a need to meet face-to-face with the professionals with whom I work. My only communication with Austin Frakt — the coauthor of my most recent book — has been via email and phone. We’ve never met in person. And I’ve never even talked on the phone with any of the attorneys whose services I’ve used for my business. My communication with them has been nothing but email.
Alternatively, if you do feel the need for real-time, face-to-face discussions with your advisor, would you be comfortable talking via Skype? Or would you not be comfortable unless you were physically sitting in the same room as this person?
And don’t forget that if the goal for this advisory relationship is for the advisor to someday work with your spouse, your spouse’s communication preferences (rather than just your own) should be a high priority here. After your death or incapacitation, would your spouse be comfortable working with an advisor across the country, whom he/she has never met in person?
The question also depends to some extent on what type of services will be provided by the advisor.
For example, if all you’re looking for is portfolio management (i.e., picking an initial allocation, then rebalancing as necessary and tax-loss harvesting when advantageous), that’s a very impersonal service. Your portfolio is probably indistinguishable from the portfolios of many other investors, so the advisor will need little to no ongoing input from you about how to perform the required tasks.
In contrast, if you want your advisor to provide comprehensive financial planning services, there’s going to need to be quite a bit of ongoing communication between the two of you, so if you really don’t like doing that sort of thing remotely, a remote advisor probably isn’t a good idea.
In addition, if you’re looking for somebody with state-specific tax planning expertise, a local professional is certainly more likely to have that than an advisor many states away.