Tax-efficient Retirement Withdrawals

Considering taxes, in what order should U.S. retirees consume different sources of retirement savings/income? In their August 2018 paper entitled “Constructing Tax Efficient Withdrawal Strategies for Retirees with Traditional 401(k)/IRAs, Roth 401(k)/IRAs, and Taxable Accounts”, James DiLellio and Daniel Ostrov describe and illustrate an algorithm that computes individualized tax-efficient consumption for U.S. retirees of:

• Tax-deferred retirement accounts [Traditional IRA/401(k)].
• Post-tax retirement accounts [Roth IRA/Roth 401(k)].
• Other taxable retirement accounts.
• Other sources of money subject to income tax, including: earned income, some pensions, annuities bought with pre-tax money, earnings from annuities bought with post-tax money and sometimes Social Security benefits.
• Other sources of money that do not affect tax rates of retirement accounts, such as: tax-free gifts, Health Savings Accounts, some pensions, principal from annuities bought with post-tax money and sometimes Social Security benefits.

Their model adapts to individual retiree circumstances and accommodates typical changes in tax policies (changes in marginal rates and number of brackets). For tractability, they make simplifying assumptions. The principal simplification is that  return on stocks, stock dividend yield, inflation rate, tax brackets and rates, other income sources and consumption rates are known each year (not random variables). When the goal is to optimize a bequest, inputs also include year of retiree death, marginal tax rate of the heir and rate the heir consumes inherited retirement accounts. They do not attempt to determine the optimal mix of  stocks and bonds/cash within retirement accounts (their deterministic model would prefer all stocks). Using illustrations of algorithm outputs based on varying input assumptions, they find that: (more…)