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  1. The first approach is to take a fixed dollar withdrawal each year, plus inflation increases. For example, a $1,000,000 portfolio might begin with a $40,000 withdrawal in the first year that is increased by 3% annually to help offset inflation. Fixed dollar + 3% Year 1: $40,000 Year 2: $41,200 Year 3: $42,436 Etc. The advantage of this approach is that it produces predictable cash flows for spending purposes. The disadvantage is that the lack of flexibility means the investment portfolio could potentially be depleted if long-term performance ends up being worse than expected. Alternatively, the portfolio could grow substantially over time to where the individual ends up spending far less than what they could have afforded to. The result would be a large legacy to beneficiaries, which may or may not be the desirable outcome. The second approach is to take a fixed percentage withdrawal each year, based on the current portfolio value. For example, a $1,000,000 portfolio with a 4% annual withdrawal would produce the same $40,000 withdrawal in the first year. Due to market performance, this will be different each year thereafter. Fixed percentage +15% portfolio return: $1,150,000 * 4% = $46,000 withdrawal Or… -15% portfolio return: $850,000 * 4% = $34,000 withdrawal The advantage of this approach is that the portfolio can never be depleted, and there is significant upside spending potential when market performance is strong. The disadvantage is that spending amounts can be volatile each year,which may be unrealistic for those who need a certain dollar amount every year from their portfolio to cover fixed living expenses. Those in this situation might consider deferring social security and also annuitizing part of their nest egg so that a higher amount of fixed living expenses are covered by sources of guaranteed lifetime income.The remaining portfolio value can then be used to produce a fixed percentage withdrawal that can fund discretionary spending. The third approach is a hybrid where an investor would use a fixed percentage withdrawal, but then place a floor on how much spending may be cut from the prior year and a cap on how much spending can be increased. For example, a $1,000,000 portfolio with the same 4% withdrawal rate could be modeled along with a -3% floor and +5% cap. Fixed percentage plus floor and cap Year 1 withdrawal: $40,000 Year 2 spending floor = $40,000 * -3% = $38,800 Year 2 spending cap = $40,000 * 5% = $42,000 If we use the same positive or negative 15% portfolio returns for the year as in example 2, we see that the withdrawal amount would be the floor or cap amount for the year since the 4% of the $850,000 and $1,150,000 portfolio values would be below the floor and above the cap. The end result is a withdrawal strategy that combines the advantages of both the fixed dollar amount and the fixed percentage withdrawal strategies. Adding some flexibility to withdrawals incorporates the impact of market performance, but within a more predictable range than a pure fixed percentage approach. Stress Test: 1929 - The mother of all bear markets Portfolio: 70% S&P 500, 30% 5 Year US Treasury Notes Rebalance: Annually Withdrawal rule: 5% of end of year portfolio value, -3% floor, +5% cap Past performance doesn’t guarantee future results. No deduction of taxes or fees are included, and indexes are not available for direct investment. Recent History: 1990-2019 Summary There are many different ways to spend from a portfolio during retirement. Some investors prefer to change their portfolio so that the securities provide the cash flows through dividends, but this is not recommended as it moves an investor away from the optimal portfolio that is well diversified and/or results in underconsumption. A total return approach, where withdrawals are based on a hybrid model combining the advantages of the fixed dollar amount and fixed percentage withdrawal strategies, is more likely to produce desired outcomes and is also more tax efficient. The chosen percentage withdrawal rate can be adjusted up or down based on the expected number of years that withdrawals will be taken and based on the chosen allocation between stocks and bonds. Furthermore, different floor and cap rates can be chosen to meet each individual’s tolerance for variations in spending. For this reason, the assistance of a qualified financial advisor is recommended. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University.
  2. In 2018 I wrote about the magic of compounding and the tyranny of taxes, and showed how significant tax-deferred growth is over the long-term. In this article I’ll refer to all pre-tax account types as Traditional 401(k)’s and all after-tax account types as Roth 401(k)’s since most Americans build up their retirement balances in these types of employer plans but note that the math and conclusions are the same with Traditional and Roth IRA’s. Traditional 401(k)’s allow the individual to contribute pre-tax dollars and buildup a balance entirely tax-deferred until withdrawn. Withdrawals are then considered ordinary income and become taxable at your personal tax bracket at the time of withdrawal. Roth 401(k)’s are largely the inverse where contributions are made after tax, and then withdrawals of both principal and earnings are tax free if certain conditions are met. This results in a situation where each person decides if they’d like to pay their income taxes at the time of contribution or at the time of withdrawal. The IRS in effect says, “pay me now, or pay me later.” So which account is better, Traditional or Roth? The answer depends on your tax bracket at the time of the contribution vs. the time of withdrawal. If you’re in a higher tax bracket today when you contribute relative to your expected tax bracket at the time of withdrawal, you should use a Traditional 401(k). If you’re in a lower tax bracket today when you contribute relative to your expected tax bracket at the time of withdrawal, you should use a Roth 401(k). This is simple math, and an example will help. Traditional 401(k) example: $10,000 pre-tax contribution $10,000 doubles in value to $20,000 due to investment performance $15,200 is withdrawn after-tax for an individual in the 24% tax bracket Roth 401(k) example: $10,000 of income allows a $7,600 after-tax contribution (24% tax bracket) $7,600 doubles in value to $15,200 due to investment performance $15,200 is withdrawn tax free Under both scenarios, an investor in the 24% tax bracket at the time of contribution and withdrawal ends up with the same after-tax result. So, the decision is most important when you have clear expectations about future tax brackets and your own income. I personally believe that future tax brackets are likely to be higher than we have today, so favoring Roth accounts is sensible for most Americans as it hedges this risk. We actually have below average tax brackets today relative to history. For example, the top marginal tax bracket today is 37% while there have been times in the past where the top bracket was 70%+. There was even a time where it was over 90%. Additionally, the US has a mountain of debt in the form of future entitlement program liabilities that will need to be addressed, and raising taxes is likely to be part of the solution. Those who are in the highest tax brackets today are the likely potential exception as they will still benefit from favoring pre-tax contributions when considering the likelihood of having less taxable income in retirement. Note that this decision can be one in which you choose to diversify, similar to your investment portfolio, by making part of your contribution pre-tax and part after-tax. In addition to shifting more of your contributions going forward to after-tax Roth accounts, it can sometimes make sense to start paying taxes now at current tax rates by making partial Roth conversions of pre-tax dollars. The help of a qualified CPA and financial planner may be highly valuable for analyzing these long-term tax planning decisions relative to your specific situation, so feel free to reach out to us if you’re interested in a second opinion about your current course of action. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios. Related articles Investment Ideas for Conservative Investors 3 Principles to a Successful Investment Experience Financial Planning Lessons From the Pandemic Risk Depends On Your Time Horizon Buy When You Have the Money, Sell When You Need the Money Cash is (no longer) Trash What’s Wrong With Your 401(k)? (If anything) The Magic of Compounding, and the Tyranny of Taxes