Three Strategies for Retirement Withdrawals

Benz: So you looked at what you call a hybrid strategy. Let's discuss that and why you think that can be a nice alternative to these other two strategies that we've discussed so far?

Jaconetti: So the hybrid strategy actually is similar to the percent of portfolio, so each year you'll take a percent of the portfolio, but then you would actually put a band around it, a ceiling and a floor. So you would never let your year-over-year spending change by more than the ceiling amount or drop by more than the floor amount.

If you have a good year where the market, say, is up 10%, and you want to say your year-over-year spending will never go up by more than 5%, you'd actually invest the extra back into the portfolio. So if there is a time when the portfolio, say your spending amount would drop by 10%, but you only want it to drop by 5%, you would actually be able only drop it by 5%, you would be able to spend a little more. So it keeps spending within a certain range. So you would have more control over the short-term spending, but you'd still be taking into account what happens with the markets.

Benz: So you're essentially letting the good years make up for some of the lean years to help smooth out your overall spending.

Jaconetti: Right.

Benz: That sounds like a very useful piece of research.

Next, Colleen, I want to talk about sequence of withdrawals. This is another thing that retirees wrestle with--most people come into retirement, they've got money in different pots, they've got maybe IRAs, maybe company retirement plans as well as taxable assets. I'd like you to talk about what your research shows in terms of how retirees should sequence those withdrawals?

Jaconetti: The point of the decision is really to try to minimize the tax liability over the whole course of the horizon for retirees. So, we would say, generally, spend from your required minimum distributions first. So any retirees over 70 1/2 is required to take money from tax deferred accounts each year. So it will be the first monies that they should probably spend from.

Benz: If you don't take that, you'll pay a big penalty, so you've got to do that.

Jaconetti: Exactly. Then after that, we'd say investors should spend from their taxable portfolio, and then followed by the tax advantaged. So within the taxable portfolio, we would first say they should spend the interest, dividends, and capital gains distributions on assets held in a taxable account. So these monies are taxed to the investors whether they are spent or reinvested. So it's best to use those next for spending purposes rather than reinvest it and spend later and possibly have to incur capital gains to meet spending needs.

Benz: Then you would save the tax-deferred vehicles until last.

Jaconetti: Right, and actually after we do the taxable flows, we'd actually start spending from your taxable portfolio in a way that minimizes gains. So if you have assets in your taxable account, you would try to minimize the amount of capital gains. So, maybe selling assets at a loss or matching gains and losses.

And then after that you would go to the tax-advantaged accounts, and that would include the tax-deferred accounts, so the IRAs and 401(k) plans, or tax-free accounts, such as Roth. And which one you would spend from would really depend on the expectation of your current tax rate relative to your future tax rate. So if you think your taxes in the future will be higher, you would spend from your tax-deferred accounts today, locking in the lower tax rate. And if you think your future taxes will be lower, then you would spend from your tax-free accounts today, and then you would spend from tax-deferred accounts later when your tax rate is lower. So we're hoping that by minimizing the taxes you pay over the course of someone's retirement, it would actually help them have either more money to spend or extend the longevity of their portfolio.

Benz: So a related question that people grapple with is, how do I know what my tax rate will be in the future versus what it is now on the day that I am retiring. And it seems like you've really got two things in the mix: your own personal tax rate as well as what happens with taxes at large. I think a lot of people look at the current taxation and see that maybe it's low relative to where it's been historically, and could that get worse? How do you suggest that people try to get their arms around those complicated questions?

Jaconetti: Right. It is very difficult. Really, there is no crystal ball to tell us what the future of tax rates will be, but people can estimate, generally what their social security income would be, or their pension income or the income from their portfolio, and have a general idea of where they may fall.

Now, how they will be taxed on it in the future is a little bit more uncertain. So one thing we would say is to maybe have a little bit of tax diversification ... consider spending a little bit from your tax deferred and a little bit from your tax free, so that you have flexibility going forward.

Benz: So hedge your bets--just in case things unfold in a different way than you thought they would, you'd be protected.

Jaconetti: Exactly. At least give yourself some flexibility.

Benz: Well, Colleen, thank you so much for sharing this research. I know retirees are always really hungry to get concrete strategies for managing these really difficult decisions. Thank you.

Jaconetti: Great. Thank you.