September 21, 2021

Bogleheads® Chapter Series – Wade Pfau on Retirement Income Style Analysis, Tax Efficiency

Dr. Wade Pfau discusses Retirement Income Style Analysis (RISA) and tax planning for efficient retirement distributions.

Hosted by the Retired Life Stage Chapter. Recorded on September 21, 2021.

Chat from the recorded meeting can be accessed here.

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Bogleheads® Chapter Series – Wade Pfau on Retirement Income Style Analysis, Tax Efficiency


Roland: Welcome to the Bogleheads Chapter Series. This episode was hosted by the Retired Life Stage Chapter and recorded September 21,  2021. It features Wade Pfau, Phd., CFA , discussing RISA, his retirement income style awareness tool, as well as tax planning considerations in retirement.

Bogleheads are investors who follow John Bogle's investing philosophy for attaining financial independence. This recording is for informational purposes only and should not be construed as personalized investment advice.

Welcome everybody to the retired life stage meeting. I'm Roland, one of the chapter coordinators, along with my colleagues Robert, Henry, and Raj.  We're very pleased to have Wade Pfau joining us this evening.  We'll start  with our usual disclaimer that this presentation is for informational purposes only and should not be construed as personalized investment advice and I'll turn the mic over to my colleague Robert who will formally introduce Wade and the presentation topics.

Robert: Thank you, Roland. Yes, well it's my pleasure this evening to introduce our guest, Dr. Wade Pfau. I think many in the Boglehead community are quite aware of his accomplishments. Wade is a retirement researcher and professor of retirement income in the Phd. program for Financial and Retirement Planning at the American College of Financial Services. He's also principal director of retirement research at McLean Asset Management and he's the founder of Retirement Researcher. Wade holds a Master's and Doctorate in Economics from Princeton University and a Bachelor of Arts and a Bachelor of Science degrees from the University of Iowa. He's also a chartered financial analyst.

Wade is a prolific writer and researcher. He's authored many papers and books on a wide spectrum of retirement related topics, including in retirement withdrawal rates, optimum asset allocations for retirement and the role of annuities in a retirement portfolio. His latest book, which we'll speak about tonight, is called, The Retirement Planning Guide Book: Navigating the Important Decisions for Retirement Success, which I have. Let me show you, nice and big. 

As a retirement community here, most of us know that the  decumulation phase of our assets can be a lot more complex than the accumulation phase. And I think this work helps us in that regard. Wade's going to speak  twice tonight, two different presentations. 

The first presentation is going to work the left side of our brain and it's structured more towards the behavioral side of finance. We'll be looking at the retirement income styles and decisions. It's kind of a Morningstar style box for self-awareness of income strategies. I believe they use the acronym RISA, which is Retirement Income Style Awareness. These questionnaires and RISA, in theory, can reveal an individual's tolerance for risk and retirement, what income self best fits that individual, and the value of financial advice if they choose to move in that direction.

The second presentation will work the other side of our brain and it really deals with  chapter 10 from this textbook, and it's tax planning for efficient retirement distributions. Here Wade will present some tax efficient distributions that can prolong the sustainability of retirement assets. And taking advantage of really tax diversification and tax bracket management. So with that I hand it over to Dr. Wade Pfau.

Wade Pfau: Okay thank you Robert. And thanks Roland and Raj and LadyGeek and everyone who's been helpful in studying at the meeting today. I joined the bogleheads, I think it was 2010. My forum profile will verify that it's pretty active for a few years. I haven't been as active in recent years, but it is great to reconnect again with the bogleheads community. And as Robert mentioned, the presentations today are based on The Retirement Planning Guidebook, which I’ve really been writing for nine years now, and it's finally finished. 

The presentations aren't equal in length. Just in terms of this topic was about 15 pages of the book, and then the tax planning chapter was more than 70 pages, so we won't have that big of a difference in presentation lengths, but hopefully we'll have some more time for the tax planning

We'll start with the retirement income styles. So with that being said, I've now generally tried to approach retirement with these 12 general topic areas. And I think what we're talking about first,  retirement income styles, is the best starting point to start thinking about building a retirement strategy. And also in that regard too, we ran a poll about which chapters my retirement researcher community was most interested to hear about and tax planning, our second presentation today, won that full by a wide margin, and the retirement income styles was in third place. The second place one was the, how much can you spend from an investment portfolio, that whole four percent real world type topic that I know is also quite popular at bogleheads.

But we'll talk about the retirement income styles, and then you can just see the other aspects like understanding different retirement risks, quantifying your goals, determining if you're prepared for retirement, looking at different investment and annuity strategies, which will stem from understanding your retirement income style. And then the social security claiming decision, health care and medicare decisions, long-term care, retirement housing, the tax planning, legacy, and incapacity planning. And then just as important as any of the finances is just the non-financial aspect of having purpose and passion for retirement, and then implementing and monitoring the plan.

So with that being said, for the retirement income style discussion the agenda will be to just discuss that there are a lot of different retirement income strategies out there, and we haven't really in the past had a way to choose among them. And I think that's just created conflict because you can ask basic questions about retirement and get completely different answers based on who you're talking to.

And so we need a way to better filter these styles and this led to a research project that I did with Alex Murguia where we tried to identify just by reading, and reading everything out there, about retirement planning. How did people talk about retirement planning? Were there particular factors that seemed to be prevalent in terms of there's some sort of trade-off out there? And then we did a trial to test those with. We started with about 900 questions. Alex likes to talk about that we've whittled it down quite a bit since then, but can we figure out if there are distinct preferences that might help to define a style? And what was really interesting about that, and as I'll be talking about,is just how well these different preferences work together to actually explain the main retirement strategies that we know about. And so then linking these styles to the different strategies and different retirement tools.

So we know that retirement is different from pre-retirement. That this is the whole issue of what makes retirement income planning distinct. Pre-retirement you're still working and can rely on work to fund your lifestyle. You're saving for the future, but  generally you have more of an accumulation mindset, where you can focus more on risk-adjusted returns, modern portfolio theory, like building that efficient frontier, seeking a well-diversified investment portfolio.

But a few things change in retirement. You now change from adding new savings to now taking distributions, and that you don't know how long you're going to be doing that for. So there's this element of longevity risk. There's an element of when you're taking distributions from your portfolio there's sequence of returns risk that a market downturn can harm you in a way that it doesn't pre-retirement. Because if you have to sell from a declining portfolio there's less available to recover from any sort of subsequent market recovery. And then the different spending shocks, with health care, long-term care and so forth.

And so this analogy about mountain climbing is with mountain climbing we might think the goal is to make it to the top of the mountain. Just like with retirement planning we think the goal is to reach the retirement date with a certain wealth accumulation target,whatever that number may be. But the reality is you need to make it back down the mountain as well. And with mountain climbing, most of the accidents do happen on the way down the mountain.

With a retirement income it's more difficult. There's more challenges post-retirement than pre-retirement. And so that speaks to the need to to think about retirement a bit differently. But it is still the wild west in terms of retirement income strategies, and you'll see so much debate and discussion. And that's where we want to try to just provide some more general guidance or some way to some framework for thinking about these different retirement strategies.

Now this is from a book I wrote a few years back that was focused more on investment-based strategies. But I think there's 37 different strategies here and that's just a sampling. One of these, like the bogleheads, I would classify as having a variable spending strategy. There is that variable withdrawal percentage, I think that's the name of it. 

The Financial Planning Association has clarified that there's three main types of retirement strategies. Then there can be a lot of subcategories, and that's where the previous slide was, more about the subcategories.

But you have generally systematic withdrawal strategies that in this retirement income style awareness we're going to rename as just total returns, because it's more about taking systematic withdrawals from a total return investing portfolio. It's probably where a lot of bogleheads are kind of thinking as a starting point for retirement income. 

There's essential versus discretionary, which is about building a floor of more lifetime based reliable income. protected lifetime income. Like emphasizing more Social Security and then beyond that beyond any pensions. There may be a role for an annuity to help build a protected lifetime income floor, and then with the remaining assets investing for upside and investing more for discretionary types of expenses.

And then time segmentation was always some sort of hybrid between the two, and that's also known as a bucketing strategy. That's where you invest differently for the short term and the long term. With time segmentation you might say well if I have bonds maturing for the next five years I can have at least five years worth of expenses covered and then all my other assets and my growth diversified investment portfolio are meant to cover the expenses in year six and beyond and I have an opportunity to endure a market downturn, and to have time for the portfolio to recover because I'm just spending my fixed income until I get through that period and hopefully then the market will recover and then I can resume drawing from the growth portfolio to replenish the the time segmentation portfolio, the the front-end fixed income ladder.

And so again the systematic withdrawals is the total return investing approach. Its starting point is like the 4% rule of thumb that's discussed quite a bit. I know I saw even on the main page of bogleheads right now there was a thread mentioning the 4% rule. That was what Bill Bengen developed in the 1990s, the idea of if you have a portfolio with 50% to 75% stocks and you're planning for a 30-year retirement horizon, you should be able to take 4% out of the portfolio in year one, and then that gives you a level of spending that you can adjust for inflation. And based on US historical data, anticipate your money will last for at least 30 years.

Now this can also include  variable spending strategies where you're spending changes in response to portfolio performance and so forth, but this is very much an investment focused diversified portfolio spending from the portfolio as a core retirement strategy.

And then sort of opposite from it is more like that essential versus discretionary, but we'll call that income protection with retirement income style awareness. And that's more the sense of thinking about simple income annuities building a lifetime protected income floor to cover your essential expenses so you're protected from longevity risk even if you live to 100 you still have the money coming in through the contract. You're protected from the market risk for that, but then you can use the investment portfolio on top to then cover more diversified or more discretionary types of spending. And these are going to be, as we get into the retirement income style awareness, these will be the two core strategies. 

And the other two strategies I'll talk about really have more of a behavioral element to them. So time segmentation, again it's that I invest with bonds for the short-term expenses, and then with stocks or other more growth-focused assets for longer-term expenses. And that's some sort of hybrid, trying to rely on the market but also getting some sort of short-term contractual protection, just not over the lifetime but over a shorter time period.

And then a fourth strategy we'll consider is the wrist wrap strategy, which is a cousin of that income protection strategy. The simple income annuities are not very popular in practice, and in practice deferred annuities with living benefits are used much more frequently, whether it's the variable annuities or the fixed index annuities. Or now we even have the registered index linked annuities. These are annuities that still provide some sort of underlying liquidity and provide some upside potential, but can also support a lifetime income. And so it really is going to work out to be a distinct strategy from income protection. 

So these are the four basic retirement strategies that most anything can then kind of be somewhat close to one of these four. And that like the bogleheads variable percentage withdrawal strategy I would put in the family of total return strategies.

Now the next question is how do retirees choose from these possibilities. And so they might be listening to a radio show, or hearing commercials on the radio about different financial advisors pitching different strategies. They may just read personal finance blogs. Of course discussions at the bogleheads. It's going to be a great resource for everyone on the call today. They may just be reading consumer finance, personal finance type consumer media. Attending different seminars or other events, webinars, a local class--a lot of local organizations, adult education programs-- will provide retirement planning classes. Or working with a financial advisor.

But still we don't really have the tools to identify who should use what type of strategy. Like that's the question, if I'm starting to think about retirement should I use an income protection strategy, should I use a total return strategy. We haven't really had the tools for that. And a lot of financial service professionals tend to put their stake into one camp and so if I'm an investment manager I would tend to recommend a total return strategy to everyone, or if I'm an insurance agent I would tend to recommend some sort of annuity-based strategy to everyone. And it's like if the only tool you have is a hammer then everything looks like a nail, even when it's not. And so we haven't had a way to really better filter these strategies.

Now this starts to get into like retirement is different as we started the presentation. So people might have different concerns about different types of retirement risks and you can think about what are you the most worried about. Is it the idea that you might outlive your assets? Are you really worried about that sequence of returns risk, which is like Murphy's law, the one where like if I retire today tomorrow's going to be the day that the stock market drops. Is that something that you're really worried about?  The different spending shocks, are you very worried about what if i have a significant long-term care event, the impacts of declining cognitive abilities, the impacts of compounding inflation and so forth.

And that speaks to these, the four L's. These are the financial goals of retirement and they're impacted by different risks. And so you may then have different concerns about these goals.

So longevity is about your essential spending and it's the idea that no matter how long you live you want to at least ensure you have your basics covered. Is that something that resonates with you,  something you're worried about. Or are you maybe just focused more on the lifestyle, which is your overall lifestyle goal, including discretionary spending. Are you someone who might view your retirement as a failure if you're not able to meet all your lifestyle expenses. And I'm guessing with bogleheads there's probably more of an emphasis on kind of the longevity is because bogleheads tend to not just spend excessively and so forth. 

But lifestyle does imply some sort of like if you're a member of a country club. A lot of people would classify that as a discretionary expense, but some people might be really worried if they can't meet that expense. They may feel like their retirement is a failure. So do you have a greater concern for lifestyle expenses?

Legacy goals. Now what we find in practice is legacy goals are often not a primary concern for most people. A lot of people do take the view that well the heirs can have whatever's left over at the end. Of course some people do like to earmark a specific legacy goal: I would like to leave X number of dollars to so and so. And so if that's a bigger concern it's usually not going to rank as a top concern for most retirees but it might for you. It's just how you think about legacy as a particular concern in terms of a goal you want to be able to ensure you can meet.

And then liquidity is about having additional liquid assets available to cover unexpected spending shocks. And there's different ways to think about liquidity. We'll get to that in a moment. But is liquidity something that worries you?  And if you're very worried, like you're concerned about spending today because you're concerned about a long-term care event that could happen. That would imply more of a liquidity concern as being something that you're--liquidity is more about than just an emergency fund, it's significant spending shocks and needing to make sure that you can handle unexpected expenses outside of what you've budgeted for.

So then how do we match up your style based on your concerns, the risks that you're concerned about and just going through that thought process. Well that's where this research that Alex and I did and  it's a project that was going on last year and finished it this year and this is the actual research article for it. If anyone's interested to read the full length version, it is pretty long. but I'll give a more basic explanation of it today.

And then what we found, is like I said we were just looking at all kinds of different writings about retirement planning trying to identify factors and then what we did was an exploratory factor analysis to just let the data tell us from the questionnaires which factors or which questions seem to correspond into some sort of particular factor that can explain a set of preferences. And then what we found, and I'll talk about what these are, but the two primary factors that came out of this exploratory factor analysis is a statistical method, it's what we call probability based versus safety first, and then optionality versus commitment. And then we found four factors that were significant. They weren't shown to be as distinct or as important but ultimately they can help tell the story and  these, well I'll go through each of these in detail so no need to list them by name right now. But we'll talk about these and then what comes out of that and I’ll explain that as well. When we understand  how somebody scores on these different factors that really can help to describe what type of retirement strategy will resonate with them whether it's a total return or risk wrap or income protection or a time segmentation.

And so this is based on the retirement income optimization framework, which is those four L’s as the financial goals. On the left mapping into liabilities or expenses. On the right, and then thinking about how we position assets to meet our goals. And the different styles are going to put different emphasis there. Where if you’re total return you don't care as much about reliable income as a specific asset. You're fine using the diversified portfolio to cover essential expenses, and also if you’re total return you're going to put less emphasis on having reserves as a distinct category. You're more comfortable with just general liquidity, not necessarily thinking about how assets are earmarked for different purposes, and so forth.

And so this slide is just an article that came out today in Advisor Perspectives. So risk tolerance questionnaires, that's the fundamental tool a lot of people use to decide on an asset allocation, it's like how much short-term market volatility can you stomach. To explain, should I have a 40% stock allocation or a 90% stock allocation.  There's a lot of concerns about risk tolerance questionnaires in general, about how well they work. And really the point here is not to get into any of that discussion but to just point out risk tolerance questionnaires don't really line up with retirement concerns very well, and as can be expected,they actually do line up with the lifestyle concern, which is kind of how you might think about it.  Like if I'm more risk tolerant, if I can stomach more market volatility, it might especially, when we get through this whole discussion, it might imply I'm comfortable. I have more concern about my overall lifestyle.and I'm not necessarily thinking as much about the other concerns. 

But with the two main factors that we'll look at with retirement income style awareness, we can find a match to all of the different retirement concerns. Where reserves would be liquidity, in this context. So these two main factors, now this is where we're starting to get into the meat of the matter. So how would you like to draw your retirement income? If you're someone who's probability based you're more comfortable relying on market growth. We have the idea of the risk premium, that stocks will outperform bonds over reasonable holding periods. And if you're comfortable relying on the risk premium and you know historically the S&P 500's outperformed long-term government bonds by six percent on average since the 1920s, if you're comfortable using that to fund your retirement, you're more probability based.

Safety first is you really would prefer to have some sort of contractual protection supporting your income. That could be holding individual bonds to maturity or it could also be using risk pooling through an annuity. But you're less comfortable relying on the market. In this regard you'd rather have some sort of contractual protection backing up your retirement plan and you can think about how you might answer, how you might identify yourself on that spectrum.

And then optionality. This kind of surprised me, because if I had to guess in advance which would be the two most important factors, I don't think I would have picked this one. I  probably would have picked something more like accumulation versus distribution. But this is just how much optionality do you want in your plan. And if you're someone who has more of an optionality preference you really emphasize having flexibility, wanting to keep your options open. And that's because a sense of you want to be able to take advantage of new opportunities. You don't want to really be locked into any particular strategy. You really value the optionality for a plan. 

And commitment orientation is you feel more comfortable just locking into a solution. If you know that something will solve for a lifetime income need you don't necessarily need the optionality as much. Of course you're going to want to have some liquid assets, but you have the sense, partly as well, that  you've got a plan that will work. So you can take it off your to-do list. You don't have to worry about ongoing decision-making and everything. You're more comfortable committing to a strategy.

And this, as I said ,is going to be one of the two important factors based on that exploratory factor analysis. And then well, we can see how these fit together. So we create this matrix, and that's how Robert said, like a morningstar style box type situation. On the left is safety first; on the right is probability based. On the top is optionality and on the bottom is commitment. And so you can see these four quadrants developing, where if you're in the upper right you're probability based, comfortable with market growth, and want to keep your options open. If you're in the lower left, you're safety first, you want contractual protections and you're comfortable committing to a strategy. And then it's a mixture.

And the other two, so then the secondary factors that can help tell the story, but are not primary. They're less important in terms of they're not as distinct as important factors to help describe a strategy. But one is like how do you view flooring, time-based or perpetual. And this time base is like time segmented flooring. Like I'm thinking about I want to build a protected floor to cover my basic expenses, if it’s time-based preference would mean it's like time segmentation, if I can have my basic expenses covered over the next three to five to eight years, there's some flexibility there.

But if I can have the front end expenses covered I could have a time-based preference versus perpetual flooring, well that's more like the world of an annuity with risk  pooling and supporting a lifetime income needs. So do you have a time based or a perpetual flooring desire? How do you view your reserve assets? And this is where I mentioned these two attitudes about liquidity. If you have a true liquidity mindset you really want to have assets that are not earmarked for other goals, that are truly liquid in the sense that they're your reserves. You've already got other assets that are covering your future budgeted expenses, covering your legacy goals. These are assets specifically set aside as reserves to provide the liquidity to cover unexpected contingencies or spending shocks, and you make that distinction as important. I want to be able to have these assets earmarked separately as reserves.

Whereas those who have more of a technical liquidity mindset aren't making that type of distinction. They’re thinking about their assets more generally as they have a total pot of assets and they don't necessarily have to have distinct reserves. To just figure things out, if they have an unexpected expense they'll figure out later how that's going to impact other spending and so forth. They adjust.

Technical liquidity is like a brokerage account. It's liquid but it may be earmarked for other purposes but you're really not thinking about things that way you're just generally thinking about a big pot of assets now what's your mindset about retirement investing.

If you have an accumulation mindset you're really just maintaining the pre-retirement accumulation style of investing in post-retirement. Which is to focus on risk-adjusted returns for your portfolio. And that's where your emphasis is, over trying to maintain a predictable income from the portfolio. And I mean any of these preferences are completely valid, there's no problem with that. But you're not worried as much about predictable income. You'd rather focus more on just maximizing portfolio returns, subject to your risk tolerance.

Whereas if you had a distribution mindset you do focus more on predictable income and in that regard you don't necessarily need to maximize your portfolio returns anymore. You'd rather have stable predictable income being generated by your portfolio and so you'd prefer strategies that do that even if they sacrifice having the highest possible total return from the portfolio.

And then the final one of these is front loading versus backloading. If you have a front loaded preference you want to spend more today while you're healthy and alive and assured that you can actually enjoy it, and you worry less about if you have to cut your spending in the future. That's okay,  with a front loaded preference.

And if you have a back loaded preference, this is the idea of longevity risk aversion, that you're worried about living beyond your money. So you're willing to sacrifice some spending today to better protect your future lifestyle. You're wanting to more backload your spending. You don't want to be 95 years old and not have anything left except a Social Security benefit. So you're willing to spend less today to stretch that money out into the future.

And now we can add those characteristics to this recent matrix as well, and it's all based on correlations. So probability based does tend to be correlated with optionality, that if you're comfortable with market growth you also tend to want more optionality. That's what that diagonal area arrow's about, going from the upper right to lower left. And then at the same time safety first tends to be correlated with commitment. If you want contractual protections you also tend to be more comfortable committing to a strategy.

And then if you're safety first and optionality, those tend to not be as correlated with each other and that's where the sense of a behavioral strategy develops. You want contractual protections but you want optionality. It's kind of a bit of a contradiction there, but there's a strategy that has been created since around the 1980s that can accommodate that. Likewise in the bottom right hand corner, probability based and commitment. You're comfortable relying on market growth but you'd also want to commit to a strategy. And there's also a bit of a-- it's those two don't necessarily go together. 

And then we can start adding in where these other characteristics apply. So in the upper right hand corner that's more of an accumulation mindset. Tends to be up there as well, the top half of the chart is more frontloading as a preference. Well  on the left hand side you have the true liquidity. In the bottom left corner you've got more of a distribution predictable income perpetual income floor. On the whole bottom half you can have more of a back loading preference. And then on the right you also do have a technical liquidity at work there. 

So this really gives us our retirement strategies. Think about a total return investing strategy. You're comfortable relying on market growth. You want to keep your options open. You're more comfortable with the tools of modern portfolio theory, more of an accumulation risk adjusted return. You do think more in terms of technical liquidity. You have more of a front-loaded preference and the time base, you don't really have a need for a perpetual income floor. So that's the 4% rule, I mean that's systematic withdrawals from an investment strategy. And those characteristics can explain that quite well.

Then in the bottom left where the other kind of consistent preferences are, you’re safety first. So you want contractual protections. You're willing to commit to a lifetime strategy, well commit to a strategy. You have a distribution mindset so you want predictable income. You're comfortable with a perpetual income floor. You want more true liquidity which is earmarking assets for specific goals, and then seeing what's left as reserves. And you have more of a backloaded preference, so that's kind of describing simple income annuities for building a lifetime income floor, and then a diversified investment portfolio can go on top of that. 

Then in the upper left that's time segmentation. You want contractual protections but you also want optionality. And so the  framework developed to provide both of those concerns is that you have contractual protections with the holding of fixed income assets for short-term expenses, but then most of your assets are left in a growth-based investment portfolio providing the optionality.

And then the risk wrap in the lower right hand corner. That's also a behavioral type strategy that's just been developed since the 1990s and again that's that whole world of deferred annuities, like variable annuities with lifetime income benefits attached to them. You're comfortable relying on market growth but you also you're not completely comfortable. In some ways you also want you to commit to a strategy. You have more of a back loaded preference. You have that technical liquidity mindset which is the hole the deferred annuities talk about. How they're liquid. But you know that's been earmarked for your future spending, so you can't really take advantage of that liquidity. But that all explains building a lifetime income floor with deferred annuities with living benefits, and then applying the investment strategy on top of that.

And then based on the Retirement Researcher, on my website. The kind of people who are part of that community, the study we did with them, we did find about a third of them were in that total return quadrant, somewhere around a third are in the income protection, and then somewhere around 15% were either time segmentation or risk wrap.

And then these are styles. So that once you understand your retirement income style it doesn't mean that you have to stick to that strategy. But I think it can be a useful starting point to think about how you want to go to approach building a retirement income strategy. And I really explained at this point, but again, it's just going through the four strategies: the total return and the characteristics it has, the income protection and the characteristics it has, the time segmentation and the characteristics it has, and then the risk wrap strategy and the characteristics it has.

And so to conclude about this, there are a number of different viable retirement income strategies, and this is a really important starting point, that I do try to be agnostic and to say that any of these strategies are valid and viable. It's just a matter of understanding who they're right for. And the right approach for someone depends on their personal style and just because one strategy is right for you, a different strategy might be right for someone else. And there's more flexibility out there for people to find the kind of strategy that will best resonate with their personal preferences and personal style.

 I mean it's just like when you pick a career. There's not one kind of job that's superior for everyone. Some people might like more of a salesman type role where they have to like maybe more volatility to their income and that sort of thing more like a total return approach. A college professor tends to be more of like an income protection style with the bond of a tenured position providing income on an ongoing basis. So there's no right or wrong answer to what job someone chooses. And really there's no right or wrong answer to which style someone chooses for their retirement and so this RISA, retirement income style awareness, can provide a starting point for that discussion. So then that was chapter one of the book. 

So now we'll get into the discussion around tax planning for efficient retirement distributions.

And as some of you noted, at least a few of you it sounds like--I did this presentation today at Retirement Researcher and it's a really hot topic right now-- and I don't have too much in the way of tax reform in this, but we don't know what the ultimate new tax legislation will look like. But with what we've heard in the last couple of weeks it's not necessarily changing too much of this discussion. That some of the tax brackets are moving around. The big thing might be we're not going to have the back door Roth anymore, and we'll have to see how that plays out. But otherwise the ongoing tax reform debates are not really impacting too much of what's in this presentation.

Okay, so in that 12-step process we're thinking about retirement. We're talking about tax planning now and so we'll talk about the logic of tax efficiency, tax diversification, asset location, tax efficient retirement distributions, pitfalls to monitor when generating taxable income, and then an example for tax bracket management. And that was one I did, put an excerpt of that book into a column at Advisor Perspectives that was picked up at the bogleheads. So if you saw that thread that's one of the places where this session was announced. I’ll talk more about that example, like some more commentary on it.

So the logic of tax efficiency, and this is the punchline coming out of that example at the end, where with retirement planning there's so many different aspects of it. Where making short-term sacrifice can help support a long-term benefit. And that's what we'll see in that example at the end.

Where the gray colored strategy is watching the wealth spend down for someone who has two million dollars at age 60. They're retired. If they take social security at 62 and then do a conventional spend down strategy: taxable, tax preferred, tax-free. You can see there they've got more money there for a while until about age 77. And then it keeps plummeting, and then they run out of money around age 88. 

And the  strategy that I'll identify as a more tax efficient strategy-- is going to get into the whole strategic Roth conversion--they're going to manage a very high level of taxable income until they turn 70. And then they're going to start their Social Security benefit, and then subsequently be able to manage a much lower taxable income level of a much lower adjusted gross income. And so in the short run they're going to fall behind, especially because they're delaying Social Security and they're paying more taxes early on. But that's going to set them up for long-term benefit. And ultimately with that strategy their money is going to last 5.6 years longer. And they're at age 88, they still have about $320,000 left compared to that other strategy that's run out at that point. So in the short run there's going to be a smaller legacy value for their assets, but in the long run the strategy is going to pay off and help them.  And this is the example I'll be showing at the end of the presentation. 

So short run costs for long-term efficiency. And doing like this is an important topic because it really can extend the portfolio longevity for a retiree. And why is that?  Why is what we're talking about important? Because we have a progressive tax system in the United States where as your income goes up you're paying taxes at higher tax rates. And so this is all about trying to--like we have to pay taxes--but trying to pay taxes when we can pay them at lower tax rates. And then try as much as we can, within the law, this is all within the law, avoid paying taxes when we're in higher tax rates, by strategically preparing for that.

And also the tax code is filled with all kinds of non-linearities and traps in terms of what I'll get into. How you may think you're in the 22% tax bracket in retirement when you might actually be paying more than a 50% marginal tax rate in some circumstances. A marginal tax rate, that's like I just said, can be higher than income tax rates and we have a number of different types of tax treatment in the tax code to coordinate.

So non-linearities in the tax code. Many tax rules are connected to adjusted gross income not taxable income, and the difference there is the below-the-line tax deductions. So having a big tax deduction can't save you from some of these non-linearities because it's the adjusted gross income before the deduction that counts. Itemized deductions then only count when they're higher than the standard deduction. Preferential income sources, long-term capital gains and qualified dividends, stack on top of other income and have different tax rates and there can be implications of that. A dollar of income can trigger tax on up to 85 cents of a Social Security dollar, as well as triggering tax on that dollar of income. It can also, a dollar of income can trigger higher medicare premiums, and I won't get into detail about that. but we also have that 3.8% Net Investment Income Tax, it is very non-linear and now you have to calculate it as the minimum of two different numbers. And required minimum distributions will start to play a role after age 72 and that can surprise someone by pushing them into a higher tax bracket.

So what we're talking about here with income taxes, the basic kind of when you're going through the 1040. Total income is all your taxable income sources. You take off the above the line deductions, retirement account contributions, HSA  contributions. That sort of thing gives you the adjusted gross income. And then you can either take the standard deduction or itemize and that will give you then taxable income.

Okay, so this is where, probably with this group tonight, we can accelerate this conversation. Everyone most likely is aware of the taxable brokerage accounts, tax-deferred accounts such as IRAs and 401-ks and other employer-based retirement plans, and then after tax accounts which I’ll sometimes call tax exempt, sometimes called tax-free, and sometimes called Roth. And these are the three main types of tax structures we have in terms of the tax code, providing different tax treatment. So the taxable accounts, you pay ongoing taxes on income shot off from the account, as well as any realized capital gains. Long-term capital gains, qualified dividends qualify for lower tax rates. The cost basis or principal into the account can be taken out without tax. You do get a step up in cost basis at death, avoiding capital gains tax. And that was something people were worried was going to disappear with the tax reform ,but as of now, it looks like it will remain.

And then also, distributions from taxable accounts can be structured to get capital gains or capital losses. You can trigger capital gains or you can trigger capital losses. And if you trigger a capital loss there's the wash sale rule. You have to wait 30 days to buy back the same asset. But you can trigger capital gains by selling the asset and immediately buy it back,and triggering that taxable income if you're doing that for a strategic reason.

Tax deferred accounts. We think of them as generally being deductible contributions and then tax deferred until distributions are taken and those are taxed as ordinary income. Required minimum distribution starts at age 72.  You may have an employer match, and also early withdrawal penalties can be an issue before age 59 and a half.

Tax exempt or Roth accounts.  Roth IRAs, employee contributions to Roth 401-ks, you had to pay taxes on that money, it's not tax deductible. But once it goes into the account, assuming you have a qualified distribution, which you can set up to have fairly easily assuming you're at least 59 and a half and have a Roth IRA open for at least five years, then you do not have to pay taxes on the distribution. Roth IRAs do not have required minimum distributions. Roth 401-ks do, but you can just roll over to a Roth IRA to avoid that problem. 

There are income restrictions on making contributions to Roth IRAs and like I said, right now we have the backdoor Roth idea where you make a non-deductible contribution to an IRA and then convert that to a Roth. That currently with the proposal proposed legislation will not be allowed starting in 2022, but that of course, any of that, can change as we're nowhere near the final tax law.

And this can be a good choice in low income years, to contribute to the Roth account when you're in a lower tax rate relative to the future. So when you're choosing between the two, this is all kind of basic financial literacy type stuff as well, that you're trying to pay taxes at lower rates. So when you have a high income or you're in high marginal tax brackets, that's a good idea to make the contribution to a tax deferred account and get the tax deduction. If you're in between jobs, or something where you currently have a lower income, facing lower tax rates, that can be a good opportunity to put into a Roth account.

And the same logic applies to Roth conversions. You want to do it when the current tax rates are lower relative to what you believe they'll be in the future for your situation. And it's also nice to have some tax diversification between each of the different types of tax structures. 

Now if you'd like, because there's limits on how much can go into the Roth and employer plans and IRAs, if you'd like additional tax benefits beyond that there are different options: 529 plans, health savings accounts with the high deductible health insurance, where you get that triple benefit of tax deductions, tax deferral, and tax-free distributions for qualified medical expenses. I-bonds or E-bonds give you that they're taxable but you get tax deferral; you're not paying taxes until the distribution or until you have redeemed them. Tax-exempt bonds can give you tax deferral and tax-free distributions though they have a warning when it comes to retirement. Interest from those can be counted towards determining Social Security and Medicare taxes. Non-qualified annuities and then life insurance can all provide tax benefits as well.

Asset location. So we have these different tax structures, where do we put our assets. First, asset allocation is always most important. Like if I view my strategic stock allocation is 60% stocks, I should go with that first even if I only have 40% of my investable space in a taxable account. It's always asset allocation first.

But then you can follow the guidelines on asset location, about where to keep that money. And so when we talk about taxable versus tax advantaged accounts, whether that's tax deferred or tax free, we start with, well any tax exempt bonds. There's no point in owning them anywhere but a taxable account. Then US stock index funds tend to be very tax efficient asset classes so they can easily go into a taxable brokerage account. International stock index funds may have a higher dividend so a little bit more taxable income comes out of it, but if it's low turnover generating less taxable income.

Like I was saying today, interest rates are very low right now and so because cash or bonds are not really generating much income that unfortunately makes them very tax efficient because there's no taxable income being generated. So in a very low interest rate environment bonds can actually get pushed higher up on the list, but in a more normal situation bond interest is taxed as ordinary income on an ongoing basis so bond mutual funds are generally less tax efficient.

Actively managed stock funds are less tax efficient because of more turnover and realized capital gains within the fund itself and so forth. Then commodities and real estate investment trusts as being the least tax efficient most benefit from having in a some sort of tax advantaged account.

Then within the tax advantaged world should it go in tax deferred or tax exempt. Well the general thought there is assets with higher expected returns can go in that Roth tax-exempt environment. So if you have any emerging market stock funds, any small cap value type funds, a Roth is a good candidate for where you might want to put that sort of thing. And then assets with lower expected returns, like bonds or other kinds of lower yielding but tax inefficient asset classes would belong more in the tax deferred account.

Now there's two reasons for that. One of the side effects of a tax deferred account is if you had any long-term capital gains they’re taxed as ordinary income. You lose that long-term capital gains treatment in the tax deferred account. But you can get around that issue by holding within a Roth account you don't have to worry about paying taxes on any of those gains, that's all coming out tax free. And also, to the extent that we tend to spend Roths later in retirement,having more longer term higher yielding  but meant to be held for the long term type assets there can make sense. So taxable accounts for tax efficient asset classes, tax deferred for tax inefficient, lower returns, tax-free for tax inefficient but higher return asset classes.

Now the tax efficient retirement distributions, which is more our focus, for this the conventional wisdom on a withdrawal order sequencing strategy is to spend taxable assets first, then tax deferred, and then tax exempt. But we can do better than that by using a tax bracket management framework. And so tax bracket management is we're going to aim to pay taxes at the lowest possible rates. And that means if we currently have an opportunity to generate more taxable income and pay a lower tax rate on it, we'll want to do that. 

So we might be paying a higher tax bill because we're on purpose generating more taxable income, but we're doing that to pay at a lower tax rate and to help better set up the situation that in the longer term we can better avoid the higher tax rates. So we want to fill up lower tax brackets with taxable income and potentially draw from other resources that are not taxed if we still wanted to spend more but wanted to avoid a higher tax bracket.

That will also help with the process of required minimum distributions after age 72 where if we can get some of that money out before we're less likely to face a big RMD that could push us into a higher tax bracket. It's part of that story of short-term sacrifice. You have to pay more taxes in the short run but by doing that at lower tax rates that can create longer term benefits. And the biggest impacts, we can see  that they both happen at around the same income levels, which is the point where you jump from the 12% to the 22% federal tax bracket, which is $40,525 for singles, $81,050 for married filing jointly. And then the preferential income jumps from zero to fifteen percent at not quite the same numbers but very close, $40,400 for single, $80,800 for joint filers.

So if you're able to manage lifestyle spending, especially from taxable resources, and keep your taxable incomes under these thresholds, that can give you strong opportunities to go ahead and fill up these thresholds. It's the same story for other tax brackets too, it's just this is where you'll see the biggest impact of tax planning .So this is more of a middle-class type retirement strategy as opposed to a very high net worth strategy, because these are not super high income levels from the perspective of a high net worth type individual. And there's a lot of tax advantages that can be available, especially when we start adding in some of the other non-linearities in a moment.

So we're talking about generating more taxable income than necessary to pay taxes at a lower tax rate. So there's three ways we can do that. the first is we said the conventional wisdom is you spend all your taxable money first then tax deferred and then tax-free well what you can do to generate more taxable income is you cut back on the distribution from the taxable account and replace that with the distribution from the tax deferred account and so that can give you the spending you want while raising taxable income to the desired bracket that you're trying to manage. 

Second you can cover the spending goal from taxable accounts but then increase your taxable income by doing Roth conversions from the the IRA to the Roth IRA and then also you can pay the taxes on those conversions ideally from the taxable account as well, not from the IRA. A reason why you could accelerate payments out of the taxable account even faster because you're using that to pay the taxes on the Roth conversions, and you're using the Roth conversions to generate more taxable income in the short run.

And then the third approach is to on purpose sell assets with long-term capital gains, not for any sort of market timing or anything, but you can immediately repurchase them and you're doing that to generate taxable long-term capital gains and to reset your cost basis to a higher level. And especially if you can take advantage of doing that when you're still in the zero percent tax bracket for long-term capital gains and that we saw those around $40,000 for singles, $80,000 for married filing jointly.

You can really take advantage of that and you're paying taxes,but at a zero percent tax rate and so that's a very attractive feature. Then it jumps to 15 and 20 percent and one of the aspects of the tax reform being discussed now is to have it 0%, 15% and then 25%, and then that Net Investment Income Tax on top of that too, potentially.

So you can work around with this. You have resources that will create taxable income on the left. You have the income with preferential tax rates in the middle, the qualified dividends, long-term capital gains. And then you can have spending resources once you've filled up the tax bracket.

If you still want more spending you have ways to draw additional spending power without generating more taxable income. And that can be the cost basis of your taxable account, Roth IRA distributions, a portion of non-qualified annuity distributions, a portion of Social Security benefits, health savings accounts distributions for qualified medical expenses, reverse mortgages, and also cash value from life insurance, as different options for covering spending but not having more taxable income.

So Roth conversions. It could be within employer plans too, but it's easiest to just say an IRA to a Roth IRA. You cannot  convert required minimum distributions. So it's got to be an amount in excess of that. They only begin at age 72, so you can, it's not an issue before 72, but it is after 72. You can't convert amounts that are required to come out as required minimum distributions. Like I said, ideally you wouldn't pay taxes from the IRA on those conversions. Hopefully you have some other resources to pay those taxes.

Now if you're retired by your 60s and you're delaying Social Security, that can be a great opportunity where you don't have a whole lot of taxable income to really get a strategic kind of Roth conversion strategy running. Also, other times you might do this: if you have a year with a large tax deduction, maybe a big medical expense or something that's just a big tax deduction in a particular year, you might offset that by generating more taxable income. 

And then also moving more shares during a market downturn can be an opportunity if you have other resources to pay the taxes. If the market goes down you just have more opportunity to get money sent over to the Roth generating less taxable income. You're moving shares over at a lower value so that you're generating less taxable income when you do that.

Now I'm talking about front loading taxes,and here's some additional reasons why you might like to front load taxes beyond what i'm describing. And the first is just the public policy risk. A lot of people are concerned that taxes will be higher in the future and if that is something that concerns you, you might like to therefore accelerate some of those tax payments today when you feel like you may be in a lower tax system today than in the future.

The death of a spouse is important as well for tax planning because after the year of the spouse's death that household shifts from married filing jointly to a single filer. And those tax brackets are a lot lower. And so some expenses might go away but income doesn't necessarily drop in half by any means. And you're going to have a higher tax bill as a single filer than as married filing jointly, so you could have more exposure to paying tax on Social Security, more exposure to medicare premium heights and so forth.

And also the Secure Act in 2019 created a lot of conversation around Roth conversions because now receiving an IRA as a beneficiary is a lot less attractive. If you're an adult child receiving an IRA  as a beneficiary you may be in your peak earnings years and before the Secure Act you could use a lifetime stretch to distribute. Inherited IRAs have required minimum distributions but the rules work differently. You used to be able to extend those out over your life expectancy. After the Secure Act adult children are all going to face the 10-year window where you have to distribute the entire account balance within 10 years. And so if that's overlapping with your highest tax years, highest earnings years, you're at the peak of your career at that point, that would speak to this strategic Roth conversion.

If I already know that some of my IRAs may be inherited, as I'm not necessarily going to run out of money at this point, I'm going to be comparing my tax bracket today as a retiree to my beneficiaries tax bracket, and that might accelerate my Roth conversions.

At the same time anything going to a charity the IRA can be a great resource for that because it's the same concept of paid taxes when you're in the lowest tax bracket. Anything going from an IRA to a charity can be taxed at zero percent. And so you wouldn't necessarily want to convert assets that would go to charity. But you might like to convert assets that will go to a non-eligible designated beneficiary.

So a human who doesn't get special treatment to have a lifetime distribution. There's still some people that can get the lifetime stretch. Spouses, well spouses can just rename the account in their own name; but also people who are less than 10 years younger than the deceased individual, so perhaps siblings in that situation; permanently disabled individuals. But otherwise most human beneficiaries are going to face that 10-year window.

Okay, so those are reasons why you might want to accelerate taxes. Now here's some pitfalls to monitor when you are generating more taxable income. So there's a number of issues and I'll emphasize three of them here. 

The first is the Social Security tax torpedo, and if you haven't heard of that before it's going to be a lot of fun. The potential for increased Medicare part b and part d premiums, pushing preferential income into higher tax brackets. So pushing more into a higher tax bracket, I'll explain that, and then some others that I'm not getting into now.

But also if you're pre-medicare age and you have an Affordable Care Act health insurance policy, subsidies could be jeopardized. Although in 2020, 2021, and 2022, this is not an issue, the subsidy cliff there was taken away, but it returns in 2023. Where if your income goes one dollar above 400% of the poverty line you suddenly lose all subsidies for the health insurance, and the net investment incomes are taxed at 3.8 percent.

The additional medicare taxes on higher earnings and the alternative minimum tax are all pitfalls of generating more taxable income. But again we'll focus on those first three with the boxes next to them.

So the Social Security tax torpedo. Up to 85% of your Social Security benefits are taxable. The tax schedule to determine how much of your Social Security is taxable was designed in 1994 and it's one of those rare parts of the tax code that's not inflation adjusted so those numbers have been the same since 1994 and that just means over time with inflation more people are going to be hit by taxes on their Social Security benefits.

Determining the benefit taxation and then the marginal tax rate is quite complex. And this is where the people who designed how Social Security will be taxed. I don't know how they could have created a more difficult situation than they did. I had to spend days just with the programming on this to make sure I wasn't making mistakes and everything because you calculate three different numbers, see which is smallest, and there's so many non-linearities here. but we'll we'll walk through what's going on in just a moment and then proactive planning can help to potentially avoid the full tax torpedo, that you may be able to set up so you're not paying taxes on 85% of your Social Security benefits it might be hard to get that down to zero percent but if you can pay taxes on 20% of your benefits instead of 85% of your benefits that could be a big win. And that's going to be a key part of what's helping when I talk about the tax efficient strategy adding so many years of portfolio longevity.

And a key point, if I was giving a presentation about Social Security, a key message would be to think about delaying towards age 70 to take advantage of the insurance value, the inflation protection, the survival benefits. And this whole tax planning discussion is just another reason to consider delaying Social Security towards at least for the high earner, in a couple towards age 70 and for a single individual. The low earner in a couple might claim earlier but not the higher earner.

Okay so this is where things start to get tricky with the Social Security tax torpedoes. So there's going to be a bunch of different modified adjusted gross income numbers, and if you look in the tax rules the definitions will be quite long but there's a bunch of small things that probably don't affect most people when we talk about Social Security.

The basic idea of the Social Security modified adjusted gross income is it's your adjusted gross income less your taxable Social Security benefits and you don't know what percent of--that's what makes it so hard here--is you're not going to know what percent of your benefits are taxable until you've figured all this stuff out .So you kind of have to work through a loop, but your provisional income, and it's sometimes called combined income, based on the source. It's that Social Security modified adjusted gross income. So it's your adjusted gross income less your taxable Social Security benefits. But then plus half of your benefits. So you're putting half of the benefits back into this. And then also any tax exempt interest is going to be added as well into this number. And then this is what we're working with in terms of those 1994 thresholds to determine how much of your Social Security benefits will be taxable. And these are not like taxable incomes. These are that provisional income which is that unusual measure that includes half of your Social Security benefit.

So this is what the tax torpedo would look like. Every Social Security benefit has a different tax torpedo, every level of benefit, so if you, a 2021 single filer with a $30,000 annual Social Security benefit, what we're graphing on the bottom is all your income except Social Security .So it's your adjusted gross income minus your taxable Social Security plus your tax exempt interest. And then we're looking at your marginal tax rates. And those jump up to be 12%,  22% and so on with the yellow. And then the purple is looking at Social Security.

What's your marginal tax rate?  And you can see you may have thought, well by the time you added Social Security you may have thought you were going to be in the 22% tax bracket. But there's a little period there where you're actually paying a marginal tax rate of 40.7% and that's the Social Security tax torpedo. 

That's where, at these kinds of income levels, you may be paying a much higher tax rate than you expected. And so what's happening in that is a dollar of income when you're in that range identified there up to that 43,000 plus, a dollar of income you're going to pay taxes, 22% on that dollar plus that's going to uniquely trigger a dollar of your Social Security to be taxed at 85%. So 22% of 85% of a dollar of Social Security and so those add up to 40.7%. And that's now your marginal tax rate. A dollar of income, you're paying taxes not just on that but it's also pushing another dollar of your Social Security to be taxed at 40%.

And that torpedo jumps around because there's just where you are with the tax brackets. It's jumping around at different places, but that 40.7% is the highest it gets, and that's in that range where it's pushing you into paying tax on 85 cents of a dollar of Social Security. and with this benefit level that adds up.

Or that happens up into an adjusted gross income of $69,006  which if you took a standard deduction off of that we're talking about a taxable income of $56,806 if you're under age 65. So that incomes just below that range you're at a 40.7% marginal tax rate even though you were expecting to be in the 22% marginal tax rate.

The next thing is Medicare, the income-related medicare adjustment amounts. The premium increases  work differently and this is where you have to pay higher premiums for part b medicare, as well as if you have a prescription part d drug plan, part d as well. And those premiums just jump at different income thresholds. Now your medicare modified adjusted gross income is your adjusted gross income plus a bunch of minor things, but the main one is just that tax exempt interest.

But the tricky thing there is, it's from two years prior, not from the current year. Now two years up to today things can change, so if you do have a life-changing event, such as you retired and don't have earned income anymore, you can file form SSA-44 and request not to have that IMRA premium hike.

And see that there's a whole list of valid excuses, just doing a strategic Roth conversion is not a valid excuse. So you will be stuck with any higher medicare premiums that generate. But in some cases you might have a valid reason to request not having those premium hikes, but how this plays out is so if you're single and your modified adjusted gross income is $88,000, your total premiums for the year and I’ll show that better on the next slide, one more dollar of income causes you to face annual premium increases of $860 in 2021. So that is an 86,000% marginal tax rate on that dollar of income. And then it goes back down again beyond that. But this is working differently than the tax torpedo. This is if you have one dollar too much, in two years you're going to trigger a big additional premium hike. And so this becomes relevant even if you start Medicare at 65, this starts to become an issue with your income at 63..

And so here's the table for 2021. So this is based on incomes in 2019, and here you can see the thresholds for single filers, married filing jointly. You have standardized part b medicare premiums for the medical insurance. Part d can vary, but this is going to be based on the average part d premium in 2021 which was $33.06 per month. And so those are monthly numbers, but then the number on the right is annual. So it's the part b plus the part d times 12. And that's per individual, so married couples would have to double those numbers.

And you can see that once you get one dollar higher into that second one it's $860 more, $2,178 or $2,179 per year up to $3,030.39 per year. And that is, again, the next premium jump is at  $111,001 for singles, $222,000 for couples filing jointly. And then you're jumping up by another $1,300 of annual premiums. And so it's just that one dollar of income is triggering the big increase in medicare premiums, and so that's something to be aware of.

Now if you have to occasionally generate, trigger one medicare hike, it might be worthwhile in the long run, but you want to be careful about making ongoing mistakes where you accidentally just trigger slightly too much income and therefore have to deal with a much bigger medicare premium two years later.

And then we have this preferential income issue. So your long-term capital gains and your qualified dividends stack on top of your other taxable income. And so here's an example to illustrate the basic idea. We have a single individual, their taxable income is $42,400, but that's divided. They have $38,400 as ordinary income and $4,000 as long-term capital gains. So taxes on that. The $38,400, they're still in the 12% federal income tax bracket on their ordinary income. And then they stack the $4,000 on top of that. $2,000 of that will be taxed at 0% and $2,000 of that will be taxed at 15%. 

Now suppose they add one dollar more of ordinary income, so they have $38,401 of ordinary income that they have to pay 12% tax on that dollar. But look at what else it does. They now have one less dollar being taxed at 0% for their long term capital gains, and one more dollar being taxed at 15%. So they're paying 15% on that long term capital gain dollar also. So they thought they were in the 12% federal income tax bracket, but they're actually paying a 27% marginal tax rate on that dollar of income. And where that can get really fun is that when it also overlaps with the Social Security tax torpedo. So that 47%, you can add another 15% on that.

 If you're also having the same issue happen where you're triggering another dollar to be taxed at 15% on the long term capital gains, now you're at like a 55.7% federal marginal tax bracket. So even though we may think taxes will be less in retirement, if we're not planning for this, taxes can be quite a bit higher than we expect, when these circumstances are triggered.

Okay so let's now see how this plays out with an example.In this example it's a 60 year old single individual. I'll refer to her as she, although gender doesn't matter for the example, that just makes it easier to stick with one. So she's 60 years old. We're simplifying investment returns, she's basically investing in bonds. I just assume inflation is zero, not so because I want to show all their future tax numbers and to not have to worry about inflation and how that impacts what those numbers mean. I think it helps to make it more easy to interpret the results if we just assume there's no inflation.

But she is getting a 2% real return, so all of her assets are growing at 2% a year. Now I heard she's got $400,000 in her taxable account, $1.3 million in tax deferred ,and $300,000 in tax exempt. She wants to spend $95,000 a year pre-tax.

So this came up at the bogleheads, that is more than 4%, but also she's going to have so much, 

something like the four percent. Really, that rule never can be used in practice just because no one actually spends a constant amount from their portfolio every year. You always have to deal with the fact that we're not doing anything complicated here. She always wants to spend $95,000 but at some point Social Security is going to kick in for her and also taxes are going to go on top of that. And if she doesn't have constant taxes every year there's no constant distribution amount from her investments.

She does have a nice smooth spending goal, but taxes go on top of that and then at some point Social Security will come into play. If she claims that, that's our primary insurance amount. Her full retirement age is 67.  So if she claims at 62 she'll get $21,000 a year from Social Security. If she claims at age 70 she'll get $37,200 a year from Social Security.

Now there's five strategies I do look at in the book chapter, and for this we'll focus on one and five, the first and the last. But let me just walk through these. The first strategy. She's going to claim Social Security at 62 and she'll follow that taxable, tax deferred, tax-free distribution strategy. Her money, she'll be able to meet that spending goal for 28.99 years. Then her money runs out. No more investment assets and then she'll continue to have Social Security at $21,000. 

Now strategy number two. She doesn't change her tax strategy, but if she just delays Social Security until 70 that will increase 1.86 years on to her portfolio longevity, her money will last 1.86 years longer. Okay, and that's the benefit of delaying Social Security.

Now the rest of these strategies all have Social Security at 70 but they're adding more sophistication with the taxes. So strategy three is they're going to do tax bracket management. She will do so, but without Roth conversions. She's just going to spend less from taxable, more from tax deferred, to manage an adjusted gross income of $60,000 and a little bit later I'll show you the charts of how I come up with that number.

I think that is something I haven't seen elsewhere where in doing this I checked every adjusted gross income level and saw which one gave her the most portfolio longevity. And so managing $60,000 was the amount that worked best to give her the most portfolio longevity. And that gave her 3.83 more years than the baseline strategy, which were almost two more years than just delaying Social Security. So an additional two years of portfolio longevity by being a more tax efficient strategy. For she's now going to do Roth conversions and coincidentally the same adjusted gross income level would maximize her portfolio longevity and that's getting her about four and a half years longer than the baseline strategy one.

And then strategy five, she's going to do a two-part strategy. She's 60 years old right now, so until she's 69, for the first 10 years of her retirement, she's going to manage an adjusted gross income that goes right up to the second medicare threshold. So she will have a higher medicare premium starting at age 65 for one threshold. But she's going to go up to just before the second threshold, then she'll stop doing that when she turns 70. 

So the year she starts collecting Social Security. She's already done such a big Roth conversion strategy, by that point that now, for the rest of her retirement she can manage $25,000 of adjusted gross income, have much less of her Social Security be taxed, and her money lasts 5.6 years longer than in the baseline.

Okay. So that's what we're walking through here. So this is the claim Social Security at 62, conventional wisdom taxable, tax deferred, tax-free. This is her whole retirement situation that she's spending down from her taxable account, tax deferred account, tax exempt accounts. So you're seeing the account balances on the left, the amount distributed from each of the accounts each year under the spending of her Social Security benefits, her required minimum distribution amounts-- they're never binding in this example, she always wants to take out more from her tax deferred than the required minimum distribution--Roth conversions.

Her adjusted gross income, and then her taxable income, which would just take the standard deduction off of the amount of her Social Security that's taxable, and then her federal income tax bill. So this strategy, the first years of retirement through age 64,. she's just spending her taxable account. And I was assuming her cost basis matched her account value, so she's not really generating much taxable income. She does have the 2% interest every year in her adjusted gross income, but it's nowhere near the amount of her standard deduction. 

So she's paying zero percent federal income taxes but she's wasting tax capacity. She could have at least generated taxable income up to the standard deduction and still had zero percent tax rates. Whether she went beyond that is up to her, but she could have generated more taxable income without actually generating any taxes. 

But then she gets into trouble around age 65, because this is where she switches to just spending from tax deferred and to pay to meet her spending goal, and pay her tax bill that's pushing her up to an adjusted gross income of $115,000 for most of those years. That's into that second medicare threshold for her, so she's looking at more than $2,000 additional dollars of medicare premiums, and I'm just adding that to the federal income tax numbers. 

So she's not, when she's spending from her tax deferred account she's being taxed on 85 % of her Social Security that's  $17,850 out of $21,000 and she has more than $20,000 of taxes for a long time, all the way through age 82. That's when she runs out of the tax deferred account and starts spending from her tax exempt account.

Then she's back to the issue where she doesn't have any taxable income at this point. She still has to pay those higher medicare premiums, that's that age 83 tax bill of  $2,164. That's just that additional medicare premium based on her income at age 81. But after that she doesn't have any more taxes, her adjusted gross income is zero. She's just spending from her Roth. This means she doesn't have taxes but she's wasting tax bracket space again and she ends up running out of money before she turns 89 years old. And then at ages 89 and higher she's able to spend her $21,000  of Social Security benefits. 

She's not triggering any taxable income. It is well below those thresholds for provisional income. So she had a lot of taxes between ages 65 up to about age 82, and that really disrupted her retirement. She can do better than this, to have that money last longer.

And these were what I was saying. I test every level of adjusted gross income, see how long the portfolio lasts and that's where I find a tax bracket management strategy. An adjusted gross income claim of $60,000  at 70 is giving her the most portfolio longevity there, and that's why I picked that as the standard. If you look at $60,000, that's where that curve gets the highest, on the top purple curve for the Roth conversions/Social Security at 70.

And then this is just a matter of trial and error, of saying, well what if she did two different things. What if she managed an even higher level before Social Security begins, and then reduce after that. And this is where she's going right up to the threshold of where her Social Security or her Medicare would be taxed. In reality you probably wouldn't want to go this close to those thresholds because one more dollar of income would accidentally trigger the higher medicare premium. So you might kind of build in a buffer of a thousand dollars. But the basic idea, you're going to pay more taxes early on but then after age 70 you're going to manage a $25,000 tax bracket, and that gives you the most portfolio longevity in that bifurcated strategy.

And here's how the tax situation plays out with this most tax efficient version. With this, she's going to do Roth conversions early on. So she's spending from her taxable account. She's paying taxes from her taxable account. She's then doing Roth conversions to manage that $111,000 of adjusted gross income. And then she's going to have a higher federal income tax bill in those early years. Her taxable account depletes by age 64. Then she doesn't do Roth conversions anymore because she doesn't have a way to really pay the taxes on that. So she's taking $111,000 out to spend from her tax deferred account.That doesn't meet the full amount she needs to cover her taxes, so she's taking a bit more out of her tax exempt account at that point and she continues to pay those high taxes up until age 70.

Then her Social Security begins and then she's able to at that point for a managed $25,000 of adjusted gross income that's going to dramatically reduce her tax bill. She does have the one or two years there where she's paying the higher medicare premium again but at some point her taxes dropped down to $1,460 and that's just based on her $6,843 of taxable Social Security out of the benefit of $37,200. So she's paying taxes on a much smaller percent of her Social Security benefit.

That's helping a lot. She front loaded her taxes, but after age 70 it's smooth sailing. She's able to take much less out of her tax deferred account at that point, blend it more with her Roth account distributions, and her higher Social Security benefit,and her money lasts until she's 94. And then after it does run out, at that point she still has that higher Social Security benefit. So  her money lasts 5.6 years longer and even if she does run out she still has 77%  more coming out of Social Security.

So that's kind of how this fits together to work better for her to help manage in particular--well in that first example,she was paying two bumps up the the medicare brackets as well as 85% on her Social Security, she was wasting tax capacity--here she's front loading her taxes and setting herself up very well. So once her Social Security begins not much of it is taxable, and she gets to pay lower taxes for the rest of her life. And that's what's generating more portfolio longevity for her in this example. 

So key ideas coming out of all this. The progressive tax code in the US and all those various pitfalls I talked about really can have an impact on your marginal tax rates. And so it can make this kind of planning important. So setting up pre-retirement with tax diversification and asset location, and then as you enter into retirement, thinking about Social Security claiming and how that impacts as well with managing tax brackets. And potentially conducting a strategic Roth conversion strategy again for money that you don't anticipate going to charity can lay the foundation for a much stronger retirement income plan in that regard.

So again, the book. Chapter 10 of the book, that's more than 70 pages about what I was talking about right now. Let me go ahead and wrap up there and get into the questions. Again, so thank you.

Robert: Thank you, that was wonderful. We just want to thank you once again for your time and expertise.These are pretty thought-provoking discussions that we as retirees certainly are trying to maneuver at a time where things should  become simpler and they become more complex.

And so we appreciate your insight into issues that we're all going to have to face to some degree. And again we thank you for the work you put into the book or we can kind of ponder it a little bit more. Thanks again, we really appreciate it.  By the way, Wade, will you make your slides available for the bogleheads?

Wade Pfau: Possibly. Yeah I can do that. I also want to thank in addition to Robert for doing a superb job and getting this organized, also Henry and Raj helped out behind the scenes with their input and perspectives.

Robert: We appreciate that as a reminder for everybody we now have a bogleheads YouTube channel. Once we have this recording edited we'll have it posted up there. Also I advise everybody to please bookmark the Bogleheads Calendar of Events, which is in the blog section of the forum, to see all the upcoming local and chapter national meetings as well. But the YouTube channel now also has the Bogleheads on Investing Podcasts.They're being uploaded as well, with Rick Ferri.

Again thank you so much Wade. This was a phenomenal presentation. We appreciate your efforts, especially after having done a webinar already this afternoon. And you definitely gave us  tremendous food for thought and peaked our curiosity to investigate this further with the book and other resources you have to offer. So thank you very much.

Wade Pfau: Thank you.



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