Why proper spending order is critical, to the tune of 70 bps, for RIAs to optimize client draw-down of retirement savings

Brooke’s Note: I liked this spending order article because it answers questions that I’d feel too stupid to ask. Many veteran advisors will not need to read this. But even the experienced spender-out of portfolios might find it worthwhile to sharpen his or her knowledge on this topic, which I’ve never seen hit head-on in an article. Now maybe we can get Colleen to write a spending order article geared to teenagers.

This article originally appeared in the May/June issue of IMCA Investments & Wealth Monitor Article.

In recent years, many people have become aware of the detrimental impact of higher costs on their investments, as evidenced by the significant cash flows going into low-cost mutual funds and exchange traded funds (Kinniry et al. 2013).

Spending order is an important consideration for retirees. Spending order is simply the order in which investors withdraw money from their accounts. Because various accounts are taxed differently, the spending order directly impacts the amount available for spending. Like low-cost investing, efficiently spending from a portfolio today can help fund a better life for tomorrow. See: Why most RIAs bent on launching in-house ETFs should swallow hard and start a mutual fund.

For most investors, spending needs persist in retirement even though salaries may not. Pensions, Social Security, and other income sources may provide for some of an investor’s retirement income needs, but they likely won’t provide for all of them, requiring retirees to spend from their portfolios. Complicating matters is the fact that many investors have one or more retirement accounts such as traditional or Roth individual retirement accounts (IRAs) or 401(k) plans, in addition to savings and investing accounts. See: One killer Roth conversion strategy in seeking a single-digit tax return.

Before determining which account to spend from, it is important to first determine a prudent portfolio withdrawal rate. This figure is important because spending order is unlikely to help an investor extend the longevity of a portfolio if the annual withdrawal rate is too high and jeopardizes the portfolio’s sustainability. See: How one boomer put faith in stockbrokers, trusted more in himself and retired rich enough.

Steep distributions

Figure 1

Generally speaking, the amount an investor can withdraw from an investment portfolio each year in retirement will be based on how much has been saved, the asset allocation, the spending horizon, and the withdrawal method employed. As a starting point, Vanguard suggests making withdrawals at rates no greater than 3% to 5% at the outset of retirement, depending on the investor’s withdrawal method (Jaconetti et al. 2013). Once a reasonable spending figure has been established, the next step is to identify which account(s) should fund the spending. See: A refresher on how an advisor should approach the needs of clients as they near retirement.

Our research has found that for investors whose goal is to maximize spending during their lifetimes, it is advantageous to make withdrawals from their portfolios in the following order: required minimum distributions or retirement minimum distributions (RMDs) (if applicable), followed by taxable assets, and finally tax-advantaged assets.1

This may seem counterintuitive—it would seem logical to first spend from the accounts that were specifically established to provide for retirement spending; however, all of these accounts—both retirement and nonretirement—have their own tax implications, and these tax implications must be considered when developing a tax-efficient withdrawal plan, because every dollar paid in taxes is a dollar unavailable for retirement spending.

RMDs are the first assets earmarked for spending because retired investors who are age 70-1/2 and older who own assets in tax-deferred accounts are required by law to take these distributions. The penalties for not taking these distributions are quite steep: 50% of the required distribution amount.

Taxing considerations

For investors who are not subject to RMDs or who need money in excess of their RMDs, the next source of spending should be cash flows on assets held in taxable accounts. Taxable flows—including interest, dividends, and capital gains distributions on assets held in taxable accounts—are next because an investor is required to pay taxes on these amounts each year.

As a result, it’s better to use these cash flows to meet spending needs rather than reinvest them and possibly have to sell assets in the near term to meet spending needs. In the case of capital gains, investors may be subject to additional taxes, including much higher-taxed short-term gains, if the investor held the assets for less than one year.

If the total of nonportfolio income sources (Social Security, pensions, rental income, etc.), RMDs (if applicable), and portfolio cash flows is inadequate for the investor’s spending needs, then asset sales are needed. This brings the investor to the first decision point: Which account type to spend from and why? Taxes are the chief determinant of this decision.

Absent taxes, the order in which an investor withdraws from the various account types would yield identical results (assuming all account types receive the same rate of return); therefore, spending from tax-advantaged accounts before taxable accounts would have the same inflation and tax-adjusted ending asset balances. Unfortunately, because taxes are a reality, the withdrawal order can meaningfully impact how much an investor can spend each year, as well as how long the portfolio will last. See: How RIAs can help clients sell their real estate without taking a tax bite.

10,000 simulations

Our research has found that it is advantageous for investors to spend from taxable portfolios before spending from tax-deferred portfolios (after taking RMDs). We found that spending from the portfolio in this manner can help investors keep up to 70 basis points (bps) of average annualized return as compared to swapping the spending order. In other words, investors who swap the spending order and spend from tax-deferred accounts before taxable accounts may have up to a 70 bps lower internal rate of return on their portfolios.2

To calculate this value, we considered a hypothetical 60% stock and 40% bond portfolio over a 30-year time horizon, a $1-million initial portfolio split evenly between taxable and tax-advantaged accounts, and an initial spending amount of $40,000 grown by inflation annually. Using the Vanguard Capital Markets Model,3 we created 10,000 simulations—spending from taxable accounts prior to tax-deferred accounts—over the 30-year planning horizon and calculated an internal rate of return (IRR) of 4.4%, as shown in figure 2.

We then ran the same scenario with one change: The investor’s spending needs were first met with tax-deferred assets rather than their taxable assets. We found that spending from the portfolio in this manner resulted in a 3.7-% IRR, which is 70 bps lower than the original scenario (see figure 2).

It is important to note that in both scenarios, asset sales were taken only after the investor’s required minimum distributions and portfolio cash flows were applied to the annual spending. See: Performance measurement challenges for investors who live in a perpetual time horizon world.

Tax-deferred option

Figure 2

So why the difference? The primary reason for the difference is the timing and amount paid in taxes. Spending from taxable accounts before spending from tax-deferred accounts is most likely to produce a lower current tax bill and to allow for more tax-deferred growth than spending from tax-deferred accounts before taxable accounts. The additional asset growth is likely to result in less need to spend from the portfolio and therefore higher asset balances; hence a higher IRR.

In other words, spending from the tax-deferred account before the taxable account will accelerate the payment of income taxes on the tax-deferred account. These income taxes likely will be higher than the taxes paid for any withdrawals from the taxable account, for two reasons.

First, the investor will pay tax on the entire withdrawal (assuming all contributions were made with pre-tax dollars), rather than just on the capital appreciation of assets held in taxable accounts. In addition, the capital gains tax rates currently are lower than the respective ordinary income tax rates, so the investor would pay tax at a lower rate on a smaller withdrawal amount. Over time, the acceleration of income taxes and the resulting loss of tax-deferred growth results in a lower IRR.

To take it one step further, we ran a third scenario in which the investor’s tax-free assets were depleted before spending from taxable assets. In this case, the IRR from accelerating distributions from the tax-free account dropped to 3.6%, or 80 bps lower than spending from taxable assets first. In this case, the IRR difference is due to the loss of tax-advantaged growth on the tax-free account.

Spending from the portfolio in this manner reduces the amount of assets that have tax-free growth potential and is likely to result in lower future spending amounts as well as an increased probability that the portfolio will be prematurely depleted. See: An expert updates 7 matters related to the estate tax.

In short, investors should consider spending from their taxable accounts before spending from their tax-deferred or tax-free accounts. In both cases, accelerating spending from tax-advantaged accounts resulted in lower internal rates of return and lower ending asset balances.

Roth spending

Once the order of withdrawals from taxable and tax-advantaged accounts has been determined, the next step is to specifically identify which asset or assets to sell to meet spending needs. After spending taxable portfolio cash flows, investors should consider selling the asset or assets that would produce the lowest taxable gain, or would even realize a loss (if possible). Again the goal is to minimize current taxes on the portfolio. Selling assets in this manner should continue until the spending need has been met or the taxable portfolio has been exhausted.

Once taxable accounts have been depleted, investors face the decision to spend from tax-deferred or tax-free (Roth) accounts. The primary driver of this decision is the investor’s expectation of future tax rates relative to current tax rates. Generally speaking, investors should spend from tax-deferred accounts when they believe tax rates will be lowest. For example, an investor who anticipates a future tax rate higher than the current tax rate should spend from tax-deferred accounts before spending from tax-free accounts. See: One killer Roth conversion strategy in seeking a single-digit tax return.

This allows investors to lock in taxes on the tax-deferred withdrawals today at the lower rate, rather than allowing the tax-deferred account to continue to grow and be subject to a higher tax rate on future withdrawals. Conversely, an investor who anticipates a future tax rate lower than the current tax rate should spend from tax-free assets before spending from tax-deferred assets. Taking distributions from the tax-deferred account at the future lower tax rate will result in lower taxes over the entire investment horizon. See: Talking taxes: Why advisors need two approaches to shatter two counterproductive client attitudes.

Lifetime spending

Once the investor’s spending need has been met, the final step in this process should be a review of the investor’s asset allocation. If the process of selling assets to generate cash flow from the portfolio results in an asset allocation that deviates from the target asset allocation by more than 5%. the investor should consider rebalancing within tax-advantaged accounts within the constraints of the wash sale rules.4

Please keep in mind that this order assumes that the goal is to maximize spending during a lifetime, and it may not be the preferred order if an investor’s bequest or other estate planning motives supersede maximizing lifetime spending. For those investors who feel this process 
is a bit more than they are interested in 
or willing to manage, or who have estate planning considerations, seeking advice can make a lot of sense and may even pay for itself. See: Is your alpha big enough 
to cover its taxes? A classic journal article, revisited.

Colleen Jaconetti, CPA, CFP®, is a senior investment analyst in the Vanguard Investment Strategy Group. She earned BA and MBA degrees from Lehigh University. Contact her at colleen_m_jaconetti@vanguard.com.

*Endnotes *

1. Clearly, an investor’s specific financial plan may warrant a different spending order, but this framework can serve as a prudent guideline for most investors. For a more detailed analysis, see Jaconetti and Bruno (2008). For investors who are seeking to maximize spending over their lifetimes as well as their heirs’ lifetimes, a different spending order may be preferred and likely will require the guidance of a tax-planning professional.

2. For more information, see Jaconetti and Bruno (2008).

3. The Vanguard Capital Markets Model (VCMM) is a proprietary financial simulation tool developed and maintained by Vanguard’s Investment Strategy Group. Part of the tool is a dynamic module that employs vector autoregressive methods to simulate forward-looking return distributions on a wide array of broad asset classes, including stocks, taxable bonds, and cash. For the VCMM simulations in Figure 2, we used market data available through June 30, 2013, for the U.S. Treasury spot yield curves. The VCMM then created projections based on historical relationships of past realizations among the interactions of several macroeconomic and financial variables, including the expectations for future conditions reflected in the U.S. term structure of interest rates. The projections were applied to the following Barclays U.S. bond indexes: 1—5 Year Treasury Index, 1—5 Year Credit Index, 5—10 Year Treasury Index, and 5—10 Year Credit Index. Important note: Taxes are not factored into the analysis.

4. Investors ignore the wash-sale rules at their peril. A wash sale occurs when an investor sells a security at a loss and purchases a substantially identical security within 30 days before or after the sale. Therefore, the wash-sale period for any sale at a loss lasts for 61 days (day of sale plus 30 days before and after). To deduct the loss for tax purposes, an investor would need to avoid purchasing a substantially identical security during the wash-sale period. Consult a tax advisor or see IRS Code 1091 for more information.

References

Davis, Joseph, Roger Aliaga-Díaz, Harshdeep Ahluwalia, Frank Polanco, and Christos Tasopoulos. 2014. Vanguard Global Capital Markets Model. Vanguard Research (November). https://www.vanguard.com/pdf/ISGGCM.pdf.

Jaconetti, Colleen, and Maria Bruno. 2008. Spending From a Portfolio: Implications of Withdrawal Order for Taxable Investors. Vanguard Investment Counseling and Research; https://www.vanguard.com/pdf/icrsp.pdf.

Jaconetti, Colleen M., Francis M. Kinniry Jr., and Michael A. DiJoseph. 2013. A More Dynamic Approach to Spending for Investors in Retirement (October). https://pressroom.vanguard.com/content/nonindexed/2013.10.23_A_more_dynamic_approach_to_spending.pdf.

Kinniry, Francis M. Jr., Donald G. Bennyhoff, and Yan Zilbering. 2013. Costs Matter: Are Fund Investors Voting with their Feet? Vanguard Research (May). https://www.vanguard.com/pdf/s706.pdf.