Making the Most of One’s Nest Egg: Optimal Tax-wise ...nymetro.chapter.informs.org/prac_cor_pubs/coopersmith 12-07... · Copyright Coopersmith Associates LLC 2007 Cash Needs Cash

Copyright Coopersmith Associates LLC 2007

Making the Most of One’s Nest Egg: Optimal Tax-wise Planning of Withdrawals from Retirement

Accounts*

INFORMS New York MetroWednesday, December 12, 2007

Lewis Coopersmith, Ph. D.Associate Professor, Rider University

Coopersmith Associates LLC

*A manuscript has been prepared for publication with Alan R. Sumutka, CPA


Outline

Motivation For DSS Development

New Process For Planning Retirement Withdrawals

The Optimization Model

Future Development

Results for Typical Scenarios


Motivation For DSS DevelopmentWhen I asked about planning my

retirement income, my financial advisor recommended Conventional Wisdom (CW). However…

Considering federal taxes, CW does notalways make sense –

“The other piece of the puzzle is tax efficiency. You’re probably familiar with the conventional wisdom: Draw down your taxable accounts first; then turn to tax-deferred accounts, like IRAs… In this way, tax-deferred assets get more time to grow. But the sequence isn’t always that simple” *

*Ruffenach, Glenn. 2005. Before You Open That Nest Egg… The Wall Street Journal. December 12, 2005 R1.


Motivation For DSS DevelopmentComplicating Tax Issues

Tax deductions and exemptions may offset taxes owed on tax-deferred withdrawals

Delaying tax-deferred withdrawals may result in higher tax brackets when satisfying federal required minimum distributions (RMDs) after age 70.


Motivation For DSS DevelopmentMore Complicating Issues

Many different retirement accounts:

Annuities may restrict how funds are withdrawn.

Some retirement funds may have rates of return (RORs) less than taxable investments.


Motivation For DSS DevelopmentStill More Complicating Issues

My financial advisor recommended selecting “withdrawal rate” with high “sustainability probability”…

Makes more sense to plan withdrawals based on my living expenses.

Annual updating of withdrawal plans should reduce concern for sustainability!


Motivation For DSS DevelopmentYet Still More Complicating Issues

But what about tax impact…

“Determine an acceptable withdrawal rate first… then we can apply an average tax rate and see what’s left for you to live on”

But… makes more sense to figure

out what’s needed to live on… then plan withdrawals for low tax impact.


DSS Objective

Provide decision support for retirees and their wealth managers in planning retirement withdrawals.

Use mathematical optimization to Determine amount to withdraw from each wealth source Assure satisfaction of

before-tax expense specifications. Federal RMD constraints.

Compute approximate federal income taxes as an integral part of the modeling process to

maximize final accumulated wealth.


New Process For Planning Retirement Withdrawals*

Fixed Data:Age, Account Values,

Tax info, etc.

Discretionary Data:

Before-tax Expenses,

Average Account RORs

Optimization

Model

Feasible

Solution

?

Data

YES

OPTIMAL PLAN(Account Withdrawals)

OPTIONAL: Risk Analyses

Re-evaluateBefore-tax

Expenses?

RORs?

Implement PLAN

Selected From

OPTIMAL PLANS

NO

YES

NO

*There is a patent pending on this process.


The Optimization ModelData

Fixed over all scenarios: Retiree age, RMD coefficients, tax exemptions*, federal tax

brackets* and tax rates.

Social Security* initial amount, start year.

Planning related – dependent on lifestyle choices and investment

portfolio distribution: Interest/ROR rate per account.

Before-tax (federal) expenses. Sub-totaled tax-deductions.

*cost of living adjustments are applied for each year during the planning horizon.


The Optimization ModelIncome Sources

User specified: Social Security.

Pensions, estimated earned income (for future development).

Model determined withdrawals: Taxable savings and investments.

Tax-deferred fixed annuities (fixed-term or lifetime).

Non-annuity tax-deferred savings. traditional IRAs, 401(k) plans, etc.

Tax-free savings (for future development).

Roth IRAs, municipal bonds.


The Optimization ModelObjective Function

Maximize accumulated wealth at the end of the planning horizon.

Other possible objectives:

Maximize final taxable savings.

Maximize before-tax expenses, given desired

final wealth


The Optimization ModelConstraints

Withdraw no greater than available amount.

Meet before-tax expenses.

Satisfy federal RMDs.

Others: To assure correct estimation of taxes

For prototype model with a 25 year horizon and 3

account types, Number of constraints = 297


The Optimization ModelVariables – Model Determined Values

Account withdrawals.

Transfers from tax-deferred accounts to taxable savings.*

Taxes

For prototype model with a 25 year horizon and

3 account types, Number of variables = 300

*Other types of transfers can be considered in future model updates.


Results for Typical ScenariosData

A couple: Husband – age 65, Wife – age 63.

Planning 25 years of retirement.

Current retirement portfolio: $1,000,000 split -1. Taxable savings investments:

$100,000 – average ROR: 5.5%.

2. Tax-deferred annuities: $300,000 – average ROR of 5.0%. Withdrawals must be converted to either 10-year annuities or lifetime annuities.

3. Non-annuity tax-deferred: $600,000 – average ROR of 7.5%.


Results for Typical ScenariosCurrent* Before-tax Expenses

Itemized deductions: $20,800.

Item Annual Amount

Household $40,800

Personal Care $7,200

Transportation $4,800

Leisure $11,800

Miscellaneous $4,800

Total $69,400

*Husband’s age 65


Withdrawals proportional to internal asset allocation of that account.

Example: If account is 40% bonds/60% equities, a $1000 withdrawal will be $400 from bonds and $600 from equities.

Social Security: 85% taxable.

Excess* non-annuity tax-deferred withdrawals made at year-end and deposited in taxable savings.

Results for Typical ScenariosAssumptions

*(e.g., RMD more than amount needed to meet specified before-tax expenses)


Cash Needs Cash Sources/ Withdrawals

Tax-Deferred

Age of Husband

Specified Before-Tax

Expenses

Approx. Federal Income Taxes

Total

Cash-flow (incl Fed Taxes)

Social Security

Taxable Savings

Annuity Non-Annuity

Total Remaining Account Value

[1]

66 $71.0 $1.6 $72.6 $16.0 $30.6 $26.0 $- $822.4

67 $72.7 $2.9 $75.6 $16.5 $23.0 $36.1 $- $773.2

68 $74.5 $3.9 $78.4 $25.5 $16.4 $36.5 $- $809.8

69 $76.3 $3.8 $80.1 $26.2 $17.4 $36.5 $- $850.7

70 $77.9 $8.1 $86.0 $27.0 $22.3 $36.7 $29.2 $888.8

71 $79.8 $8.5 $88.3 $27.8 $23.8 $36.7 $31.4 $928.0

72 $81.8 $9.5 $91.3 $28.7 $22.7 $39.9 $33.7 $946.6

73 $83.9 $10.0 $93.9 $29.5 $24.4 $40.0 $36.2 $990.6

74 $86.1 $10.5 $96.6 $30.4 $26.2 $40.0 $38.9 $1,035.8

75 $88.3 $11.1 $99.4 $31.3 $28.1 $40.0 $41.7 $1,082.0

76 $89.7 $7.6 $97.3 $32.3 $51.0 $14.0 $44.8 $1,107.2 77 $92.0 $6.5 $98.5 $33.2 $61.5 $3.8 $47.9 $1,123.4

78 $94.4 $6.9 $101.3 $34.2 $63.5 $3.6 $51.4 $1,138.7

79 $96.9 $7.4 $104.3 $35.2 $65.5 $3.6 $54.9 $1,153.4

80 $99.5 $8.0 $107.5 $36.3 $54.9 $3.5 $58.6 $1,166.8

81[2]

$96.3 $8.6 $104.9 $37.4 $45.6 $3.4 $62.4 $1,185.0 82 $88.1 $8.8 $96.9 $38.5 $43.9 $0.2 $66.5 $1,211.1

83 $90.9 $9.4 $100.3 $39.7 $52.3 $0.2 $70.9 $1,236.7

84 $93.8 $10.1 $103.8 $40.9 $62.7 $0.2 $75.5 $1,261.7

85 $96.8 $10.7 $107.5 $42.1 $65.2 $0.2 $79.9 $1,285.6

86 $99.0 $11.5 $110.4 $43.3 $66.8 $0.3 $84.5 $1,309.4

87 $102.1 $12.3 $114.4 $44.6 $69.5 $0.3 $89.3 $1,331.8

88 $105.5 $13.1 $118.6 $46.0 $72.3 $0.3 $94.2 $1,352.4

89 $108.9 $14.0 $122.9 $47.4 $75.2 $0.3 $99.4 $1,371.0

90 $112.4 $14.8 $127.2 $48.8 $77.8 $0.6 $103.7 $1,388.7

Results for Typical ScenariosBaseline Data: Tabular Results ($000)

Low taxes due, in part, to itemized tax deductions and exemptions in the range $27,000 – 43,000 over the 25 year horizon.

Mortgage payments end

Beginning at age 70, some of the non-annuity account is withdrawn due to federal RMD

Most of the annuity account is converted into 10-year annuities andexhausted by the second year.


$-

$50

$100

$150

$200

$250

66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90

Age of Husband

Annu

al W

ithdr

awal

($00

0)

$-

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

Tota

l Acc

ount

Valu

e ($

000)

Social Security 10-Year Annuity

Withdrawals

Taxable Savings

Withdrawals

Non-Annuity Deferred

Withdrawals

Total Account Value

(Right Axis)

Specified Before-Tax Expenses

Total Cash-Flow

(incl Fed Taxes)

Results for Typical ScenariosBaseline Data: Graphic Results

For ages 66-79 and from 84-90, total cash flow comes from Social Security, 5-year annuities and taxable savings.

During ages 80-83, some of RMD withdrawal is used to satisfy the total cash-flow.


Results for Typical ScenariosBaseline Data: Wealth Planning Implications

Limited use of non-annuity deferred savings before age 80 suggests redistributing this portfolio for greater ROR in early years, even with higher volatility.

New plan:

Re-distribute to target RORs of 8.5% for ages 66-73, 7.5% for ages 74-80 and a lower risk 6.5% for ages 81-90.

New optimal plan result: final total account value of $1,448,755 – 4.3% higher than initial plan.


Results for Typical ScenariosConventional Wisdom Vs. Baseline

Conventional Wisdom (CW) Policy:

Withdraw retirement income from taxable savings first, then from tax-deferred accounts.

Tax-deferred withdrawn:

10-year annuity first.

Then non-annuity.


Results for Typical ScenariosCW Vs. Baseline: Graphic Results

$10

$312

$612

$900

$1,160

$1,389

$1,601

$1,810

$2,014

$2,212

$2,408

14.7%

8.3%

5.6%

4.3% 3.9%

5.9%

7.5% 7.8% 8.1%8.8%

$-

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$750K $800K $850K $900K $950K $1000K $1050K $1100K $1150K $1200K $1250K

Initial Total Wealth

Fin

al W

ealt

h ($

000)

Aft

er

25 Y

ears

0%

10%

20%

% Im

pro

vem

en

t O

pti

mal

over

CW

Optimal Conventional Wisdom % Improvement (right axis)

CW Exhausted

Year 25

Optimal results slightly better than CW. Two plans are similar: optimal plan starts drawing 10-year annuity year earlier than CW.

Advantages of optimal policy over CW increase as initial wealth varies either above or below a level that could be considered in line with expense needs.

NOTE: If lifetime annuities substitute for 10-year annuities in CW, final wealth of optimum is 16% higher!


Results for Typical ScenariosCW Vs. Baseline: Wealth Planning Implications

For retirees with relatively low savings: Optimal planning improves chances that initially specified

before-tax expenses will be sustainable.

For retirees who have more than enough to meet basic needs: Optimal planning provides wealth managers greater

leverage to work with retirees to better manage account portfolios to enhance quality of life.


Results for Typical ScenariosBaseline plus Car Purchases

How does model “smooth” tax burden for occasional large expense needs?

Consider car purchases every 5 years at ages 70, 75 and 80 for $20,000, $25,000 and $30,000


$-

$50

$100

$150

$200

$250

66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90

Age of Husband

An

nu

al W

ith

dra

wa

ls (

$0

00

)

$-

$200

$400

$600

$800

$1,000

$1,200

$1,400

To

tal A

cc

ou

nt

Va

lue

($

00

0)

Social Security 10-Year Annuity

Withdrawals

Taxable Savings

Withdrawals

Non-Annuity Deferred

Withdrawals

Specified Before-Tax

Expenses

Total Cash-Flow

(incl Fed Taxes

Total Account Value

(Right Axis)

Results for Typical ScenariosBaseline + Cars: Graphic Results

At age 80, withdrawals from non-annuity tax-deferred savings at ages 79 (~$5,000>RMD) and 80 contribute most of the cash needed for the car.

Age 70 Cash-flow $106,400:-Social security ($27,000)-Taxable savings ($32,100)-Annuity payment ($39,400)-Part of the RMD ($7,900) for non-annuity tax-deferred savings

Age 75 Cash-flow $124,000:

-No contribution from RMD for non-annuity tax-deferred savings


Results for Typical ScenariosBaseline + Cars: Wealth Planning Implications

Occasional need for large withdrawals is expected, but planning for them in an optimal tax-wise manner is complex.

Optimal planning takes out guesswork!

Automatically provides withdrawal policy with significant financial benefits.


Future Development

Evaluate impact of adding other income sources: tax-free savings (e.g., Roth IRAs, municipal

bonds). capital gains.

Use optimal planning to analyze Age to start Social Security. Need for long-term care insurance.

Use optimal planning as part of ROR simulation to assess sustainability risk.

Documents

Making the Most of One’s Nest Egg: Optimal Tax-wise ...nymetro.chapter.informs.org/prac_cor_pubs/coopersmith 12-07... · Copyright Coopersmith Associates LLC 2007 Cash Needs Cash