This is part 2 of the hiccups that come with trying to use the 4 percent rule. The 4 percent rule is a rule of thumb that says a person can spend 4% of the initial value of their portfolio each year, increasing the amount by inflation each year, and not run out of money for 30 years. Don’t rely on this rule of thumb, it may not work for you, and it isn’t even simple to use. Part 1 breaks down the 4 percent rule in more detail.
The 4 percent rule makes it difficult to use tax planning strategies
The 4 percent rule cannot incorporate strategies to reduce lifetime taxes in retirement because it never considers taxes in the first place! Let’s use an example to see how this works. Bob and Sue retire at age 65 and have a $2,000,000 portfolio composed of a $1,000,000 IRA and a $1,000,000 joint taxable brokerage account. They start the 4% rule at age 65 and delay their Social Security benefits until full retirement at age 67. Inflation will be 3% each year of their retirement. They are one of the few retirees that are okay with spending significantly less at the beginning of their retirement, and are looking forward to the income boost from their Social Security benefits beginning at age 67.
The 4% rule doesn’t give any guidance on which accounts to pull money from. It only states how much money can be withdrawn. This is problematic because different account types have different tax rules associated with them. Bob & Sue decide to spend from their IRAs first, because they are worried about significant required minimum distributions later if they allow their IRA accounts to grow untouched.
Bob & Sue Age | Portfolio Withdrawal | Social Security | Estimated Federal Income Taxes | After-tax Income |
65 | $80,000 | $0 | $5,750 | $74,250 |
66 | $82,400 | $0 | $5,900 | $76,500 |
67 | $84,872 | $40,000 | $10,400 | $114,472 |
What if Bob and Sue instead decided to pull their money out of their joint taxable account? Let’s assume that they have investments that qualify for the lower long-term capital gains tax rates, and the investments have grown significantly, so that for every $1 they sell, $0.75 will be taxed as capital gains and $0.25 will not be taxed as return of principal.
Bob & Sue Age | Portfolio Withdrawal | Social Security | Estimated Federal Income Taxes | After-tax Income |
65 | $80,000 | $0 | $0 | $80,000 |
66 | $82,400 | $0 | $0 | $82,400 |
67 | $84,872 | $40,000 | $533 | $124,339 |
Bob & Sue’s choice of which account to take money from caused a difference in taxes over three years of about $21,500! Choosing to take money from the IRA caused Bob & Sue to spend $21,500 less than if they choose to take from their taxable account!
The 4 percent rule of thumb can cause significant differences in after-tax income based on which accounts fund withdrawals.
The 4 percent rule of thumb can cause significant differences in after-tax income based on which accounts fund withdrawals. To equalize after-tax income using the 4 percent, Bob and Sue would need to take an equal percentage between accounts, for example 50% from the IRA account and 50% from the joint account each year. That doesn’t seem to complex, but remember this is a simplified example. Almost everyone has account types that are not evenly split. Each year, the mixture between different account types will need to be slightly adjusted based on the performance in accounts. To avoid too severe of swings based on performance, investors could have the same investments in each account type to keep performance equal across accounts. This is suboptimal from a tax perspective however, as the tax characteristics of investments should be matched up with the account type that takes the most advantage of its tax characteristics. Additionally, taking proportional withdrawals from different accounts may not be the most tax-efficient method of generating retirement income! Investors using the 4 percent rule will likely need to pay more taxes to simplify the use of the 4 percent rule, or introduce significantly complexity into their withdrawal strategy to minimize their taxes. If an investor only has one type of account, such as a traditional IRA, they won’t have this issue!
The 4 percent rule isn’t compatible with Roth conversions.
Roth conversion are one of the most powerful tax planning methods for some retirees to reduce their lifetime taxes in retirement. Roth conversions should not be done without consulting with your tax professional, because incorrectly implemented Roth conversions can increase your lifetime taxes! Back to Bob & Sue! They learn about Roth conversions in their second year of retirement as they get into their new groove. They speak with their tax professional who recommends that before they start Social Security, they fill up their 12% tax bracket with Roth conversions to reduce their lifetime income taxes. That means Bob and Sue only have one year to consider Roth conversions! They begin the 4% rule last year and spent $80,000 from their IRA account, inflation was at 3% the previous year, so they raise their spending to $82,400 this year. That left them with about $30,000 to fill up their 12% tax bracket with a Roth conversion. They go ahead and execute the Roth conversion and move $30,000 from their IRA to a Roth IRA.
Do Roth conversion amounts count against the 4 rule?
No, the amount that is moved from an IRA to a Roth IRA doesn’t count against the 4 percent rule. The 4 percent rule only applies to money that leaves the portfolio. Money that is moved from an IRA to a Roth IRA doesn’t leave the portfolio! However, the taxes paid on Roth conversions do count as a withdrawal for the 4 percent rule if they are paid from the portfolio.
After completing their Roth conversion, Bob and Sue realize, they need to pay the taxes on the conversion! Since they were in the 12% tax bracket, they will owe taxes that are 12% X $30,000 = $3,600. Do the taxes from Roth conversions count against the 4 percent rule? They have to unless the taxes are paid with a source that was not included in the original portfolio that the 4 percent spending rule was calculated off of. A separate bank account could be the source of funds, or an annuity or Social Security. Bob and Sue don’t have another income source to pay the taxes and need to pay it from their portfolio. They just broke the 4 percent rule because the taxes are an additional withdrawal from their portfolio!
Bob & Sue Age | Portfolio Withdrawal | Roth Conversion | Estimated Federal Income Taxes | After-tax Income |
65 | $80,000 | $0 | ~$5,750 | $74,250 |
66 | $82,400 | $30,000 | ~$9,500 | $72,600 |
67 | $84,872 | $0 | ~$10,400 | $114,472 |
To satisfy the 4 percent rule, they will need to reduce their spending by the amount of the additional taxes caused by the Roth conversion. In this scenario, they would’ve had $76,500 to spend, but instead must reduce this by the $3,600 of taxes owed on the Roth conversion. This is illogical because Roth conversions done right actually increase after-tax income! This also heightens the problems ran into with the first example, as now the balance of account types have shifted with money being added to the Roth conversion, making it more complex to even out income. The 4 percent rule’s original purpose was as a thought experiment to demonstrate to the financial industry that the portfolio withdrawal percentage needs to be less than the rate of portfolio return. The 4 percent rule was never designed to incorporate taxes, and it shows when investors try to combine tax planning strategies with it. There are better methods to estimate retirement income from an investment portfolio. That will be covered in the future.
Please note that this article as written with tax laws as of October 1st, 2022. Tax laws can change. Many simplifying assumptions were used in the calculations, such as there being no other income sources than discussed, the standard deduction is always taken, and state income taxes were not considered in the analysis. Please don’t rely on this as tax advice, talk to your tax advisor to determine what is right for your situation.
None of the information provided herein is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Optimum Retirement Planning LLC does not promise or guarantee any income or particular result from your use of the information contained herein. Under no circumstances will Optimum Retirement Planning LLC be liable for any loss or damage caused by your reliance on the information contained herein. It is your responsibility to evaluate any information, opinion, or other content contained.
