Tax-Targeted Qualified Disbursals

June 3, 2021 | Stephan Granitz, Chief Analytics Officer

Dynamic income withdrawals and Roth conversions

Key point

Income Discovery’s intelligent engine AIDA simplifies the complexities of discretionary tax-targeted qualified disbursals (TQDs) and implements best practices. Advisors and their clients are given guidance on the optimal incremental effective tax rate to target as part of the managed retirement income plan, then provided straightforward instructions on the size of income disbursals and Roth conversions each year.

The purpose of TQDs is taking money out of tax-deferred, qualified retirement accounts at or below a target incremental effective tax rate, minimizing the government’s share of the funds. TQDs include both dynamic withdrawals to meet annual retirement income, determining the portion of necessary withdrawals to take from qualified accounts before withdrawing from taxable or tax-free accounts, and Roth conversions. The biggest opportunity for TQDs is typically in a person’s 60s, after retirement but before beginning Social Security and required minimum distributions (RMDs).


There are currently no industry best practices for Roth conversions, nor dynamically determining the portion of qualified disbursal to meet income. The most common way to determine the amount of a Roth conversion is to estimate a retiree’s current taxable income, determine their marginal tax bracket, and fill the remainder of that bracket if the retiree’s expected bracket in the future, typically after RMDs begin, is higher. This is usually done in a simple calculator or, more commonly, an Excel spreadsheet. For example, at the end of the 2021 tax year, a couple with $61,050 taxable income after deductions would likely be instructed to convert an additional $20,000 to fill the 12% bracket.

However, the “fill the bracket” approach is flawed in that it does not take into account the full tax effect of the conversion. Most importantly, it ignores the Social Security multiplier and the impact on capital gains taxes. If someone is in the 12% bracket, filling the bracket assumes the next $1 of conversion will result in $0.12 taxes and is done assuming that this $1 taken from the qualified account later in retirement will result in more than $0.12 in taxes, usually due to deferred taxable income. 

The problem is that, if the household has begun Social Security and has capital gains, the $1 could result in $0.85 of additional Social Security becoming taxable. The $1.85 increase in taxable income could result in an additional $1.85 of capital gains being taxed at 15% instead of 0%. The total taxes on the $1 withdrawal in this case is $0.4995, a nearly 50% effective rate instead of the assumed 12%. This is an unwelcome surprise for the investor and reduces confidence in their advisor.

A similar issue, with converse results, occurs when filling a bracket above the current marginal bracket. If a couple, with no Social Security or capital gains, is currently in the 10% bracket due to experiencing a lower than average taxable income year, and the advisor fills through the 12% bracket, the resulting effective tax rate on the conversion will be less than 12%. If 12% is indeed the ideal targeted incremental tax rate for the household, it would make sense to even go into the 22% bracket until the effective rate on the entire conversion is 12%.

As shown in the following figure, a household’s initial tax base (Social Security, non-Social Security taxable income, and realized capital gains) has a dramatic effect on the incremental average tax rate for discretionary disbursals from TDAs. These households would also need to be aware of what the breakpoints are for crossing the threshold for increased Part B premiums and take that into consideration.


AIDA finds the optimal targeted rate by evaluating multiple target rates along with all other available levers in a holistic retirement income plan. Each year of a simulation, AIDA will determine the maximum total disbursal from qualified accounts at or below the evaluated targeted effective rate, taking into consideration all effects of the disbursal (including Social Security taxable portion, post-tax basis of tax-deferred accounts, and capital gains taxation). 

The industry needs to implement best practices for making tax-efficient disbursals from tax-deferred accounts. Simply assuming 85% of Social Security is taxable, ignoring impacts on capital gains taxation, and using “fill the bracket” spreadsheets or calculators is not the solution. Advisors need to utilize advanced retirement income planning software to evaluate multiple targeted tax rates with dynamic withdrawals and Roth conversions while taking into account all potential tax consequences over a variety of possible future market scenarios. The rates need to be evaluated along with other aspects of the retirement income plan – not in isolation – as decisions regarding investment allocation, annuitization, Social Security claiming, pension payment options, and others will affect the optimal target rate.

« Back