Dynamic Qualified Account Disbursal Strategies

April 7, 2022 | Stephan Granitz, Chief Analytics Officer

Benefits of taking discretionary disbursals from Qualified accounts in low-tax years

Tax-targeted qualified disbursals (TQDs) are an essential element of tax-smart retirement income strategies. The purpose of TQDs is to move money out of qualified retirement accounts, to use for income or Roth conversions, in low-tax years following retirement but generally before claiming Social Security and before forced disbursals, such as required minimum distributions (RMDs), begin. Strategically utilizing TQDs early in retirement, during high withdrawal rate years where the systematic withdrawal portfolio (SWP) is the primary source of income before pensions, Social Security, or deferred annuities begin payouts, allows deferring disbursals from taxable non-qualified accounts and increasing the effectiveness of capital gains management (CGM) strategies. TQDs need to be designed in a way that they can be systematized for scalable execution and also with the value and theory clearly understood by non-technical retirees.

Figure 1: Non-linearities in tax calculations

A TQD strategy should be defined by targeting an effective tax rate on the discretionary disbursal. This approach takes into account the non-linear nature of the federal marginal brackets due to capital gains taxes and the Social Security multiplier. Simply filling a marginal bracket ignores these effects and can lead to tax surprises such as a client in the 12% marginal bracket paying close to a 50% tax rate as shown in the TQD article linked to above. Alternatively, targeting an effective tax rate across all taxable income makes the story incomprehensible and the meaning of the targeted tax rates become much more difficult to understand. Someone targeting a 10% effective tax rate across their taxable income may need to take a disbursal taxed at 50% or more to bring their taxes to the target level, which is unfavorable to any retiree. By targeting an effective rate on the TQD itself, taking into account impacts on capital gains taxes and taxable Social Security, a household can control the taxes they pay throughout their retirement.

Figure 2: Tax base determines how aggressive TQDs can be in a given year

One common misconception about TQDs is that they should only be used to make Roth conversions. When sourcing a client’s desired annual spending and taxes, if there is a withdrawal need from the SWP, TQDs should be considered for income before making withdrawals from other taxable or Roth accounts. Using conservative tax estimates for the year, it is possible to move money out of qualified retirement accounts at a specified target tax rate. At the end of the year, when the full tax situation is known, Roth conversions can be done if there is an additional opportunity to take money out of the qualified accounts at the target rate.

Figure 3: Withdrawal order needs to be augmented by dynamic, tax-smart strategies

Using TQDs for income enables dynamic, tax-smart withdrawals as an integral part of the retirement income strategy. There are many benefits to this approach. For a household retiring in their early to mid-60s that defers Social Security and potentially purchases a deferred annuity, the early years of the income plan will have a high withdrawal rate from the SWP. Following a standard, static withdrawal order (withdrawing from taxable accounts followed by qualified accounts) will result in quickly draining the taxable accounts, allowing the qualified, tax-deferred accounts to grow. The problem then is the forced RMDs will begin shortly after Social Security and the annuity, resulting in a large tax bill in subsequent years, potentially at a higher marginal rate. This can also lead to higher Medicare premiums. Following a static, proportional withdrawal approach can result in unnecessarily high taxes as the withdrawals are made regardless of other taxable income and are fixed, as opposed to dynamically adjusting each year to the known tax situation.

Figure 4: Advisors must help retirees avoid tax torpedoes with tax-smart strategies

By strategically using TQDs for income early in the plan, it allows the taxable account to grow, thereby controlling taxes from these accounts with dynamic CGM strategies. In many cases, TQDs will result in significantly reduced or eliminated RMDs later in the plan. This in turn may  reduce the taxable portion of Social Security over the life of the plan and allow capital gains to potentially be realized tax-free. The benefits of TQD strategies and realizing additional taxes early in retirement at preferred rates can be clearly and powerfully highlighted in side by side comparisons of projected taxes to be paid throughout retirement.

Advanced software like Income Discovery, with its AI-powered analytics engine AIDA, can evaluate, execute, and monitor dynamic, tax-smart retirement income strategies at scale. Once a strategy is agreed upon with a retiree, Income Discovery’s Paycheck in Retirement will track all the relevant details of the household and the income plan, giving clear disbursal instructions each year on TQDs for income and Roth conversions. The result is advisors can confidently and clearly display their value to their clients.

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