Tax-Efficient Decumulation Strategies for Retirement
The success of a retiree’s financial plan turns on first accumulating enough to fund a comfortable and worry-free retirement and then on executing withdrawals in the most tax-efficient way. The latter process is known as decumulation, and it’s one that LifeYield technology, integrated with a firm’s financial planning and trading platforms, helps produce better results for clients, advisors, and firms.
Goals of a Personalized Decumulation Strategy
The goal during the decumulation phase is to provide clients with the most after-tax retirement income. LifeYield approaches this goal through a set of functional objectives to:
Manage a portfolio at the household level and approach decumulation with all potential sources of income in mind.
Leverage the benefits of each type of account — fully taxable, tax-deferred, or tax-exempt — that make up a household’s entire investment portfolio. For example, investments that are relatively immune to taxes are often best situated in taxable accounts; tax-sensitive investments belong in tax-advantaged accounts. The goal is to minimize taxes by optimizing asset location.
Optimize the tactics and timing of cash inflows, such as claiming Social Security benefits, tapping income from an annuity, maximizing the value of Roth conversions, minimizing the tax effects of required minimum distributions (RMDs), and more.
LifeYield can help advisors and firms navigate these stages and steps through its technology that helps clients achieve “tax alpha” and enables:
- Optimizing asset location.
- Limiting exposure to taxable distributions (dividend, interest, capital gains).
- Harvesting losses to offset gains.
- Rebalancing investments to minimize tax liability while staying true to a client’s risk tolerance and timeline.
- Preserving tax efficiency through transitions, such as consolidating accounts with an advisor and account withdrawals needed to fund point-in-time needs.
Any single activity can prove fruitful for an investor. Working in harmony and coordinating can have an outsized effect on what an investor can save for retirement and the money available for income after an investor stops working. An EY study affirmed that this could improve investor outcomes by 33% or more during retirement (download the study).
Conventional Decumulation Strategies – Descriptions and Problems
There is a common rule of thumb for the sequence of withdrawals during decumulation. It is to distribute assets first from taxable accounts, then tax-deferred accounts, and finally tax-exempt accounts. Clients can enjoy reduced taxes on long-term capital gains by tapping taxable accounts first. In contrast, tax-deferred accounts treat long-term gains as ordinary income and impose required minimum distributions (RMDs) at age 72.
Another famous convention is the “4% Rule,” suggesting retirees withdraw 4% of their assets each year.
The conventional wisdom approaches suffer from several shortcomings, starting with that they are “one size fits all” – when that is rarely true. People have different assets, account types, risk tolerances, investment horizons, life expectancies, intentions for legacies to family or charity, etc. No, decumulation planning must be personalized.
Some other problems with conventional approaches include:
The 4% Rule presupposes a 60/40 mix of equities and fixed-income securities, which may not apply to an individual client. It assumes historical (20th century) average returns for each asset class and may result in overly generous or stingy withdrawals in the current century.
Some online brokers may advise selling a client’s longest-held shares first (resulting in higher capital gains) rather than minimizing gains by selling the least-appreciated lots first. Tax-lot selling on a trade-by-trade basis is available, but many investors don’t know or understand this choice.
Social Security benefits can drop a “tax torpedo” on some higher earners. That’s why anyone deciding when to file for Social Security should avail themselves of technology that can factor in tax rates and the potential benefits of delaying filing until age 70.
Conventional strategies overlook the potential benefits of properly-timed Roth conversions by selling assets in tax-deferred accounts (possibly before claiming Social Security) to fund tax-exempt Roth accounts.
The conventional wisdom provides no insights into when and how to take RMDs or how to do so with partial Roth conversions.
And, there’s more! Decumulation strategies that lower current tax liabilities may lead to higher tax rates later on – a tax-inefficient outcome. Higher-income individuals must also make choices cognizant of the effects of their income on their Medicare premiums (through Medicare income-related monthly adjustments) and the 3.8% Net Investment Income Tax.
LifeYield’s Approach to Tax-Efficient Decumulation
LifeYield technology available to financial services firms integrates multiple features to maximize tax-efficient decumulation, evaluating and outlining the financial consequences on income and taxation for:
- Social Security: The system optimizes withdrawal strategies for clients (and their spouses), considering each client’s unique circumstances, income streams, and goals.
- Tax harvesting: LifeYield looks for opportunities to harvest losses at strategic times during the year and during a rebalance of the accounts that make up a household portfolio.
- Partial (or full) Roth conversions: The system considers how much to convert now vs. how much later, considering that there are tax benefits to timing conversions.
- Income and capital gains rates: Specifying ad-hoc withdrawals and tax-harvesting opportunities to reduce taxes and avoid the Social Security benefit tax torpedo.
- Investment taxes: Optimizing asset location at all times to minimize taxes and maximize income.
Benefits of LifeYield’s Decumulation Technology
Advisors and firms benefit from happier clients, including those with higher retirement income that can result from maximizing tax efficiency.
LifeYield can be a beneficial partner to platform builders at financial enterprises by helping them automate processes so financial advisors can:
Take the client’s household perspective
LifeYield software optimizes tax efficiency at the household level by recommending:
- In which accounts assets should reside
- Which assets (by account and tax lot) to liquidate next — through ad hoc tax-smart withdrawals, multi-account rebalancing, and tax harvesting
- How to better align portfolios to their target benchmarks’ risk/return characteristics when transitioning to a new strategy or advisor.
Score portfolio tax efficiency
LifeYield software quantifies portfolio tax efficiency using a 0 — 100 score range. It uses this scoring system to report the benefit (in dollars and cents) of the next-best actions to improve the score through better asset location.
Understand tax liabilities
LifeYield technology produces a detailed breakdown of federal and state taxes. It incorporates all the significant factors, including deductions, credits, personal exemptions, tax brackets, investment taxes, Social Security taxation, Medicare premiums, etc.
All with zero disruption to current technology. LifeYield delivers its capabilities through modern, stateless APIs that lets firms advance their capabilities (without ripping up advisor desktops) to produce better outcomes through tax efficiency.
LifeYield connects the output of a client’s financial plan to the actions that optimize after-tax outcomes during retirement. By minimizing taxes during the decumulation phase, LifeYield increases firms’ assets under management (AUM), revenues, and client satisfaction.
Most retired investors, especially ones with significant resources, have little chance of adequately managing investment taxes on their own and simultaneously maximizing their after-tax income. They are looking for expert guidance, sometimes without even realizing it! Adding LifeYield’s Retirement Income Sourcing to your firm’s current methodology delivers the best decumulation solution available, benefiting clients, firms, and advisors’ practices.
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