Optimal Retirement Withdrawal Strategy

Most retirement calculators follow the conventional retirement savings withdrawal strategy of withdrawing all the funds from the After-tax Account first, followed by the Tax-deferred Account and finally the Roth IRA.

ORP withdraws money from all three accounts in parallel in order to reduce personal income taxes.

The question is: How much (in real numbers) does ORP improve over a conventional retirement calculator's withdrawal method?

There was no easy way to compare the results produced by an Internet accessible, conventional retirement calculator to those of ORP and vice versa.

To answer this question we implemented a conventional retirement calculator (named Naive) that produces results compatible with ORP. Naive follows the conventional withdrawal method of withdrawing all after-tax funds first and then withdrawing funds from the Tax-deferred Account. Naive does not model Roth IRA accounts.

Naive is a typical conventional retirement calculator except that instead of determining the year that the retirement funds are exhausted, it further iterates to a stated estate amount by incrementally adjusting annual spending. Naive's after-tax, annual spending expressed in today's dollars is directly comparable to ORP's version of the same. Furthermore, the plan value for both calculators is the sum of all inflated, after-tax spending for the life of the plan.

Table 1 compares results between the two methods for a basic situation uncluttered by extenuating circumstances::

• husband age 65, wife 65,
• retirement savings of all types = $3M, proportioned between the after-tax and tax-deferred accounts,
• retire at 65,
• no social security,
• life expectancy 85,
• estate $10K,
• no house,
• no Roth IRA:
• inflation 3.5%
• investment returns 7%
Table 1: Computational Summary

Test		Spending		Value		% Improve
After-Tax	IRA	Conv.	ORP	Conv.	ORP	Annual Sp	Value
3000	0	178	179	5,398	5,399	0.3%	0.0%
2700	300	177	181	5,311	5,490	2.3%	3.4%
2400	600	176	182	5,235	5,510	3.8%	5.2%
2100	900	174	182	5,168	5,500	4.8%	6.4%
1800	1200	172	181	5,106	5,472	5.3%	7.2%
1500	1500	170	180	5,046	5,438	6.0%	7.8%
1200	1800	168	177	4,986	5,337	5.2%	7.0%
900	2100	165	172	4,926	5,221	4.3%	6.0%
600	2400	162	169	4,867	5,097	3.9%	4.7%
300	2700	160	164	4,814	4,981	2.8%	3.5%
0	3000	157	160	4,749	4,802	1.9%	1.1%

Table 1 the compares the performance of Naive's conventional withdrawal method to ORP’s optimized schedule for various sizes of the After-tax Account and the Tax-deferred Account but always totaling $3M. The two Spending columns are expressed in today's dollars. The two Value columns are inflated dollars. The first and last rows of Table 1 are trivial cases that serve to indicate the computational discrepancies between the two implementations of the same model.

Ignore the fact that when reading down the columns the annual spending values get smaller as the After-tax Account gets smaller, giving the impression that the After-tax Account is outperforming the Tax-deferred Account. This allusion occurs because the After-tax Account pays its taxes as the income is incurred and pays no personal income taxes on withdrawals. Table 1 ignores the important fact that contributions to the Tax-deferred Account were not taxed as they were made and investment returns prior to withdrawal were not taxed.

The important message of Table 1 is in the two rightmost columns; the percentage improvement of ORP’s optimized withdrawal strategy over the conventional approach. Annual Spend shows ORP's advantage for each year of retirement. The Value improvement is over the life of the plan.

Next in Table 2 Social Security benefits are added to the mix to give a more typical retirement situation. Table 2 assumes that both the retiree and spouse began receiving $24,000 annual Social Security benefits at age 65.

Table 2: With Social Security Benefits

Accounts		Spending		Value		% Improve
After-Tax	IRA	Conv.	ORP	Conv.	ORP	Annual Sp	Value
3,000	0	224	223	6,776	6,763	-0.2%	-0.2%
2,700	300	221	224	6,634	6,792	1.4%	2.4%
2,400	600	218	224	6,513	6,790	2.7%	4.3%
2,100	900	216	223	6,407	6,762	3.6%	5.5%
1,800	1,200	213	221	6,311	6,692	4.0%	6.0%
1,500	1,500	210	219	6,222	6,596	4.4%	6.0%
1,200	1,800	206	214	6,139	6,490	3.9%	5.7%
900	2,100	203	210	6,059	6,370	3.4%	5.1%
600	2,400	200	207	5,981	6,229	3.5%	4.1%
300	2,700	196	201	5,909	6,072	2.4%	2.8%
0	3,000	193	196	5,831	5,910	1.5%	1.4%

Table 2 shows that the largest percentage spending improvement (4.4%) for ORP over Naive comes for the 50/50 split between the two accounts. For a typical situation savings are heavily weighted toward the Tax-deferred Account, as shown in rows 8, 9 and 10 . We see that optimal withdrawal strategy will increase annual retirement spending from 2.4% to 3.5% per year. This turns out to be $163,000 to $320,000 over the span of the plan.

Comparing rows 8, 9 and 10 of Tables 1 and 2 shows that Social Security benefits lessen the percentage improvement of ORP over Naive. Other quantitive studies on this topic such as Horan[1] and Spitzer and Singh [2] omit Social Security benefits from their computations and thus tend to overstate the advantage of their Informed withdrawal methods over the Naive methods.

Table 3 extends the Table 2 situation by including a $300,000 illiquid asset, the couples home, to be liquidated in year age 80.

Table 3: Illiquid Asset Included

Scenarios		Spending		Value		% Improve
After-Tax	IRA	Conv.	ORP	Conv.	ORP	Annual Sp	Value
3,000	0	236	237	7,175	7,158	0.2%	-0.2%
2,700	300	231	238	6,887	7,187	3.1%	4.4%
2,400	600	231	238	6,887	7,182	3.1%	4.3%
2,100	900	228	237	6,781	7,151	4.0%	5.5%
1,800	1,200	225	234	6,686	7,076	4.4%	5.8%
1,500	1,500	221	230	6,595	6,977	4.0%	5.8%
1,200	1,800	218	228	6,516	6,864	4.4%	7.1%
900	2,100	215	223	6,437	6,747	4.0%	4.8%
600	2,400	211	218	6,354	6,600	3.2%	3.9%
300	2,700	208	213	6,282	6,442	2.6%	2.5%
0	3,000	204	208	6,202	6,278	1.8%	1.2%

Adding the home to the retirement mix increases the couple's assets to $3,300,000 and gives ORP more room to work in. Again rows 8, 9 and 10 are typical of most retirement plans. Comparing these rows between Tables 2 and 3 shows that ORP is able to take advantage of the additional asset.

Table 4 shows ORP's Withdrawal Plan for the 50/50 split scenario that includes the both Social Security benefits and an illiquid asset.

Table 4: ORP Withdrawal Plan

Age	TaxDef	AfterTax	RothIRA	IRA2Roth	SocSec	Taxes	Spending
65	139	214		139	48	-31	230
66	144	222		144	50	-32	238
67	149	230		149	51	-33	247
68	152	237		152	53	-34	255
69	65	222		65	55	-12	264
70	67	180		17	57	-12	274
71	69	185		17	59	-13	283
72	72	175			61	-13	293
73	74	181			63	-14	303
74	77		187		65	-14	314
75	79		194		68	-15	325
76	82		201		70	-16	336
77	161		151		73	-35	348
78	217		118		75	-49	360
79	225		122		78	-51	373
80	94	230			80	-18	386
81	98	238			83	-19	399
82	249	73	62		86	-56	413
83	258		140		89	-58	428
84	267		145		92	-60	443
85	276		150		96	-63	458

Table 4 shows that ORP’s strategy is to do continuous withdrawals from the Tax-deferred Account in a manner that keeps taxes under control and takes maximum advantage of the Roth IRA. Early in retirement the After-tax Account (column 2) is being drawn down for spending without paying personal income taxes. Partial distributions are being annually rolled over from the Tax-deferred Account (column 1) to the Roth IRA (column 4) paying personal income taxes on each withdrawal.. When the After-tax Account is empty the Tax-deferred and Roth IRA accounts provide for spending.

At age 80 the illiquid asset is sold and the proceeds fund spending, along with a low level of withdrawals from the Tax-deferred Account. Once the house proceeds are exhausted then withdrawals resume from the Roth IRA for the remainder of the plan. Age 82 is particularly interesting because it shows withdrawals from all three accounts in the same year.

The Taxes column (column 7) tells the story. The highest taxes are paid early on during the IRA to Roth IRA rollover phase. The Roth IRA is stocked up early in retirement to provide tax free distributions to supplement the IRA distributions and keep them in a lower tax range, 15% in this case, for the rest of retirement.

Conclusion: ORP’s optimal retirement withdrawal strategy increases the amount of money available for spending during retirement. ORP’s strategy is to take advantage of the Federal progressive income tax code. ORP makes partial rollovers to the Roth IRA when they are only lightly taxed and then withdraws the money from the Roth IRA tax free later on when Naive's strategy makes large, taxable withdrawals from the Tax-deferred Account.

References

1. Withdrawal Location with Progressive Tax Rates; Stephen M. Horan; Financial Analysts Journal; June 2006; Volume 62, No. 6; pages 77-87
2. Extending Retirement Payouts by Optimizing the Sequence of Withdrawals John J Spitzer and Sandeep Singh; Journal of Financial Planning; Apr 2006; 19, 4; ABI/INFORM Global pg. 52

Last Update: July 31, 2008		© 1998-2008, James S. Welch, Jr