According to research from the Vanguard Group, another area where a skilled financial advisor is supposed to able to add value is helping retirees manage withdrawals from their portfolios in order to minimize taxes. According to their paper:

Advisors who implement informed withdrawal-order strategies can minimize the total taxes paid over the course of their clients’ retirement, thereby increasing their clients’ wealth and the longevity of their portfolios. This process alone could represent the entire value proposition for the fee-based advisor.

The paper goes on to show how correct ordering can improve returns by up to 0.70% annually versus people with multiple different account types withdrawing in the wrong order. The thing is, ordering your withdrawals properly isn’t all that complicated. Most of it is summarized in this flowchart:

• RMDs stand for required minimum distributions. In general, these are forced withdrawals from pre-tax “traditional” IRAs (including SEP and SIMPLE IRAs) and pre-tax workplace defined-contribution plans (including 401(k) and 403(b) plans) once you reach age 70.5. Since it is mandatory and taxed at ordinary income rates, you may as well spend them first.
• Next, taxable flows include things like interest, dividends, and capital gains distributions that are already being “spun off” from your taxable portfolio. These are also going to be taxed no matter what anyway.
• Next, spend your taxable portfolio itself by selling shares and paying any capital gains taxes that may be due. Sell investments with the lowest gains first to minimize taxes. Don’t sell if you don’t need the money.
• What you have left are tax-deferred or tax-free (Roth) accounts. Do you want to pay taxes now, or later? If you think your marginal tax bracket will be higher in the future, then you should pay taxes now (withdraw first from tax-deferred account). If you think your marginal tax bracket will be lower in the future, then you should pay taxes later (withdraw first from Roth accounts). You could make your decision differently each year depending on your current situation.

A key component of retirement planning is figuring out how to draw an income from all that money you’ve invested. “Create your own paycheck.” The trick is figuring out how to take a stable amount out every year without running out of money.

This has led to a debate about “safe withdrawal rates”. The 4% number has been thrown around a lot, where for example if you retired with $1,000,000 in a balanced portfolio of stocks and bonds you might take out $40,000 a year (increasing with inflation) for 30 years with confidence. The problem is that if you simply take out 4% of your starting balance and then keep taking that number out every year robotically then your outcome depends a lot on sequence of returns. If you hit a prolonged bear market just a couple years into retirement (i.e. value drops to $700,000), your nest egg is much less likely to survive. On the other hand, if you hit a bull market for the first 10-15 years and only experience the bear market afterward, then you may die with more money than you started with.

This is why many experts encourage a more flexible “dynamic” withdrawal strategy that adjusts withdrawals based on portfolio performance. There are an infinite number of ways to implement this, so I looked for an industry example and found it in the Vanguard Managed Payout Fund (VPGDX)*. This all-in-one fund uses a 4% target distribution rate and with regular, monthly distributions that you can indeed treat like a (somewhat variable) paycheck. The fund is actively managed for total return, although a majority of its components are passive index funds.

How does the Vanguard Managed Payout fund calculate how much you can spend each year? Reading through the prospectus, we find that the monthly payout is calculated on January 1st every year, then kept constant for the next 12 months, and then reset again the next January 1st. If you started January 1st, 2014 with a $1,000,000 in this fund you would get a payout every month of 2014 for $2,995 ($35,940 a year). Why isn’t it 4% or $40,000?

The fund’s dynamic spending approach uses a “smoothing” method that keeps the monthly payout from changing too dramatically from year to year. Specifically, the 4% withdrawal rate is based on a 3-year rolling average of hypothetical past account value (assumes you spend the monthly distributions, but reinvest any year-end capital gains and dividends). Screenshot from prospectus:

So since the average of the past 3 years is lower than the current value, you’re getting 4% of a smaller number. As you can see, with smoothing your annual income from this fund can vary significantly over time. A starting portfolio size of $1,000,000 might get you an annual distribution varying from less than $36,000 or more than $44,000. Other smoothing methods include setting a maximum ceiling or minimum floor value, but this fund does not do that. Ideally, you would use the income from this fund to supplement other income from more reliable sources like Social Security, pensions, or guaranteed income annuities. That way your overall income will vary even less, and you’ll only have to cut back a little during down years.

(* Previously, Vanguard had three different Managed Payout funds with three different target spending rates of 3%, 5%, and 7%. I think this was confusing for many investors who didn’t really understand that the 7% fund would most likely experience a significant loss of principal over time. This is only speculation on my part, but the 7% payout fund did gather 8 times the assets as the 3% payout fund, even though 3% is a more realistic number for most folks. Vanguard now says that 4% is best for the “typical retirement period of 20–30 years”.)

It’s not just how much you save, it’s when you save that matters. The best time to start is now. This is the power of compounding returns, which this single chart will help you visualize:

• Susan (grey) invests $5,000 per year from age 25 to 35 ($50,000 over 10 years) and stops.
• Bill (green) invests $5,000 per year from ages 35 to 65 ($150,000 over 30 years).
• Chris (blue) invests $5,000 per year from ages 25 to 65 ($200,000 over 40 years).

You’ll note that Susan still ends up with more money than Bill, even though he invests three times as much money over 30 years, all because Bill starts late. Susan and Chris start out the same, except that Susan stops after 10 years while Chris keeps going. Chris only invests $100,000 more than Susan, but ends up with $500,000 more money in the end. A 7% annual return is assumed.

The chart is from a JP Morgan slide deck for their asset managers, via Business Insider.

I’m also reminded of Warren Buffett and his Snowball biography – “Life is like a snowball. The important thing is finding wet snow and a really long hill.”

Updated. In my post Roth IRA Contribution vs. Emergency Fund Savings, I suggested that people should just fund their Roth IRAs first over an Emergency Fund. Why? If you contribute $5,000 in a Roth IRA, you can take out $5,000 later with no tax or penalty – be it one day later, one week later, or one decade later.

For supporting evidence, you will have to wade through IRS Publication 590. First, we head to the Roth IRA section, specifically the subsection called Are Distributions Taxable?. Here, the first sentence states:

You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s)

Sounds pretty clear, but let’s keep looking. The next section talks about qualified distributions, like those made after you turn 59.5, which are definitely not taxable. We are given this decision flowchart (Figure 2-1), and… whoops, we may not even pass the first box. Taking out your contribution within the first 5 years is not a qualified withdrawal. 

But wait. Not all unqualified withdrawals are taxable. Going to How Do You Figure the Taxable Part?, we are directed as follows:

To figure the taxable part of a distribution that is not a qualified distribution, complete Form 8606, Part III.

Here is a link to Form 8606 [pdf] and the Form 8606 instructions [pdf].

Here’s how you would fill out the form for the simple situation of taking out former Roth IRA contributions. On Part III, Line 19, you would include the money you took out as a distribution – “Enter your total nonqualified distributions from Roth IRAs in 2013”. This would carry over to line 21. But then on Line 22 you would “Enter your basis in Roth IRA contributions”. Line 23 tells you to subtract the difference (21 minus 22). If you are taking out less than you formerly contributed over the years, your net taxable amount would be zero.

What about a possible 10% penalty? In the section on the penalties Additional Tax on Early Distributions, we see this:

Unless one of the exceptions listed below applies, you must pay the 10% additional tax on the taxable part of any distributions that are not qualified distributions.

Since this unqualified distribution of a former contribution is not taxable, there is no “taxable part” and thus no penalty to worry about.

In conclusion, although taking out a former Roth IRA contribution as a distribution may be (1) an unqualified distribution, it is also (2) not taxable and (3) not subject to any additional penalties. When subsequently filing your taxes, remember to fill out IRS Form 8606 as indicated above so show the IRS that you are only taking out your original basis.

Now that the dust has settled a bit, here’s a quick breakdown of the newly-announced myRA based on the description “simple, safe and affordable starter retirement savings account”.

• Simple = Direct payroll deduction. myRA will be funded directly through paycheck withholding, likely using the same infrastructure used to buy savings bonds via TreasuryDirect. No employee match. No bank account required. One investment option.
• Safe = Government-backed principal protection. The only thing you can buy in the myRA is a security identical to the G Fund of the Thrift Savings Plan available to federal employees. First, it has a principal guarantee so that your balance will never go down. Second, it pays interest based on the weighted average of all treasuries with maturities 4 years or more (2.5% as of January 2014). So it has the higher interest you’d get from owning longer-term bonds without the risk of loss.
• Affordable = Low contribution requirements. Minimums of $25 needed to start, and $5 per paycheck for future contributions.
• Starter = Temporary and small. Must be rolled over to a “regular” Roth IRA held at a private custodian when the account value reaches $15,000 or after 30 years.
• Retirement account = Structured as a Roth IRA. The myRA is a Roth IRA with the US government as the custodian, as opposed to a private company like TD Ameritrade. Account grows tax-deferred, and qualified withdrawals at retirement are tax-free. Same contribution limits ($5,500 for 2014) and same income limits ($129k MAGI for single, $191k MAGI for couples in 2014).

I would also add that it is not available yet, and will only be coming to select employers in “late 2014”. The goal is to be available to all W-2 employees via payroll deduction eventually, but that is unlikely to be earlier than 2015. For a more in-depth discussion, I liked this article by Michael Kitces at Nerd’s Eye View.

Much like modern car manufacturing, this is an attempt at fashioning a “new” retirement vehicle using existing parts from other models. Why? The President had to piece this thing together using executive order instead of pushing new legislation through Congress.

Will myRA entice people who currently aren’t saving for retirement? I like the ease of paycheck deductions and the idea that you’ll never lose money. But the overall package just isn’t exciting enough. There is no buzz. People are not clamoring to sign up right away. Instead of just 4+ year Treasuries, it should offer both a principal guarantee and the highest interest rate of any US bond (30-year Treasuries?). Make it as attractive as possible.

Target date funds (TDFs) get their name because they adjust their portfolio holdings automatically over time based on a given target retirement date. In general, this means shifting from mostly stocks to less stocks over time (known as the “glide path”). TDFs continue to grow in popularity, especially within employer-based plans like 401k’s and 403b’s.

Morningstar Fund Research recently released its 2013 industry survey, Target-Date Series Research Paper [pdf]. While it feels targeted at financial professionals, there are some good nuggets for us individual investors looking to decide where to invest. For example, we have to be careful as look how widely the glide path can very between different brands of target funds:

(click to enlarge)

While the most popular TDF providers have much more similar glide paths, they still differ in important ways (especially after retirement age).

(click to enlarge)

Other highlights from the paper:

[Read more…]