Archives for January 2021

If you’ve read much about retirement planning, you’ve probably encountered the “4% rule” — the idea that, if you spend 4% of your portfolio balance in the first year of retirement, then adjust that level of spending upward each year in keeping with inflation, your portfolio will probably last through a 30-year retirement.

An unfortunate side effect of the proliferation of this concept is that people sometimes think that it’s automatically dangerous to spend more than 4% of your portfolio per year. In reality, there are plenty of cases in which spending more than 4% per year isn’t particularly risky — and even some cases where that’s the safest thing to do!

The “4% Rule” Often Involves Spending More than 4%

The idea of the 4% rule isn’t to spend 4% of the portfolio balance each year. Rather, the idea is to spend 4% in the first year of retirement, then adjust the dollar amount based on inflation going forward, regardless of how the portfolio performs.

As a result, even with the original 4% rule strategy, there are plenty of scenarios in which a person ends up spending more than 4% of the portfolio balance in a given year. (For example, any scenario in which the portfolio declines at all in Year One will result in spending more than 4% in Year Two.) Scenarios of that nature are already accounted for in the research that found that a 4% initial spending rate was reasonably safe.

Age Matters

Depending on your age, spending more than 4% per year can make perfect sense. As an obvious example, consider a 85-year-old widower. He doesn’t need his portfolio to last another 30 years. He might want to spend at a low rate, if his goal is to leave most of his savings to heirs, but he doesn’t have to.

Conversely, if you sell a business at age 35 and plan to be retired as of that point, living primarily off the portfolio, I would not suggest spending 4% per year. Given the super long time span that’s likely to be involved, it would probably be prudent to start with something more like 3% — or possibly even less.

Intending to Deplete the Portfolio

One long-time reader of this blog is unmarried, in her 60s, retired after a career with the federal government. Her home is paid off. And, in her own words, her savings are “modest, compared to what I would have tried to accumulate if I did not have a pension.”

Her plan is to spend about 10% of the portfolio balance per year, and I think that’s entirely reasonable. She plans to deplete the portfolio — that’s the goal. Spend the portfolio down while her health is still such that she can get the most enjoyment from the additional spending, and then live on the (not-at-all-trivial) pension for her remaining years.

Delaying Social Security

Finally, as we’ve discussed about a zillion times, delaying Social Security is typically advantageous for most unmarried people, for the higher earners in married couples, and in some cases even for the lower earner in married couples.

But delaying Social Security means spending down the portfolio at a faster rate in the meantime — often a rate in excess of 4%. And that scares some people.

But in reality, this is typically the safest thing to do.

You can carve out a separate chunk of your portfolio to satisfy the higher level of spending in early retirement, and put that money in something low-risk. (For example, build an 8-year CD ladder to satisfy the 8 years of higher spending until your Social Security kicks in.) In such a case, yes, you’re likely spending more than 4% in those years. But that chunk in question has almost no risk. And the result is a lower long-term spending rate once your Social Security does kick in. (Plus, in the event that you were to deplete your portfolio, you’d be left with a higher level of income than if you had not delayed Social Security.)

One of the most common retirement tax planning errors I see is specific to married couples: not accounting for the tax changes that will occur once one of the two spouses dies.

For example, using data from the SSA’s 2017 Period Life Table, we can calculate that, for a male/female couple both currently age 60 and in average health, there will be, on average, 11.3 years during which only one spouse is still alive. (That is, the expected period for which both spouses will still be alive is 17.4 years, while the expected period for which either spouse will be alive is 28.7 years. The difference between those two lengths of time, 11.3 years, is essentially the expected duration of “widow(er)hood” for the couple.)

Why This Is Important for Tax Planning

When one of the two spouses dies, there is generally a decrease in income, but it’s typically somewhat modest as a percentage of the household’s overall income — especially for retired couples who have managed to accumulate significant assets. What generally happens is that the smaller of the two Social Security benefits disappears when one spouse dies*, but the portfolio income is largely unchanged (unless the deceased spouse left a significant portion of the assets to parties other than the surviving spouse).

And, beginning in the year after the death, the surviving spouse will only have half the standard deduction that the couple used to have. In addition, there will only be half as much room in each tax bracket (up to and through the 32% bracket), and many various deductions/credits will have phaseout ranges that apply at a lower level of income.

In other words, there’s half the standard deduction and half as much room in each tax bracket, but the surviving spouse is left with more than half as much income. The result: their marginal tax rate generally increases, relative to the period of retirement during which both spouses were alive.

The tax planning takeaway is that it’s often beneficial to shift income from those later (higher marginal tax rate) years forward into earlier (lower marginal tax rate) years. Most often that would be done via Roth conversions or prioritizing spending via tax-deferred accounts.

It’s tricky of course because, as with anything dealing with mortality, we don’t know the most critical inputs. To put it in tax terms, how many years of “married filing jointly” will you have in retirement? And how many years of “single” will you (or your spouse) have in retirement? We don’t know. We can use mortality tables to calculated expected values for those figures, but your actual experience will certainly be different.

So it’s hard (or rather, impossible) to be precise with the math. But it’s very likely that a) there will be some years during which only one of you is still living and b) that one person will have a higher marginal tax rate at that time than you (as a couple) had earlier. So, during years in which both spouses are retired and still alive, it’s likely worth shifting some income forward to account for such.

Often the idea is to pick a particular threshold (e.g., “up to the top of the 12% tax bracket” or “before Social Security starts to become taxable” or “before Medicare IRMAA kicks in”) and do Roth conversions to put you slightly below that threshold each year. But the specifics will vary from one household to another. And the decision necessarily involves a significant amount of guesswork as to what the future holds.

*This is a simplification. There can be various factors (e.g., government pension) that would make the total household Social Security benefit fall by an amount more or less than the smaller of the two individual benefits.