Buck Conventional Wisdom When Taking Retirement Withdrawals
Thursday, April 16, 2015

You can extend how long your retirement savings last by bucking the conventional wisdom on how to take withdrawals. Even if you are not in retirement yet, you will want to pay attention because the strategy may impact your decisions about what retirement savings accounts to maintain and contribute to.

Conventional wisdom says retirees should withdraw savings from their taxable accounts first, tax-deferred accounts (e.g., traditional IRAs, 401(k)s, etc.) second and tax-exempt accounts (Roth IRAs) last. The general idea is to let the money in the most tax-favored accounts grow as much as possible. In the current issue of the Financial Analysts Journal, Baylor professor (and long-time AAII Journal contributor) William Reichenstein along with Kirsten Cook of Texas Tech University and William Meyer of Retiree Inc. challenge this notion. They say by altering how savings are withdrawn, and even by using Roth IRA conversions and recharacterizations, a retiree can extend the lifespan of his or her portfolio.

At the basis of their rationale is the fact that the aftertax value of funds in a tax-deferred account (TDA) and a tax-exempt account (TEA) are the same if the tax rate is flat. As such, the retiree’s strategy should be to avoid being bumped into a higher tax bracket and take advantage of years when he or she has a large amount of deductible expenses (e.g., big medical bills). This can be accomplished by taking funds from the taxable account first (where taxes are paid on capital gains and dividends, but not on distributions) and then capping withdrawals from the TDAs to the point at which the retiree would be bumped into a higher marginal tax bracket if a larger withdrawal were taken. Any additional dollars needed to fund living expenses should be taken from the TEA, which has tax-free distributions (as long as certain basic conditions are met.)

Before I address the strategy, I want to explain how funds in a TDA and a TEA could have the same aftertax value because I realize this may seem like a strange concept. Let’s assume that an investor in the 28% marginal tax bracket makes a one-time out-of-pocket contribution to a retirement account in the pretax amount of $10,000. He realizes a return of 7.5% per year for 25 years and then withdraws the entire amount. The initial $10,000 contribution to the traditional IRA grows to $60,983. (All $10,000 is used because the contribution occurs on a pretax basis). The ending balance is taxed at 28% when he makes his only withdrawal, lowering the aftertax balance to $43,908. The initial contribution to the Roth IRA would be $7,200. (He cannot afford to contribute the full $10,000 on an aftertax basis.) This balance grows also to $43,908 and is withdrawn in full with no taxes paid on the withdrawal.

(A higher marginal tax rate in retirement would shift the outcome in favor of the TEA, while a lower tax rate in retirement would favor the TDA. Even if one expects the marginal tax rates to increase in the future, an investor could pay a lower marginal tax rate if his or her annual income is lower in retirement than it was during the working years. One argument for incorporating Roth IRAs is to diversify against the risk of not falling into a lower tax bracket.)

Going back to withdrawal strategies, Reichenstein, Cook and Meyer propose withdrawing from the taxable account first, while simultaneously converting part of the tax-deferred account (e.g., a traditional IRA) to a tax-exempt account (e.g., a Roth IRA). The maximum amount of the conversion should be just below the limit at which the retiree would be pushed into a higher tax bracket. Money needed to pay for taxes on the conversion would be paid out of the taxable account. Once the taxable account is drained, the retiree would withdraw from the TDA up to the point that he or she is not pushed into a higher tax bracket, with any additional money needed to cover living expenses withdrawn from the TEA.

This is where a retiree can take advantage of the tax law. Withdrawals from the TDA can be increased during years with big deductions (e.g., high medical bills) without pushing the retiree into a higher tax bracket.

A more advanced strategy—and one that would extend the amount of time retirement savings last—would be to split a Roth IRA conversion into two equal amounts at the start of each year with one half placed into an account holding only stocks and the other placed into an account holding only bonds, with the taxes on the conversion being paid from the taxable account first and the tax-exempt account second (but only after the taxable account has been fully drained). At the end of the year, the account with the worst performance would be recharacterized back to a TDA. In other words, if stocks fared worse than bonds, the year’s conversion of dollars from the traditional IRA into a Roth IRA holding stocks would be undone. The conversion into the bond account would remain unchanged, allowing the retiree to maintain the Roth IRA conversion that is most favorable from a tax standpoint. The conversion amount into each account would be the maximum amount that does not push the retiree into a higher tax bracket. (This advanced strategy can be done with more than one asset class, with the obvious trade-off of more complexity.)

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AAII Model Portfolio Update

No changes were made to the Model Shadow Stock Portfolio and none were made to the Model Fund Portfolio this month.

In the Model Shadow Stock Portfolio, Kimball International, Inc. (KBAL) is above valuation limit. Stocks are eligible for deletion if their price-to-book ratio exceeds 2.4. Kimball International ended March with a price-to-book ratio of 2.79, which makes it eligible for deletion at the portfolio’s next quarterly review in June. 

Two stocks in the portfolio have been put on earnings probation because their last 12 months of earnings from continuing operations are negative: International Shipholding Corp. (ISH) and Olympic Steel Inc. (ZEUS). Stocks on probation can be eligible for deletion if they continue to report losses on an adjusted basis for the trailing 12 month periods.

The Model Fund Portfolio was down 0.1% in March, while the Model Shadow Stock Portfolio, which invests in micro-cap value stocks, gained 4.6%. 

The Model Shadow Stock Portfolio’s 4.6% increase for March handily beat both of its comparison benchmarks: The Vanguard Small Cap Index fund (NAESX) gained 1.2% and the DFA US Micro Cap Index fund (DFSCX) gained 2.3% in March. Year to date, the Shadow Stock Portfolio has gained 5.6%, while the NAESX is up 4.8% and the DFSCX is up 3.1% over the same time period. Since its inception in 1993, the Model Shadow Stock Portfolio has a compound annual average return of 17.0%, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.4% annually over the same period. 

The Model Fund Portfolio’s 0.1% decline in March compared to a 1.0% decrease for the Vanguard Total Stock Market Index fund. Since its inception in June of 2003, the Model Fund Portfolio has a compound annual average return of 9.3%, slightly trailing the Vanguard Total Stock Market Index fund over the same time period, which gained 9.5%.

The Week Ahead

Earnings season will hit full stride with nearly 150 members of the S&P 500 reporting. Included in this group are Dow Jones industrial average components International Business Machines (IBM) on Monday; Du Pont (DD), Travelers (TRV), United Technology (UTX) and Verizon (VZ) on Tuesday; Boeing (BA), Coca-Cola (KO) and McDonald’s (MCD) on Wednesday; and 3M (MMM), Caterpillar (CAT), Microsoft (MSFT) and Procter & Gamble (PG) on Thursday.

The economic calendar is light. March existing home sales will be released on Wednesday. Thursday will feature March new home sales and the April PMI manufacturing flash index. March durable goods orders will be released on Friday.

The Treasury Department will auction $18 billion of five-year TIPS on Wednesday.

What’s Trending on AAII
  1. The Importance of Diversification in Retirement Portfolios

  2. Rebalancing Update: Retirement Adjustments Necessary

  3. Increasing Retirement Withdrawal Rates Through Asset Allocation

AAII Sentiment Survey

The proportion of individual investors describing their six-month outlook for stocks as neutral is above 45% for a second consecutive week for the first time in more than 26 years. Optimism rebounded back above 30%, while pessimism declined.

Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded by 3.4 percentage points to 32.1%. Even with the upward move, optimism is below its historical average of 39.0% for the sixth consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 2.0 percentage points to 45.1%. This is the first time neutral sentiment has stayed at or above 45% on consecutive weeks since January 20 and January 27, 1989. (Neutral sentiment was 47.0% and 49.0%, respectively, on those dates.) This week is the 15th consecutive week with neutral sentiment above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, declined 1.4 percentage points to 22.8%. This drop puts bearish sentiment at a seven-week low. The historical average is 30.5%.

Seeing neutral sentiment stay at or above 45% is very unusual, though it did it reach and hold even higher levels throughout 1988. Historically, unusually high levels of neutral sentiment have been correlated with better-than-average market performance over the following six- and 12-month periods. (See Analyzing the AAII Sentiment Survey Without Hindsight in the June 2014 AAII Journal for more information.) There is no guarantee history will repeat in the future, however.

Keeping some AAII members encouraged is the ongoing bull market, sustained economic expansion, earnings growth and a still-accommodative monetary policy. Causing other AAII members to be cautious or pessimistic are prevailing valuations, recent price volatility, geopolitical events, the pace of economic growth, the impact of the stronger dollar in earnings growth and worries that a notable decline in stock prices could occur.

This week’s special question asked AAII members what, if any, global events are influencing their six-month outlook toward the stock market. Responses varied, with several members listing more than one event. More than one in five (22%) respondents said that events in the Middle East are having an impact. Ongoing instability was the primary factor, though several respondents mentioned the framework for a possible deal with Iran. About 19% of respondents said that Europe is influencing their outlooks, particularly its rate of growth. The stronger U.S. dollar is influencing the outlooks of 15% of all respondents. A nearly equal number, about 11% each, said that the global economy and central bank policies are having an impact on their expectations for the stock market.

Here is a sampling of the responses:

  • “Economic stimulus measures overseas may help to offset a fully to slightly overvalued U.S. market.”
  • “Growing unrest in the Middle East.”
  • “Iranian nuclear accord reaching finalization.”
  • “The continuing strength of the U.S. dollar.”
  • “The European Union economy seems to be stabilizing thanks to accommodative monetary policy.”


This week’s Sentiment Survey results:

Bullish: 32.1%, up 3.4 points
Neutral: 45.1%, down 2.0 points
Bearish: 22.8%, down 1.4 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!