How do you determine after-tax budget with 4% SWR?

[jason]

A conservative, safe withdrawal rate for the PP appears to be 4%.  In a taxable account, some taxes may be incurred on the 4% withdrawal.  But it seems very complicated to estimate those taxes.  For example, when cashing out of assets early on, taxes will be minimal because gains have been minimal.  So, for example, if someone invests $1 million in a PP today, and one year later their portfolio increases 9% to $1.09 million, and they then withdraw 4%, that’s a withdrawal of $46,300.  But very little of that will be taxed as long term capital gains because the vast majority of what they withdrew was just cash that they had put in.  Only $6,300 of the $46,300 would be taxed, I think.  But 20 years later, if the values of the assets have tripled, then taxes will be much higher when assets are sold to take out withdrawals.  Does anyone know how to calculate the after-tax budget in these scenarios, and also how to account for how that will change over time?  I plan on sticking to the 4% SWR rule, but I’d really like to know what spending budget that will give me, after taxes.  I was wondering/hoping that someone has created a website or Excel/google doc to calculate this.  Any calculations would have to include a range of adjustable variables including total income/specific tax brackets.  The math for all this is way over my head, but I know there has to be a way to figure this out.

[Mark Leavy]

My approach is to ensure that I never withdraw more than 3% for living expenses - and then just pay whatever taxes come up out of the portfolio cash fund.

[Tyler]

A lot of it comes down to your spending needs.

For a retired married couple with no other income, the first $75k in long-term capital gains is tax free.  And that's before any tax loss harvesting.  You still have to pay taxes on interest and non-qualified dividends, but the same couple will have $20k in tax-free space using the standard deduction and personal exemptions.  Since the PP isn't paying out much interest these days, that's pretty manageable for a lot of people. 

Of course, forced IRA distributions complicates it.  Planning a little buffer like Mark does is a good idea. 

[MediumTex]

Trying to work some Roth IRA or Roth 401(k) money into the mix as you go along can also make the tax issues easier in retirement.

If, for example, you need an extra $10,000 to spend, but taking it out of taxable retirement accounts would mess up your overall tax strategy for the year, it sure is nice to have a Roth bucket to dip from.

[jason]

My approach is to ensure that I never withdraw more than 3% for living expenses - and then just pay whatever taxes come up out of the portfolio cash fund.

I was thinking the same thing - that I could just spend 3% out of the 4%, and save the remaining 1% for taxes, but that seems overly conservative.  I'd prefer to try to come up with an estimate of the actual number.  I was hoping a long, complicated formula could be used to figure this out.  But this type of math was never my strong suit.

[sophie]

3% probably is overly conservative (if it's set for tax reasons only).  If you're paying 25% as an overall tax rate, presumably you have income from other sources which would reduce the amount you need to draw from the portfolio.

I was puzzling about this as well, and decided to discount my projected annual earnings by 10%.  If you want to get out the calculator, you can figure the income you won't pay taxes on (standard deduction + personal exemptions), then figure the tax on income in each bracket, up to your 4% figure.  If your 4% figure is over the 15% tax bracket, assume capital gains/dividends are taxed as ordinary income, for simplicity, then assume that this is about half of your taxable investment withdrawals.  Then total up the tax and that will give you the overall percentage.  If you are counting on income other than from investments, be sure to add that in.  I'm assuming all Social Security income is taxable (if not now, it surely will be).

The Roth IRA and HSA are definitely important as they can be used to avoid jumping into a higher tax bracket.

[Libertarian666]

I have written a program that estimates how much you can spend without running out of money before a conservative life expectancy, including the effects of federal income and payroll taxes. I'll be happy to let any of you beta test it if you will sign an NDA and give me feedback on how it works for you.

[Tyler]

I was thinking the same thing - that I could just spend 3% out of the 4%, and save the remaining 1% for taxes, but that seems overly conservative.  I'd prefer to try to come up with an estimate of the actual number.  I was hoping a long, complicated formula could be used to figure this out.  But this type of math was never my strong suit.

You might try Turbotax.  Set up a dummy return with real investment data and estimated social security payments (if applicable) but no earned income and see what happens. 

[jason]

3% probably is overly conservative (if it's set for tax reasons only).  If you're paying 25% as an overall tax rate, presumably you have income from other sources which would reduce the amount you need to draw from the portfolio.

I was puzzling about this as well, and decided to discount my projected annual earnings by 10%.  If you want to get out the calculator, you can figure the income you won't pay taxes on (standard deduction + personal exemptions), then figure the tax on income in each bracket, up to your 4% figure.  If your 4% figure is over the 15% tax bracket, assume capital gains/dividends are taxed as ordinary income, for simplicity, then assume that this is about half of your taxable investment withdrawals.  Then total up the tax and that will give you the overall percentage.  If you are counting on income other than from investments, be sure to add that in.  I'm assuming all Social Security income is taxable (if not now, it surely will be).

The Roth IRA and HSA are definitely important as they can be used to avoid jumping into a higher tax bracket.

The problem I am seeing is that I can probably figure out the taxes I will owe this year, but it's very hard to do the math to project taxes in the future.  The issue is that if someone starts a PP today, then one year from now, if the PP increases a normal amount, like 9%, they aren't going to pay taxes on the full 4% that is withdrawn.  Only a tiny percentage of that withdrawal will actually be a capital gain.  But 30 years from now, the asset prices might be 500% higher than they are today, so when you sell assets 30 years from now, the majority of the cash received will be taxed as long term capital gains.  And then one also has to take into account inflation.  So, any formula would need to account for all of these variables: CAGR, tax brackets, inflation, interest rate on cash, interest rate on Treasuries, and so on.

[Libertarian666]

3% probably is overly conservative (if it's set for tax reasons only).  If you're paying 25% as an overall tax rate, presumably you have income from other sources which would reduce the amount you need to draw from the portfolio.

I was puzzling about this as well, and decided to discount my projected annual earnings by 10%.  If you want to get out the calculator, you can figure the income you won't pay taxes on (standard deduction + personal exemptions), then figure the tax on income in each bracket, up to your 4% figure.  If your 4% figure is over the 15% tax bracket, assume capital gains/dividends are taxed as ordinary income, for simplicity, then assume that this is about half of your taxable investment withdrawals.  Then total up the tax and that will give you the overall percentage.  If you are counting on income other than from investments, be sure to add that in.  I'm assuming all Social Security income is taxable (if not now, it surely will be).

The Roth IRA and HSA are definitely important as they can be used to avoid jumping into a higher tax bracket.

The problem I am seeing is that I can probably figure out the taxes I will owe this year, but it's very hard to do the math to project taxes in the future.  The issue is that if someone starts a PP today, then one year from now, if the PP increases a normal amount, like 9%, they aren't going to pay taxes on the full 4% that is withdrawn.  Only a tiny percentage of that withdrawal will actually be a capital gain.  But 30 years from now, the asset prices might be 500% higher than they are today, so when you sell assets 30 years from now, the majority of the cash received will be taxed as long term capital gains.  And then one also has to take into account inflation.  So, any formula would need to account for all of these variables: CAGR, tax brackets, inflation, interest rate on cash, interest rate on Treasuries, and so on.

That's (part of) what my program does.

[Mark Leavy]

With my apologies to Jason and tech. I think it is a misguided effort to try and too closely model your future tax situation.  After retirement you will be exposed to life options that you can't even imagine while you are still a full-time employee. It is better to just model a rough number and charge bravely ahead!

[Libertarian666]

With my apologies to Jason and tech. I think it is a misguided effort to try and too closely model your future tax situation.  After retirement you will be exposed to life options that you can't even imagine while you are still a full-time employee. It is better to just model a rough number and charge bravely ahead!

If you have a lot more money than you thought you would have, sure.

Most of us don't have that "problem", though.

[Mark Leavy]

With my apologies to Jason and tech. I think it is a misguided effort to try and too closely model your future tax situation.  After retirement you will be exposed to life options that you can't even imagine while you are still a full-time employee. It is better to just model a rough number and charge bravely ahead!

If you have a lot more money than you thought you would have, sure.

Most of us don't have that "problem", though.

Money is a big factor. No denying that.

But if you're retired you can decide to live anywhwere. You can be a goat herder in Tibet or a pimp in Thailand. You can be the cool old dude that clears the tables at Burger King.  How do you model a path unknown?

[Mark Leavy]

I've seen too many people spend an enormous amount of effort optimizing the trivial.

Yes, you can shave a few basis points here and there.

But how would your life change if you lost 20 lbs and became a dive instructor in the Caymans?

[sophie]

The problem is that when as you get older, it gets harder to uproot yourself and move to a new place where you may not know anyone.  I admire people who can do it, but I suspect I won't be the one who manages to become a goat herder in Tibet - as awesome as that sounds.

There's always going to be something you can do to plug an income shortfall without having to move.  Become an Uber driver, work part time in a local store, do some consulting, put up signs and tutor high school kids, rent your place out temporarily and go visit family or travel for a few months, cat sit or dog walk for neighbors.  Unfortunately, taxes are impossible to predict, except they're much more likely to go up than down :-)

[ochotona]

A conservative, safe withdrawal rate for the PP appears to be 4%.  In a taxable account, some taxes may be incurred on the 4% withdrawal.  But it seems very complicated to estimate those taxes.  For example, when cashing out of assets early on, taxes will be minimal because gains have been minimal.  So, for example, if someone invests $1 million in a PP today, and one year later their portfolio increases 9% to $1.09 million, and they then withdraw 4%, that’s a withdrawal of $46,300.  But very little of that will be taxed as long term capital gains because the vast majority of what they withdrew was just cash that they had put in.  Only $6,300 of the $46,300 would be taxed, I think.  But 20 years later, if the values of the assets have tripled, then taxes will be much higher when assets are sold to take out withdrawals.  Does anyone know how to calculate the after-tax budget in these scenarios, and also how to account for how that will change over time?  I plan on sticking to the 4% SWR rule, but I’d really like to know what spending budget that will give me, after taxes.  I was wondering/hoping that someone has created a website or Excel/google doc to calculate this.  Any calculations would have to include a range of adjustable variables including total income/specific tax brackets.  The math for all this is way over my head, but I know there has to be a way to figure this out.

Back to Jason's original question...

1. How many years are you away from retirement?
2. What is your average tax rate?
3. What is your marginal tax rate?
4. Do you expect your income to be higher or lower in retirement than it is now? By how much (%)
5. What % of your assets are tax deferred (Trad IRA, 401k), tax free (Roth, HSA), or taxable now (reg brokerage account)
6. Are you a government optimist (tax rates will stay level or decrease), or a government pessimist tax rates will increase?)

[Tyler]

Just one data point (that will be completely different from yours):

I just filed my 2015 taxes, which was our first full year after we both left our full time jobs to live on our own terms.  I fell into a part time gig towards the end of the year, which combined with dividends and interest pretty much paid our meager annual expenses.  Before that, we just lived off the PP cash.  Our MAGI was high enough to qualify for ACA subsidies, but after the standard deduction and personal exemptions we had zero taxable income.  We didn't rebalance our PP, but if we needed to we still had plenty of room in the 0% LTCG tax bracket and some old tax loss rollovers.  Basically, it was a tax-free year.  I think years of conditioning to turning over a huge percentage of your income to the IRS blinds people to how the system is a lot different on the low income side, especially if your expenses are also very low. 

To Mark's point, having all of that extra time and flexibility eventually found me in a pretty nice part-time setup that I never expected would be possible.  I'll pay taxes next year, and am fine with that. The most detailed retirement plans aren't necessarily the most accurate, as they rarely account for exciting new opportunities that you now have the flexibility to pursue.