Author Topic: Factoring Taxes into 4% Rule  (Read 3809 times)

BigBangWeary

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Factoring Taxes into 4% Rule
« on: October 27, 2015, 06:02:31 AM »
Do you factor taxes when calculating your 4% SWR?

Would someone with a 500,000 portfolio in a sheltered account (ie. no taxes owing) really be in the same place as someone who has most of their investments outside of such a vehicle and plans to withdraw 4% yearly?

I am thinking of a younger family aiming at ERE who has built up a lot outside of a sheltered account that they hope to live off of, vs. someone who has taken longer and has managed to save a similar amount in something like a TFSA or ROTH IRA.

What about the same $500,000 invested offshore while the family lives in Panama, etc? How significantly does this impact your 4% calculations and your ability to retire early?

Then there are income taxes and how you actually take this money out of your investments. It just makes the 4% rule seem like too blunt of an instrument. Any thoughts?

terran

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Re: Factoring Taxes into 4% Rule
« Reply #1 on: October 27, 2015, 06:22:36 AM »
The 4% rule makes no assumptions about taxes, it simply says that 4% is the maximum withdrawal that has historically always resulted in portfolio lasting at least 30 years. Taxes are simply another expense you'll have to pay out of the money you withdraw, so you need to figure that out for your particular circumstances and mix of accounts. Having all your money in a Roth IRA will result in lower expenses (because of taxes) than having all your money in a Traditional IRA, so you will need to withdraw less, and therefore will need to save less, but it will also probably be harder to save.

runningthroughFIRE

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Re: Factoring Taxes into 4% Rule
« Reply #2 on: October 27, 2015, 10:50:26 AM »
The 4% SWR rule is a pretty basic method of determining how much you will need to retire, and doesn't take taxes into account.  Exactly how precise you need to be depends on what you want your life to look like.  Many on these forums don't expect to fully "retire" in the traditional sense, and will have some kind of gig that produces income.  Others keep working for a few months, or even a year or two past their FIRE number to build up a safety margin, which could be in part to pay taxes.

If you want to retire and never do a single thing to earn money again ever in your life, then the 4% rule might not be quite enough.  If you want to keep working but maybe lower the hours, do something less profitable but more fun, or just work random odd jobs whenever the mood strikes you then the 4% rule becomes a little more realistic.

bacchi

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Re: Factoring Taxes into 4% Rule
« Reply #3 on: October 27, 2015, 11:14:21 AM »
Would someone with a 500,000 portfolio in a sheltered account (ie. no taxes owing) really be in the same place as someone who has most of their investments outside of such a vehicle and plans to withdraw 4% yearly?

Probably. With Roth conversions and low earned income, you never have to pay capital gains.

https://www.schwab.com/public/schwab/nn/articles/Taxes-Whats-New


Edit: http://www.gocurrycracker.com/never-pay-taxes-again/
« Last Edit: October 27, 2015, 11:25:11 AM by bacchi »

mandy_2002

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Re: Factoring Taxes into 4% Rule
« Reply #4 on: October 27, 2015, 12:07:50 PM »
If this retirement planning were for me, I would add taxes as a budgetary item.  (Along with all things in life, if the costs increase, which they may very well do, then planning and tactics may need to change.  Hopefully I have built in a little fluff to account for slight increases.)  For me, much of my retirement income will come from money that has already been taxes, so this is really a worst case scenario. 

For my budget: 
Assuming zero tax advantaged or after tax accounts (or only Traditional 401k/IRA/pension income), a $20,000 per year income for a single person with no additional deductions equates to a taxable income of $9,700 in 2015 ($4,000 personal exemption and $6,300 standard deduction).  This equates to a 10% rate on $9,225 and a 15% tax rate on $475, or $993.75 in taxes. 

The great thing about these bottom two tax brackets is that dividend and capital gains income is currently taxed at 0%, so the ~$6,000 in income that I expect from these are tax free as well.  Because of my situation, I would assume taxes of about $500 in my budget (this includes a small amount for state taxes). 

BigBangWeary

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Re: Factoring Taxes into 4% Rule
« Reply #5 on: October 29, 2015, 01:05:40 AM »
Thanks for the replies. Right, so if you had a $500,000 portfolio and you were living in a tax-free environment (a few left in the world), and you lived off dividends, etc. wouldn't the 4% rule need to be adjusted? Since taxes are not an expense?

Frs1661

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Re: Factoring Taxes into 4% Rule
« Reply #6 on: October 29, 2015, 03:54:00 AM »
The rule wouldn't be adjusted, but your yearly expenses would be, so the amount you need to save would be reduced. You would need to save 25x your yearly expenses either way.

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BigBangWeary

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Re: Factoring Taxes into 4% Rule
« Reply #7 on: October 30, 2015, 01:12:21 PM »
Right, ok thanks. My theory was just that if one can reduce income taxes to near zero while living off your nest egg, then you need less money to retire.

terran

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Re: Factoring Taxes into 4% Rule
« Reply #8 on: October 30, 2015, 01:16:44 PM »
Right, ok thanks. My theory was just that if one can reduce income taxes to near zero while living off your nest egg, then you need less money to retire.

This is correct. But, you have to ask yourself: is it better to reduce taxes now, or reduce taxes in retirement? :-)

Also, there are ways to reduce taxes to near zero in retirement without investing only in Roths now.

SwordGuy

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Re: Factoring Taxes into 4% Rule
« Reply #9 on: October 30, 2015, 02:36:57 PM »
Right, ok thanks. My theory was just that if one can reduce income taxes to near zero while living off your nest egg, then you need less money to retire.

And you've totally garbled up what's essentially a no-brainer exercise.   

You need to separate in your mind the concepts of "how much can I safely withdraw from my stock" and "what will be my expenses, both voluntary and involuntary".