The Optimal Rule performs a nonlinear constrained optimization. So, it maximizes the after-tax inheritance transferred from the retiree to his or her heirs. The “optimal solution” is a set of annual withdrawal decisions from one of three types of accounts.
- Tax deferred accounts, like a 401(k), 403(b), 457 plan, and Individual Retirement Accounts (IRAs). All withdrawals are subject to taxation as ordinary income.
- Tax free accounts, like a Roth IRA, Roth 401(k) or Roth 403(b) accounts, where withdrawals are tax free.
- Taxable brokerage accounts. All withdrawals are suject to long-term capital gains tax for a pre-defined tax basis.
The optimization is subject to constraints that include:
- After-tax income from all sources must equal your after-tax retirement income needs. Therefore, we assume that needs are for both discretionary and non-discretionary expenses over your pre-determined retirement horizon.
- Account balances must always be greater than or equal to $0.00.
Unfortunately, the nonlinearity in this optimization is due to the progressive tax system in the U.S. So, these results do not guarantee a so-called “global maximum”. However, the optimization algorithm uses an initial guess that is based on ‘a priori‘ knowledge of the heir’s tax rate, leading to results superior to the Common Rule.