Category: Taxation

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Finding your Optimal Retirement Income

We introduced a new feature to ETFMathGuy.com in 2019 to help current and future retirees plan for the future. We have now upgraded it to find optimal retirement income. Fortunately, the calculator still offers answers to the many commonly posed questions for those nearing or currently in retirement.

  • How long will my portfolio support my discretionary and non-discretionary expenses?
  • How much will my heir or favorite charitable organization receive?
  • What will my future tax liabilities look like?

This calculator models income tax, capital gains taxes and other important elements of U.S. tax law relevant to individuals and couples in retirement. However, this model does not represent tax advice, and is for educational purposes only.

Sequencing Withdrawals for Optimal Retirement Income

In the former version of our calculator, we only applied the so-called “Common Rule“. Using values for a hypothetical 60-year old couple with a 20 year retirement horizon, the figure below shows how the couple can achieve $150,000 of annual after-tax retirement income. Notice how this “married filing jointly” couple has a effective 0% income tax bracket, as labeled on the right of the figure, due to use of the standard deduction. In 2020, this value is $24,800. To re-create these results or create your own, please visit our our interactive retirement calculator.

Common Rule withdrawal sequencing leading to a $1,203,938.01 inheritance. optimal retirement income
Common Rule withdrawal sequencing leading to a $1,203,938.01 inheritance.

While the “Common Rule” is widely adopted by financial planners and major discount brokers like Fidelity and Vanguard, it is known to sub-optimal. Why? This rule typically produces very little tax burden in the earlier years of retirement, unless they are triggered by Required Minimum Distributions (RMDs). Consequently, later retirement years can see very high income tax to maintain retirement income at acceptable levels. This rule also doesn’t take advantage of the step-up in cost basis realized by the retiree’s heirs.

Optimizing Retirement Income Withdrawal Decisions

The latest version of the retirement income calculator can now optimize withdrawal decisions using an “Optimal Rule“. So, using the same values for the calculator as our previous hypothetical couple, their heir’s inheritance increases by 13.7%, or $165,000. If their heir is a qualifying charitable organization, the inheritance increases by  $335,343.94 or 26.1%. We encourage you to try out your own scenarios to see how you can improve your retirement withdrawal decisions.

Optimal Rule withdrawal sequencing leading to a $1,368,938.05 inheritance, a 13.7% increase. optimal retirement income
Optimal Rule withdrawal sequencing leading to a $1,368,938.05 inheritance, a 13.7% increase.

Plans for the Future

We have plenty of other plans for our retirement calculator. For instance, delaying social security, including tax-free municipal bond interest, and assessing the benefits of a Roth conversion are just a few. If you have any thoughts of what you would like to see, please send us your feedback!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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The SECURE act and Your Retirement

On December 20, 2019, the SECURE act (Setting Every Community Up for Retirement Enhancement act) was signed into law. This new law made a number of changes that could effect your plans for retirement. We discuss a few highlights of this new law in this post.

New age for Required Minimum Distributions (RMDs)

The SECURE act recognizes that more individuals are delaying retirement. So, the new law changes the age to take initial RMDs from tax-deferred accounts, like 401(k)s, 403(b)s and traditional IRAs. Previously, initial RMDs were triggered in the year you turned 70 1/2.

Required Minimum Distributions (RMDs) are changing.
Tax laws for retirement are changing. source: Getty Images

The new age under the SECURE act is 72 for individuals who reach 70 1/2 in 2020. Using a handy online age calculator or performing a little mental math, that means anyone born after June 30, 1949 can wait until the year they turn 72 to take RMDs.

How will this new RMD age affect your retirement plan?

In late 2019, we developed a retirement calculator that included income and capital gains tax forecasts. It also included RMDs under the old law. We are happy to announce we have updated our calculator to include this new law. Please check it out! We also added a tool tip for each input in the calculator, to help you better understand how the model works.

We updated our retirement calculator to include the age change of RMDs from 70 1/2/ to 72.

Bad news with the SECURE act

Unfortunately, there is also some bad news for retirees coming from the SECURE act. The so-called “Stretch IRAs” are now not nearly as valuable as they were prior to this law. Previously, IRAs that are passed to nonspouse heirs could be withdrawn over their life time. This feature made inherited IRAs very appealing to younger heirs, who could stretch their payments, limit their income taxes, and stretch pre-tax gains over a longer time. The new law limits this time to 10 years. In a bit of good news, this law does not affect existing inherited accounts.

Conclusions

Tax law will continue to change. We shouldn’t expect congress to continue to keep the taxes status quo. Instead, current and future retirees should consider diversifying their retirement income sources to accommodate possible future changes.

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Retirement Calculator by ETFMathGuy

Seasons greetings to all! We hope this post finds you well. We are happy to introduce a new and evolving feature available to ETFMathGuy subscribers: a new Retirement Calculator!

Retirement Calculator

You may have noticed a new menu option when logging into ETFMathGuy.com labeled “Retirement Calculator”. Please be sure to log-in to our site to access this interactive calculator. If you don’t recall your password, it can be reset here. You also may need to refresh the page containing the calculator.

A new retirement calculator to help you better understand the feasibility of your retirement income.
A new retirement calculator to help you better understand the feasibility of your retirement income.

Another Retirement Calculator?

There are certainly many retirement calculators available online, either free, as part of your brokerage account, or by subscription. I have been using the Fidelity Retirement Income planner for some time, which is free to Fidelity account holders. While there are similarities between our retirement calculator and others, here are a few of the features our retirement income planner includes.

  1. We assume qualified stock dividends and non-qualified bond dividends. Some planning tools tax stock and bond dividends the same. So, we made the assumption that stock and bond investments in a taxable brokerage account hold ETFs like the iShares Core S&P 500 ETF (ticker IVV) and the iShares Core U.S. Aggregate Bond ETF (ticker AGG).
  2. We assume taxable account withdrawals trigger only long-term capital gains taxes. Some planning tools include all taxable account withdrawals as part of ordinary income, which only occurs for capital gains in investments held for less than one year.
  3. We model capital gains taxes and qualified dividends at either the 0%, 15% and 20% rates, with income levels based on taxable income for the current tax year. Some planning tools either exclude taxation of these sources of retirement income, or tax them all at the 15% rate.

Questions or feature requests

We encourage you to try out our new calculator, which also provides more detailed information on how it models retirement income and taxes. We also would love to hear about features you would like to be included in the calculator as its development continues.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Is direct indexing better than buying an ETF?

Direct indexing may be gaining popularity soon, thanks to a continued fee war between several large brokerages. Both Schwab and Ameritrade recently announced commission-free stock trades, in addition to their commission-free ETF trades. This may sound like an appealing alternative, but direct indexing is far from simple.

What is direct indexing?

Direct indexing creates a portfolio that tracks an index through buying individual stocks. So, in the case of the S&P 500, you would invest in common stock from the 500 companies that make up the index. By eliminating the commission for each trade, the cost barrier of buying and selling each stock goes down significantly. However, it still requires many trades. In the case of the S&P 500, there are actually 505 common stock listings for the 500 companies in the index. It turns out that a few companies, like Google, have two share classes. So, one could eliminate the expense ratio of 0.04% currently charged by the iShares Core S&P 500 ETF (ticker: IVV). For a $100,000 portfolio, that is a savings of $40 a year. For portfolios of this size, I would argue that the convenience of trading a single ETF is worth $40 a year.

Tax benefits of direct indexing

When an investor builds a portfolio of common stock with direct indexing, they get more control over its holdings. While ETFs are known to be very tax efficient, tax loss harvesting is not possible at the individual security level. This benefit doesn’t make a difference in retirement accounts that aren’t paying taxes on selling stocks, but can be significant in taxable accounts for high income earners.

Conclusions

I am happy to see commissions for stock trades hitting $0, but I’m not convinced that for most investors, direct indexing makes sense. There is a cost savings, but the additional effort could be significant. And, if your larger investments are in tax-deferred or exempt retirement accounts, there aren’t any tax benefits available anyway. Tax loss harvesting appears to be the most compelling reason to direct index. It is most beneficial to individuals paying the highest marginal tax rates.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Taxation and your ETF investments

Taxation of your ETF investments is an important consideration. As we discussed in our previous post ETF Tax Efficiency vs. Mutual Funds, ETFs are quite tax efficient. Here, we summarize taxation of your ETF investments when held in a taxable account.

ETF taxation occurs in two ways. First, taxes occur when an ETF issues a dividend. Also, taxes occur when an investors sells their ETF for a gain (or loss). So, let’s first look at the preferred (lower) level of taxation available for ETFs.

ETF taxation of qualified dividends and long-term capital gains

ETFs issue two types of dividends, called qualified and non-qualified. As shown below, ETF investors prefer taxation of qualified dividends, due to their lower capital gains rates. Many stock-based ETFs issue these types of dividends. For example, the iShares core S&P 500 index ETF (ticker: IVV) currently distributes a qualified dividend yield of 2.05%. Investors who buy an ETF and sell it at least one year later also realize these preferred rates.

Tax rates for qualified dividends and long-term capital gains. source: https://taxfoundation.org/2019-tax-brackets/
Tax rates for qualified dividends and long-term capital gains.
source: https://taxfoundation.org/2019-tax-brackets/

ETF taxation as ordinary income

Unfortunately, ETFs can also be taxed at the higher rate of ordinary income. The tables below shows the current rates and income brackets for unmarried, married, and head of household tax payers.

Tax rates for non-qualified dividends and short-term capital gains. source: https://taxfoundation.org/2019-tax-brackets/
Tax rates for non-qualified dividends and short-term capital gains.
source: https://taxfoundation.org/2019-tax-brackets/

ETF investors face these taxes when either the ETF issues a non-qualified dividend, or is bought and sold in less than one year. Most bond-based ETFs issue non-qualified dividends. For example, the iShares Core U.S. Aggregate Bond ETF (ticker: AGG) generates non-qualified dividends, currently with a yield to maturity of 2.52%.

Don’t let the “tail wag the dog”

While taxation is an important aspect of ETF investing, it should not be the sole consideration. Indeed, Federal taxes could be minimized if one only needs the interest payments from municipal bond ETFs, like the iShares National Muni Bond ETF (ticker: MUB). But, a diversified portfolio should have a variety of asset classes. Instead, consider holding your portfolio of ETFs in a retirement account like a traditional or Roth IRA.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Risks and Opportunities in Fixed-Income ETFs

Fixed-income ETFs (also known as bond ETFs) continue to grow at a rapid pace. Bond ETFs now exist across a wide spectrum of characteristics. Looking for shorter or longer maturity? Or, how about higher yield (aka junk bonds) versus investment grade or Treasury bonds? ETFs even cover the bond markets in both emerging and developed economies worldwide.

At this rate, State Street Global Advisers predicts that assets in bond ETFs could reach $1 trillion by the end of 2019.

What is driving demand?

Like stock-based ETFs, low cost is a big driver. Greater tax efficiency, as we discussed in detail in a post earlier this year, over bond mutual funds helps too. But, the biggest demand could be simply choice.

“Investors really have a lot of choices — more than they’ve had in the past five years. “

Noel Archard, State Street Global Advisors

Liquidity concerns?

Our opinion at ETFMathGuy is that liquidity concerns are minimal. In fact, real-time ETF price availability helps the price discovery process, and should improve liquidity.

“Fixed-income ETFs have been tested more than once over the past 10-11 years, without any major issues. “

Rich Powers, Vanguard

The current focus of fixed-income ETFs

The current focus of fixed-income ETFs is now in portfolio construction. Here at ETFMathGuy, we are helping to lead this initiative by building portfolios to take full advantage of what fixed-income ETFs have to offer. For instance, in the May taxable conservative portfolio for Vanguard, we show a portfolio with a a variety of fixed-income ETFs in it. We also seek to include higher volume alternative ETFs, to mitigate any possible liquidity issues and minimize the bid-ask spread trading costs.

May 2019 taxable optimal portfolio for risk conservative investors, by ETFMathGuy.
May 2019 taxable optimal portfolio for risk conservative investors, by ETFMathGuy

In conclusion, fixed-income ETFs are in important core component of an optimally diversified portfolio. We invite you to browse through the current month optimal portfolios to see the importance of bond ETFs.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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ETF Tax Efficiency vs. Mutual Funds

Much has been written about ETF tax efficiency. In this blog post, we summarize what these tax advantages look like to a individual investor who may be considering mutual funds as an alternative.

Let’s start with the basics of capital gains taxes. Short term capital gains are taxed as ordinary income, which for individuals in higher tax brackets, is far from ideal. Below are the tax brackets for married filing jointly in 2018.

The 2018 tax brackets and rates for married couples filing jointly.
Source: CNBC.COM. About half of Americans don’t know what tax bracket they’re now in—here’s how to find out., by Kathleen Elkins

So, let’s suppose you and your spouse made $175,000 in 2018. Then, for every additional $1 of short-term capital gains, you owe 24 cents of income tax. If you are fortunate enough to be earning more, tax rates are even higher. For this reason, higher earners often use municipal bond ETFs in their taxable portfolios.

What produces short-term capital gains?

There are several ways that individual investors produce short-term capital gains with ETFs and mutual funds.

  • Buying an ETF or mutual fund and reselling it for a gain in less than a year.
  • Non-qualified dividends, often produced by fixed income mutual funds and ETFs.
  • Mutual funds that buy and sell assets in their fund to meet their stated objectives or to satisfy investor redemption*.

*This last point is where ETFs carry a significant advantage. The higher the turnover of a mutual fund’s assets, the more often short-term capital gains are passed on to the individual investor.

“If your fund distributes capital gains often, your tax bill may suffer.”

Source: “How Often Do Mutual Funds Pay Capital Gains?”, by
Claire Boyte-White, Investopedia.

But, ETFs have a creation/redemption process that shields these gains from the ETF investor. While some would say it’s a tax dodge, this process has represented a significant ETF tax efficiency for over 20 years. Below is a chart that shows how often these events occurred in comparable index ETFs and index mutual funds.

Examples of ETF tax efficiency, by generating fewer taxable gains than mutual funds.
Source: Bloomberg.

Conclusions

Tax efficiency is an important aspect that individual investors should consider. ETFs generally offer better tax efficiency than comparable mutual funds. While this efficiency is important for all investors, higher wage earners can reap the greatest tax benefits of using ETFs versus mutual funds.

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Commission-free Municipal Bond ETFs and a diversified portfolio

Commission-free ETFs cover a number of important asset classes, including municipal bonds. “Muni” ETFs can add an important asset class to a diversified portfolio, as returns often differ from other bond ETFs. “Muni” bond ETFs also carry the important benefit of tax-exempt interest.

“…munis are well-known for delivering tax-exempt interest”

Cinthia Murphy, ETF.com, March 18, 2019

Not surprisingly, discount brokers like Fidelity don’t permit their use in tax-advantaged retirement accounts, like IRAs. Since there are currently 46 municipal bond ETFs, most retirement accounts really don’t have access to the full list of commission-free ETFs advertised by discount brokers. The chart below summarizes the number of commission-free ETFs available. It includes the five discount brokers analyzed regularly by ETFMathGuy to develop optimal portfolios.

This chart shows that no single broker offers all 46 “muni” ETFs commission-free. But, Schwab and Fidelity offer the most at 12, followed by ETrade (11), Ameritrade (10) and Vanguard (1).

So, what does this mean for a diversified portfolio with commission-free ETFs? ETFMathGuy will be expanding portfolio construction to include both IRA accounts (that don’t include municipal bond ETFs) and taxable accounts that do.

Please be sure to check back at the beginning of April to see how municipal bond ETFs affect the diversified portfolios created by ETFMathGuy.


ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.