Why taxes matter when generating retirement income: Yield versus total return
This past year we updated our After-Tax Wealth Advisor Handbook. With the Tax Cuts and Jobs Act (TCJA) in effect for over a year, we partnered with Deloitte for insights on developments to watch and steps to consider in 2019 and beyond. The handbook provides actionable tax-planning tactics for advisors as well as expert insight into tax-smart investing, leveraging our 30 years of experience.
I want to personally share one example from the handbook. I believe advisors who care about taxes and are working with clients in retirement should take a few minutes to understand the tax implications of yield versus total return income approaches.
Smarter asset management
Your client has made it! After years of saving for retirement, the day has come to turn your investor’s hard-earned life savings into income. At Russell Investments, we believe how investors generate income in retirement should be customized based off their circumstances and preferences, reflecting their unique situation.
Retirement portfolios are likely to consist of multiple accounts with different tax statuses
A retiree’s unique situation depends on how much income is needed, and how much has been accumulated in each of these three buckets:
- Tax-deferred accounts are traditional 401(k) or IRAs. Distributions from these accounts are fully taxable. If $10,000 is withdrawn, that amount will be taxed at an investor’s ordinary income tax rate the year the distribution is made.
- Tax-exempt accounts are typically Roth IRA or Roth 401(k) accounts where the contributions are made with after-tax earnings. Since these contributions were made with after-tax dollars, the distributions are tax-free.
- Taxable accounts outside of retirement savings vehicles. The income generated from these accounts is taxed at different rates depending on the investor’s individual marginal tax rates and the source of the income.
Social Security benefits, Medicare costs, pension and annuity benefits can also make this situation even more tricky. Here’s where a financial advisor can help clients navigate a complex situation in generating an income stream that reflects the investor’s unique circumstances.
Tax implications of yield vs. total return income approaches
Looking beyond yield for income
Yield isn’t the only way to generate income from a portfolio—and in many cases, it may not be the most efficient, especially when taxable accounts are involved.For example, investors who:
- Prefer greater control over cashflow patterns,
- Don’t mind spending portfolio principal, and
- Are attempting to generate a cashflow stream from a taxable account
may find a total return portfolio helps them reach their goals in a more tax-efficient manner while reflecting their circumstances and preferences.
Let’s look at an example
Let’s take a look at how not paying attention to taxes and building a yield-oriented portfolio can result in one investor, Alex, having a higher tax bill in retirement and, Charlie, a tax-smart investor having more after-tax retirement income.
Assume a $1 million nest egg from which each investor wants to withdraw $40,000 per year—a 4% withdrawal rate.
Portfolio option #1: Alex builds a yield-oriented portfolio targeting 4% pre-tax retirement income. This hypothetical portfolio would be allocated 50% to U.S. stocks and 50% to bonds. The portfolio would derive a 2% yield from dividends and 6% from bonds (mostly U.S. and global high yield bonds). Not wanting to invade principal and only wanting to spend yield is an example of mental accounting, a behavioral bias, investors like Alex face as they start to generate retirement income.
Portfolio option #2: Charlie builds a tax-smart portfolio which takes a total return approach where income is generated from systematic withdrawals. This provides greater control over the cashflow pattern with the tradeoff of spending portfolio principal. This portfolio is 60% stocks and 40% bonds. The stock portion would generate approximately 1.5% in dividend yield (assume a diversified portfolio of U.S. and non-U.S. stocks, large cap and small cap exposure); the bond portion approximately 2% (assume an aggregate bond-type portfolio). The total yield of the portfolio would be approximately 1.7%. The investor would make up the remainder of the desired income by systematically selling shares from the portfolio.
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What does the cashflow stream look like for these two portfolio options—especially once taxes are considered? In both approaches, the pre-tax cashflow is the desired $40,000. However, the after-tax cashflow looks very different for both portfolios:
- The yield portfolio hypothetically would leave Alex with $24,600 after taxes;
- The total return portfolio hypothetically would leave Charlie with $33,129 after taxes.
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Taxes matter even in retirement
This simplified, hypothetical example shows taxes matter even in retirement. Not paying attention to taxes results in Alex having $24,600 in after-tax retirement income while Charlie’s tax-smart portfolio has $33,129. That 35% difference in the amount of after-tax spending is due to the higher tax rate applied to interest and dividends—from which 100% of the yield portfolio’s cashflow is generated—than to capital gains—particularly long-term capital gains. Charlie’s total return portfolio hypothetically generated $17,000 of the desired $40,000 cashflow from dividends and interest and the remaining $23,000 through systematic selling of shares, thereby reducing the tax liability of the portfolio.
The bottom line
Of course, this doesn’t mean that a total return approach is best for all investors. In our view, a yield-oriented approach is typically a better fit for investors who have a preference to not invade principal, do not mind some variability in their cashflow and are drawing income only from non-taxable assets.
In contrast, we believe for clients who are considering drawing income from taxable assets, want to control their cashflow patterns and don’t mind spending principal, the potential tax advantages of a total return approach may be better suited.
Either way, we recommend investors work with a trusted financial advisor who understands their unique circumstances and develops an income strategy that works best based on their preferences. An advisor can help navigate these preferences while helping investors understand the trade-offs in decisions.
To learn more about the 2019 After-Tax Wealth Advisor Handbook, contact your dedicated Russell Investments regional team.