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Kahlilah Dowe: Thank you for having us.
Colleen Jaconetti: Thank you.
Amy Chain: We’ll spend most of tonight’s broadcast answering your questions. Before we jump in, though, there’s two items I’d like to point out. First, there’s a widget at the bottom of your screen for accessing technical help. That’s the blue widget on the left. And if you would like to read some of Vanguard’s thought leadership material that relates to tonight’s topic, click on the green resource list widget on the far right of the player. Now before we get into our discussion, we’d like to ask our audience a poll question, and this question relates to the level of spending flexibility that you may have in your portfolio. We want to know how much of your retirement portfolio can be used for things like travel and leisure, discretionary spending as we would call it, or how much must be used for nondiscretionary items like your mortgage or healthcare. That poll question should appear on your screen now, so go ahead and weigh in. And while our audience is weighing in, I will toss a question to you, Colleen, and you can kick us off here. This is a question that came in before tonight’s webcast from Caroline from St. John, Indiana. Caroline, thank you for your question. She says, “What are the key principles for extending the life of your retirement savings?”
Colleen Jaconetti: Great question. We actually have three principles for extending the life of the retirement savings. The first one is develop a prudent spending rule. So try to balance current spending with the need for future spending or requests. The second would be implement a tax-efficient withdrawal plan, so basically minimize the amount of taxes you pay each time you take money out of the portfolio, and that will actually help you extend the portfolio’s life or be able to spend more. And the third principle would be to actually have a broadly diversified portfolio that you can stick to in the best and worst of times.
Amy Chain: I think we’re going to have time to get into lots more about this tonight. But talk to me, of those three, where would somebody start?
Colleen Jaconetti: I guess start with what are your income and expenses, right? So really figure out how much income you’re going to have each month, what do you need to spend it on, and where is the gap? Right, because, that will help you inform what your spending strategy should be, how the rest of your asset allocation should be, and then finally what are the taxes you’re going to have to pay on the withdrawals you’re going to need to make.
Amy Chain: Kahlilah, do you get this question often from clients?
Kahlilah Dowe: Yes. So that’s one of the things, that’s the main thing, I would say, that clients look at coming into retirement. So how do I decide what I need to spend? Or, I should say, how do I decide how much I can spend from the portfolio, and how do I turn this portfolio into a paycheck? So that’s really where we start, and like Colleen said, it’s, okay, tell me how much do you think you need to spend? And oftentimes it’s kind of a trial. So they don’t always know what they need to spend. The first thing that I look at is what does this portfolio need to do for you? So what is the goal? And, of course, it’s that most of the time it’s that they need to make sure that the portfolio can provide them with the source of income. But oftentimes it’s a step further. It’s “I want to make sure that I can pass on as much as I can to my children” or “I need to make sure that I can cover long-term care expenses.” Those are some of the things that impact how much you can spend from the portfolio up front. So I would say for an investor who is looking to pass on as much as they can to heirs or who may be self-insuring for long-term care, that may be an argument for spending less up front so that they can cover some of those expenses or pass on more toward the end. The other thing that I look at is the time horizon. So for the clients that I work with who are retiring let’s say early on, then they may need to spend less up front so that the portfolio can last them for, let’s say, more than 30 years. Maybe it’s 35 or 40 years. And then the other thing that I look at is their risk tolerance, so how comfortable they are with the ups and downs in the market. And some of my clients will say, you know, “I’m going into retirement. I want to focus more on preserving what I already have” as opposed to, let’s say, growing the portfolio significantly beyond where it is, and, of course, you still have to get some growth, even going into retirement. But for those investors, they may have to spend a little less if they want to be more conservative on the onset.
Amy Chain: What I am hearing both of you say is that the considerations about how to spend your retirement portfolio start with the same thing that, figuring out how to save for your retirement portfolio. What are your needs? When are your needs going to come, and for how long will you have those needs? Is that—?
Kahlilah Dowe: Exactly.
Amy Chain: Is that right. Great. Well, we’re still waiting for some of the responses from our audience on the first poll question. Kahlilah, I’m going to come back to you with another question that we got ahead of time. This question came from Seth in Colorado. Seth asks, “Do you support the trend of allocating one’s assets more towards cash and bonds as one ages?”
Kahlilah Dowe: So I would say yes. So if it’s a portfolio that is designed to support retirement spending, you generally want to shift more toward an income and preservation strategy, still getting growth, but perhaps growth becomes more of a secondary objective with preservation and income being the primary. And so to support that sort of strategy, I would agree with that, that you’d have to start to allocate a little bit more toward bonds and also cash perhaps if you’re at a point where you’re spending from the portfolio. I think the rate at which you start to move the portfolio in that direction depends on how much you need to spend, so to what degree you’re relying on the portfolio, let’s say, as your primary source of income. And also your risk tolerance; where some clients are still comfortable still targeting a growth strategy, even though they’re in retirement.
Amy Chain: Let’s get in there and talk about that for a second. So there’s really two reasons one might be drawing down from their retirement investment portfolio. It could be the nondiscretionary or the discretionary items that we talked about. Maybe we could talk about some of the differences between the two and how that might affect how an investor chooses to spend down.
Colleen Jaconetti: Sure. I mean the more nondiscretionary expenses someone has, so the higher amount of nondiscretionary expenses of total expenses, so that means they have less flexibility, the more conservative at times they need to be in the portfolio because they have to make sure they have that base level of expenses met.
Amy Chain: It looks like of our audience viewing here this evening, about 57% say they have a moderate amount of flexibility. Their nondiscretionary spending comprises or will comprise a significant amount of the spending. Kahlilah, is that in line with what you hear from your clients?
Kahlilah Dowe: I would say more so nondiscretionary. Most of the clients that I work with, fortunately, go into retirement with little to no debt. And, of course, that’s what I recommend, the thought being that you just have far more flexibility, and we’ll talk a little bit more about how spending from the portfolio during different market conditions impacts the portfolio. But I think an ideal situation is when you go into retirement with as little nondiscretionary expenses as possible.
Amy Chain: That’s great. Let’s toss another poll question out to our audience, and we’ll keep the conversation going while we wait for them to weigh in. But, audience, you’re up. Your question is “How concerned are you about spending from the principal portion of your retirement savings?” Your answer choices are that you’re very concerned, somewhat concerned, or not concerned at all. So go ahead and weigh in. We’ll wait to hear from you, and in the meantime, let’s take another question that came from our audience ahead of time. Colleen, I’m going to toss this question to you. This one’s a little timely. Given the historic low interest rates, what are the downsides of creating an income stream from a portfolio of dividend-producing stocks?
Colleen Jaconetti: So I guess to answer this question, I think we really have to start with the premise that you have a broadly diversified portfolio and that you selected your asset allocation based on your time horizon, risk tolerance, and goals. So you’re in the right allocation, and you’re diversified. So from there, if you’re going to overweight dividend-paying stocks, the real question is where are you going to take it from? So you really have two choices, right? If you take it from the bond portion of the portfolio, many retirees have bonds in their portfolio to dampen the volatility of stocks. So if you shift some of your broadly diversified bond portfolio to overweight dividend-paying stocks, you’re really changing your asset allocation, right, and taking on more risk. So that’s just one thing to consider there. And then if you actually shift some of your broadly diversified stock portfolio to overweight the dividend-paying stocks, you’re, again, going to take on more risk, but it’s more because you’ll be overweighting value stocks. So value stocks typically are the ones that pay dividends. So what will happen is you’re going to end up having a more highly concentrated portfolio. So I think many retirees don’t realize, including my own mother, that if you shift away from a broadly diversified portfolio, for the sole purpose of increasing the cash flow from the portfolio, your principal value could actually be at higher risk than if you just took the money that you needed from the portfolio.
Amy Chain: That’s great. Kahlilah, anything to add?
Kahlilah Dowe: Yes, and I think the interesting thing is many of the clients who I work with, who are considering this strategy or have adopted this strategy, you know, when we think of stocks, we think of mainly growth, right? We look to stocks to provide the growth in the portfolio. Many of the investors who are pursuing that sort of strategy really aren’t at that stage where they’re looking for growth. And when I ask, that’s the response. It’s, “No, I’m looking for more income and more preservation, not so much growth.” And so, to your point, Colleen, I try and steer them away from that approach because you could end up with a portfolio that looks like an accumulator or someone who is still trying to accumulate assets for retirement, as opposed to someone who’s already in retirement. So I try to steer investors away from that approach because most of the times they’re taking on risk that they don’t realize is there. And the example that I draw on is, you know, if you think about dividend-paying stocks, 2008 when the market was down significantly, they were down with the overall stock market. And I think that’s important to consider because they sometimes get tagged as income-producing investments. So I just want to be clear that truly it’s a stock, and we expect that stocks will be volatile.
Amy Chain: So it could affect the principal portion of a portfolio, even if there’s income being generated.
Kahlilah Dowe: Exactly, exactly.
Amy Chain: That’s good. We have our results from our second poll question. About half of our audience tonight says they’re somewhat concerned, that they want to use their portfolio’s earnings to fund the majority of their retirement. I don’t think that sounds like a surprise to us, especially given what we heard in the first poll question.
Kahlilah Dowe: Yes, it’s not. And many investors are concerned that because the portfolio isn’t generating the income that they need, that they are at risk of running out of money. And so one of the things I point out is that, you know, you saved this money to be able to spend from it. And so, you know, the first question that I ask is are you okay with spending down this portfolio during your lifetime? And what I find oftentimes is that when they’re not getting the income that they need in the form of dividends and let’s say interest only, the thought becomes, “Does this mean that I’m at risk of depleting the portfolio?” And that’s really the underlying concern. And so one of the things that I try and call out is that it’s okay to tap the principal sometimes to get the income that you need. And we expect that you’ll have to tap the principal in some years. And, of course, there’ll be some years where the dividends and the interest cover all of the expenses, and you won’t need to do that. But I think, you know, it doesn’t have to be one or the other. I think it’s okay to do both.
Amy Chain: That’s great. Going to take another question from our audience. Timothy from Virginia asks, “While an income-generation approach is easy to understand, this is what you’re taking about, can you discuss how a total return approach is constructed and how withdrawals are made? Colleen, can you kick us off on this question? Define both for us.
Colleen Jaconetti: Sure. I guess an income approach is really people just want to spend the income generated from the portfolio. The total return approach is people are willing to spend the income and also the capital appreciation on the portfolio. So what I think many retirees don’t realize is they’re actually identical up to a point. So under both methods, you would spend your nonportfolio cash flows—Social Security, pension, trust income, part-time income first. After that you would spend from your required minimum distributions. So those are anyone who’s over 70-1/2 years old, who has a tax-deferred account, has to take distributions out. So those would be the next monies under both methods that people would be looking to spend. And then after that it would be the cash flows on their taxable portfolios, so these interest, dividends, and capital gains that they get.
Amy Chain: I think we have a chart to show this topic or not. We’ll save that chart for later, keep everybody on the edge of their seats.
Colleen Jaconetti: Exactly. So, basically, what happens is all of the cash flows that come into people are identical up to that point. That’s what should be spent first. And then what happens is if there’s still a gap, so many retirees could actually just live off of those monies. With interest rates at low levels, like so the interest dividend and the gap gains on the portfolio are falling a little bit short, then they have a choice. The choice is spend from the capital appreciation or the other choice that they have is to overweight dividend-paying stocks or higher-yielding bonds. And as we just talked about, what could happen is they could end up having a higher-risk portfolio, and their principal value could actually be at higher risk and become lower as a result of taking those nondiversified strategies as opposed to just spending the money that they needed from the portfolio.
Amy Chain: How should somebody approach thinking about what their income needs are going to be? Where do you start with that decision? How do you get your clients thinking that way?
Kahlilah Dowe: Right. So from our clients who are coming up on retirement, I look at what they’re spending right now. And that’s usually a good starting point because most investors don’t change their lifestyles significantly from let’s say three years outside of retirement into retirement. So I start out with what they’re currently spending, minus savings, and add on anything that they may have, travel, or something like that, or hobbies that they expect to take up. And we use that as a starting point. And I like to try and look at that before they’re at a point where they need to retire. I think in ten years, if you look at it ten years outside of retirement, I don’t think that’s too far in advance because it gives you some time to make adjustments if you need to, adjustments to, let’s say, your nondiscretionary expenses, paying down the mortgage maybe if you need to do that before you retire. So I would say ten years or so outside of retirement is a good time to look at what you may need to spend. And then kind of test the portfolio to see if it could sustain that rate of spending. And then if it can’t, then that’s really where I work with my clients to say, okay, what adjustments do we need to make before you get to the point where you’re making this portfolio a source of income.
Amy Chain: And I think what you’re getting at here is that there could be other ways to fund your income needs than drawing down from your retirement portfolio. Is that right? We have a lot of questions coming in from the audience asking about annuities. How would an annuity fit into this overall income-need decision-making process?
Colleen Jaconetti: Yes, so I guess when I look at an annuity, I think of them as purchasing guaranteed income stream, right, and that is for like a longevity insurance. So insurance costs money. So just like someone would purchase homeowner’s insurance or medical insurance in case of a large medical expense or their house should burn down or something, you buy an annuity to ensure that you don’t outlive your assets. So it’s certainly a viable option for someone whose Social Security, pension, or other guaranteed forms of income are not as high as they’d like them to be to maybe meet their nondiscretionary expenses.
Amy Chain: But that’s a great point, though. One should sit and take an accounting of all of their guaranteed income sources as they start making decisions about how much and from where to draw for the rest of their income needs.
Colleen Jaconetti: Definitely.
Amy Chain: Good, great. Let’s talk about RMDs. What’s the best place to put assets from RMDs that aren’t currently needed to minimize tax consequences of what amounts to unnecessary income. So this question’s coming in from Chris. Kahlilah, let’s talk about RMDs.
Kahlilah Dowe: Sure, sure. So clients who are 70-1/2 or older generally have to take required minimum distributions from their IRA accounts or their tax-deferred accounts. But some clients, obviously, don’t need the income to cover expenses. And so for those clients who don’t need the income to cover expenses, but expect to leave the money invested for quite some time, then they’re looking for tax-efficient ways to invest it, so ways to invest the money, ways that won’t give off significant income. And so my thought is if you have quite a bit of time to leave the money invested, you can take a long-term outlook. You could invest it, let’s say, in tax-efficient funds, stock index funds. That’s one thing. If you’re in a high tax bracket, you could invest in municipal bond funds. Those are tax-efficient. The one thing I would stress though is that before you go in that direction, you want to make sure that you don’t have a need for that income, not just this year, but let’s say next year. It’s something that you should really have a longer-term horizon for if you’re looking to reinvest it.
Amy Chain: Now a required minimum distribution could have a tax implication for an investor, but so could simply rebalancing one’s account. In fact, we have a question from Harold who’s asking about rebalancing and the considerations there. Any words of wisdom about how to minimize tax burdens when thinking about rebalancing a portfolio?
Colleen Jaconetti: Sure.
Kahlilah Dowe: Well, so I’ll tell you what I do for the clients that I work with. I use the distributions as an opportunity to rebalance the portfolio. So for my clients who are taking required distributions or even for clients where we’re selling some shares in their taxable account, I try to do it in a way that if there’s some losses that could be realized, we’ll try to offset it there. But the first thing I would say is to try and execute these changes in the IRA accounts, and I think if you can do that, then that accomplishes the rebalancing in the portfolio, and then also it’s better from a tax perspective.
Amy Chain: That’s a great point, looking at your portfolio allocation as a whole, considering what’s in your taxable accounts, what’s in your tax-deferred accounts, and so on and so forth.
Kahlilah Dowe: That’s right.
Amy Chain: Colleen, I’d love to hear from you. This is a question we get all the time, and I’m going to ask you to tackle it for us here tonight. What’s Vanguard’s take on the 4% rule?
Colleen Jaconetti: So the 4% rule is based on very specific assumptions. So it’s definitely a very reasonable starting point.
Amy Chain: And let’s define what the 4% rule is.
Colleen Jaconetti: Yes. So the 4% rule states that an investor, upon retirement, can expect to take out 4% of their portfolio grown by inflation of a balanced portfolio between stocks and bonds for about 30 years and not have a significant chance of running out of money. So the 4% rule is certainly a good starting point for someone with those specific assumptions, right. But some people have longer or shorter time horizons, so it doesn’t always apply to all investors. And the biggest shortfall really with the 4% spending rule is that it’s indifferent to the performance of the markets. So what could end up happening is if you have poor performance, and I guess we should start with if you have a million dollar portfolio, you’re going to take out $40,000 per year every year, grown by inflation, regardless of whether the market goes up or down. So say you have four or five years in the beginning of retirement where the portfolio, the market went down. The spending will still continue at the $40,000 plus inflation. So you could be taking out a lot more of your portfolio. And what ends up happening is you just run the risk of either running out of money or having significantly reduced spending in the future. Whereas you also could have, the, sorry, I lost my train of thought. I see that you pulled up the chart for the audience.
Kahlilah Dowe: Plus inflation, is that what you’re thinking?
Colleen Jaconetti: Ah, yes. So if you have years where the markets do well, so the opposite of if the markets do poorly. So if the markets do very well, and this is where the bottom of the portfolio viability, the markets could be doing very well. And if you don’t, you could increase your spending. But if you’re only doing the 4% plus inflation after you had five or six years of very good returns, you could actually increase your spending ahead of greater standard of living.
Amy Chain: That’s great. Let’s talk drawdown for a moment here. We have lots of questions that are asking about approaches to drawdown, which I know is a very important component of this three-pronged approach to making your retirement savings last. Can you give some examples of what a retirement drawdown, a flexible retirement drawdown strategy might be? Let’s start there, and I might probe you for some questions along the way.
Colleen Jaconetti: Okay, so as you can see really on the chart, the 4% spending rule that we just talked about is the far left column, so it’s dollar plus inflation. So as you can see, that really ignores market performance, it provides stable inflation-adjusted spending every year, but it could be either large surpluses or shortfalls, right? The other end of the spectrum, so when we talk about these, we usually kind of look at it as a spectrum, is the percent of portfolio. So what happens with the percent of portfolio is you actually spend a percentage every year of whatever the portfolio balance was. If the markets were up, you get to spend more. But if the markets go down, you get to spend less. This kind of ties back to the discretionary versus nondiscretionary expenses. Some retirees maybe can’t handle the volatility of this method.
Amy Chain: So one puts an investor in a situation where I’m spending it. Come you know what or high water, this is what I’m spending.
Colleen Jaconetti: Right.
Amy Chain: On the other side of the spectrum, there’s an investor who their income might vary greatly, depending on what their portfolio principal looks like if they’re taking an absolute percentage.
Colleen Jaconetti: Exactly. So while that person may never run out of money, the percent could go down through time. So we kind of advocate more of a dynamic approach, which is really what is in the center of the chart. So what this does is, it says each year you take out a percent of the portfolio, and this is really a hybrid of the other two methods. You take a percent out, but then you actually limit it to a ceiling and floor. So if the market went up say 10% and you are limiting your increases to 5%, you would only take a 5% increase in your withdrawal. Then you’d reinvest the remainder back into the portfolio so that if there’s a point in time where that percentage falls below the floor amount that you’re looking to receive, you actually don’t have to drop your spending as far. You can actually limit it to the floor.
Amy Chain: It’s almost like a built-in rainy day fund for your portfolio.
Colleen Jaconetti: Exactly. So it kind of is more intuitive even to how people spend. So people usually feel more comfortable spending when the markets are up and maybe a little more comfortable cutting back when the markets are down. So this kind of helps with stability of spending through time.
Amy Chain: Another component of this would be the withdrawal strategies. So you touched on it early in the webcast when I asked you the first question. Let’s discuss withdrawal strategies and their tax efficiency.
Colleen Jaconetti: Right, so I guess once you figure out how much you’re going to spend, right, so that was kind of a conversation of how much should we spend based on the strategy that you pick. Then you have an order of which you spend, which will actually help you to extend the longevity due to minimizing taxes. So when it comes to portfolio withdrawals, the first place you really go to is required minimum distributions, if applicable. So if you’re not, if you’re under 70-1/2, that might not apply to you. After that, you would go to look to spend from the taxable flows on the assets in taxable accounts, so any interest, dividends, or capital gains distributions. And the reason why they’re next is you’re going to get taxed on them either way. So regardless of whether you spend them or reinvest them, you’re going to be taxed. So it’s better to spend those monies, rather than reinvest them and have to sell them in six months and pay short-term capital gains on them. If you need additional monies after that, the next place would be to sell your taxable assets in a way that minimizes gains. So maybe try to go for assets at a loss, maybe no gain or loss, and then, finally, assets at a gain. And then once your taxable portfolio is exhausted, then you would go to your tax-advantaged accounts. And the whole goal, so tax-advantaged accounts, I guess I should say, is tax-deferred accounts, so 401(k) or IRA, traditional IRAs, or Roth and tax-free accounts.
Amy Chain: Let’s summarize this and go back again, take us through the first choice, second choice, and then third choice.
Colleen Jaconetti: So first it would be RMDs, if applicable. Second would be taxable flows, so any interest, dividends, or cap gains on assets you hold in taxable accounts, followed by taxable assets.
Amy Chain: Taxable meaning not an IRA, not a 401(k), an account that you’re getting a 1099 and paying taxes on every year.
Colleen Jaconetti: Exactly, yes. And then after you spend those flows, you would start spending from your taxable account in a way to try to minimize taxes. So try to sell those assets with no gain or loss, with a loss actually, then no gain or loss, and then, as I said, a gain. After all the taxable portfolio’s exhausted, then I would say look for your tax-advantaged accounts. And the goal here is to spend from your tax-deferred accounts, the ones you actually pay income taxes on when you spend from them, when your tax rate will be the lowest. So in the chart, column A, is if you expect you’re in a higher tax bracket in the future, right, then you would spend from your tax-deferred account today, because you’d be locking in lower taxes today. On the other side it says if you expect to be in a lower tax bracket in the future, you’d rather spend from your tax-free accounts today and then spend from your tax-deferred accounts later, and the whole goal here, what the whole plan here is minimizing taxes means you can either spend more or your portfolio will last longer.
Amy Chain: What considerations should one be thinking about when trying to decide if they’re going to be in a higher or lower tax bracket in the future?
Colleen Jaconetti: So you really have to think about what income do you have. So if you currently have part-time income that might be going away, if you have some sort of trust income, rental income, so kind of think through what are your current income sources and what are your future income sources, and that will kind of give you a good idea of whether you would be in a higher or lower tax bracket.
Amy Chain: Kahlilah, I imagine you and your team in Personal Advisor Services, this is a point in time that clients call and say, “Help. I’m withdrawing. I need to start drawing down. I don’t know what to do.”
Kahlilah Dowe: That’s right.
Amy Chain: Talk to us about it.
Kahlilah Dowe: Well, it’s exactly as Colleen described. So I typically implement a withdrawal strategy for my clients. So looking at their RMDs first, the cash flows, taxable account, sometimes it can get a little tricky with the tax-deferred accounts in the Roth because with the Roth account, the money in the account grows tax free. And so sometimes there can be opportunities, and typically we recommend letting that grow for as long as possible. But sometimes there can be opportunities to take money from the Roth IRA account before you take from the traditional IRA account, let’s say you have significant income. Like, what’s the word that I’m looking for? Deferred income. So many clients that I work with have deferred income that they’ll get, and so they don’t want to take money from the IRA account because that would really increase their taxes. So they may go to the Roth account for that reason, and so that’s one of the things that I work with my clients on, kind of just staying abreast of how their situation may change each year and how we may need to adjust the cash flows based on that. But generally speaking, Colleen, it’s just as you’ve outlined.
Amy Chain: Now when it comes to distributions from IRAs, how do charitable contributions come into play? What considerations should one be making when deciding whether or not to be making charitable contributions from their IRA accounts?
Kahlilah Dowe: Yes, so that is a hot topic because the IRS basically extended that provision in that clients can donate, I think it’s $100,000. That’s the max, $100,000 of their required minimum distributions to charities. And so many clients who do not have the need for the money and are charitably inclined anyway, in other words, they were going to gift the money at some point anyway, it’s a great opportunity to gift and then also to get the tax deduction. So anything that you actually gift from the IRA, so it has to be the required minimum distribution, and you have to be 70-1/2, that money isn’t counted against the AGI, the adjusted gross income. And, oftentimes, that really makes a big difference in terms of the amount of taxes that clients are paying. Sometimes it makes a difference in terms of the Medicare tax that they may have to pay, so it’s something that many clients are starting to utilize as a way to manage taxes and also to accomplish their charitable goals.
Amy Chain: And I’ll pause for a second and ask if you could talk a little bit about Vanguard Charitable Endowment, which offers an opportunity for clients to take advantage of some of these tax-deductible contributions, even if they’re not quite sure where to contribute. Is that—?
Kahlilah Dowe: Yes, that’s right. So some of our clients will utilize Vanguard’s Charitable Endowment program where they can give to a charity. They may not know exactly the charity that they want to give to, but they know that they have a set amount. It could be an appreciated stock that they want to gift to a charity, and so they’ll use Vanguard Charitable Endowment program to transfer the money, take the deduction up front, and then distribute the money to the charity at a later time. Unfortunately, the required minimum distributions can’t be used for that purpose, so it can’t go into that type of fund. It actually has to go directly to a charity, but it’s still something that can be utilized if you want to gift appreciated shares.
Amy Chain: Kahlilah, you mentioned Roth IRAs, and Susan from California is asking about whether or not she should be invested in a Roth IRA. Susan, we can’t answer your question specifically, but we could suggest maybe what an investor should consider when deciding to Roth IRA or not to Roth IRA.
Kahlilah Dowe: Yes, you have the Roth—and I get this question a lot. You have the Roth IRA, the traditional IRA, some investors have the Roth 401(k) or the traditional 401(k), and the question is which one should I contribute to? And I think it comes down to taxes because the tradeoff is that anything that you put into a Roth IRA or a 401(k) is after-tax money. So you’re going to pay the taxes up front. The great thing about the Roths is that you get to grow, hopefully, the portfolio over time and withdraw all of that money tax-free. I think it works best for investors who are in a lower tax bracket up front when they make the contribution but may be in a higher tax bracket at a later time when they withdraw the contribution. But on the other side of that, you know, many of my clients are in very high tax brackets right now, and they can really benefit from the deduction that they would get from contributing to, let’s say, a traditional IRA or a traditional 401(k). I like the idea of doing both if you can, so her question was should she contribute to a traditional IRA? I would say definitely consider the tax implications, right. But then also if you can get some money in a traditional as well as a Roth IRA, I think that’s the best-case scenario. Many of the clients that I work with are retired and in a position where they have so much invested in traditional IRAs, just from adding to company plans, which is great. You know, you’re saving. But the tradeoff is that when you get to the point where you have to take the required minimum distributions, you may find that you’re in a higher tax bracket than you were before you retired. And so you have to try and manage that income. A Roth, I think, is a great way to do that.
Amy Chain: Now, another question that came in from Cliff in the same arena of questioning is talking about the MAGI, the modified adjusted gross income, for a Roth IRA contribution. Can you still contribute to a nondeductible IRA and then almost immediately convert back? I think Cliff is alluding to something we call the backdoor Roth.
Kahlilah Dowe: The backdoor, right. Very popular, the backdoor Roth contribution. And many of my clients do it yearly. It’s a part of their investment planning. I’ll tell you.
Amy Chain: Let’s pause and redefine what it is and how it could be used.
Kahlilah Dowe: Yes. So there are income limitations in terms of who can contribute to a Roth IRA. But there are no income limitations in terms of who can convert money from a traditional IRA to a Roth IRA. There’s also income limitations on who can make tax-deductible contributions to a traditional IRA. And so what many high-income, what many high earners are doing is putting money, nondeductible contributions into a traditional IRA. So they’re putting the money in. They’re not taking a deduction, and anyone could do that regardless of their income. And then, they’re immediately moving that money into a Roth IRA. And that is considered a backdoor Roth conversion because you’re not doing the Roth conversion using tax-deferred money. So it’s a very popular strategy, and the only thing I would say to consider is that, if you already have money in a traditional IRA and then you put new money in and you attempt to convert just those dollars, it’s not that clean. So, in other words, you can’t cherry pick the dollars that you did nondeductible contributions on and move just that portion into the Roth IRA. And I think that’s important because what you’re trying to do is avoid paying— You’re trying to do it without a tax liability. And so, I would say, just be careful of that. If you already have IRA assets, traditional IRA assets, and you want to do a nondeductible contribution, you may have to consult a tax advisor before you go ahead with that strategy.
Amy Chain: I’m seeing lots of our audience calling in, writing in, and asking us to please go through the order withdrawal chart again. So let’s bring that chart back up, and then let’s walk slowly through this so that our clients can follow us as we go step by step in terms of what considerations they should be thinking about with order of withdrawal.
Colleen Jaconetti: And I guess I will throw out a shameless plug. There was a “Do sweat the small stuff” blog that has this chart with the exact narrative of how this should work, and it will be on vanguard.com.
Amy Chain: So, if you go to vanguard.com and search “Do sweat the small stuff,” it will take you to a blog that will write out for you all the things that Colleen is going to take us through very slowly right here tonight.
Colleen Jaconetti: Yes. So I will go slowly, yes. So the first thing that people should think about taking out is required minimum distributions. So that would be— And that’s really because they’re required by law. Anyone over 70-1/2 needs to take to take those monies out. They would go towards a spending account first. That would be followed by taxable cash flows. So interest, dividends, or capital gains distributions that anyone receives on monies held in taxable accounts should flow to their money market or checking account next to be used for spending. And the reason is that these monies are taxed to them regardless of whether they spend or reinvest them. So it’s better to put those towards spending than reinvesting them and then, say, three or six months from now, having to sell those same assets to meet spending needs. And the reason why is they could end up paying short-term capital gains taxes, which is the same as ordinary income taxes on those gains if they had any. After that, we would say spend from your taxable portfolio. So, as you had mentioned before, it’s those assets that are held outside of 401(k), traditional IRA, Roth IRA accounts. So any assets you hold there, trying to sell in a manner that minimizes taxes. So start with the assets that would be at a loss followed by assets at no gain or loss and assets at a gain. And, as we alluded to before, maybe even consider doing it as part of a rebalancing event. Then, after all of your taxable portfolio is exhausted, you have to go to your tax-advantaged accounts. And the decision here is, so tax advantages 401(k) or traditional IRA or Roth IRA and tax-free accounts. So the whole goal here is to minimize taxes on withdrawal. So spend from your tax-deferred account, so IRA or 401(k), when your tax rate, you believe, will be the lowest. So if, right now, you have a lot of part-time income and things like that, your tax rate may be higher. So that’s when you would want to spend from your tax-free account today and then wait, when your tax rate is lower, to spend from your tax-deferred accounts. And then, if you believe your tax rate today is high—I just went through lower—is higher, then you, or lower, I’m sorry, then you would spend from your tax-free accounts and then spend from your tax-deferred accounts later.
Amy Chain: Now, Andrew has written in and asked, “What about if you expect your tax bracket to be the same?”
Colleen Jaconetti: So if you expect your tax the same, it’s actually no difference whether you spend from your taxable or tax-advantaged accounts. So then, it would kind of follow— The secondary decision would be, because this is for investors who want to maximize spending during their lifetime, would be, if you have heirs that you’re trying to pass these monies onto. So then, you would kind of look through to what is your heir’s tax rate. And if you believe that your heir’s tax rate will be lower than yours— Or I guess, if you think you’re in a lower tax rate than your heirs will be when they take the money out—
Amy Chain: Say that again. If you think you—
Colleen Jaconetti: So if you’re currently in a lower tax bracket than your heirs will be when they take the money out— Right, so we’re trying— This whole goal, again, is minimizing taxes. Spend from your IRA and maybe leave your traditional IRA to go to them because they will have tax-free withdrawals, right? So not only are you paying the current income taxes today— So you’re moving the money on the taxes out of the estate and the money from the traditional IRA out of the estate.
Amy Chain: I think this is getting into a question that Suzanne, from Pennsylvania, has written into us, which is, “If you’re comfortable with your standard of living,” so if you don’t necessarily need your investment portfolio income to sustain you in retirement, “is there any downside to just letting the money ride, so to speak, in the IRA, and just continue to grow indefinitely.”
Colleen Jaconetti: No, that’s actually a great strategy. The most important thing— So, you know, and if you wanted to mix that more aggressively because you were comfortable taking more risk doing that, certainly, that would be an option. The biggest consideration kind of goes back to what kind of IRA do you have it in, if it’s a traditional IRA or Roth IRA? So the Roth IRA, obviously, higher-growth assets that would pass to your heirs would be ideal. If a traditional IRA, then it goes back to whose tax rate would be the lowest. So you may want to spend from your tax-deferred, so your IRA, traditional IRA, now because your taxable account will actually get a step-up in basis as well.
Amy Chain: Tell us what that means.
Colleen Jaconetti: So a step-up in basis is, assets held in a taxable account, upon death, any gain that you have in there, becomes zero. So the basis gets reset and is the current market value as of your date of death.
Amy Chain: Great, thank you. Speaking of longevity and the increased longevity of all of us, hopefully, today, right, Curt wrote in for a question, Curt, from Bowie, Maryland. Curt, thanks for the question. Kahlilah, I’d love for you to answer this one. Curt says, “With an emphasis on increased longevity, do you see investment models shifting more toward growth and away from a sort of preservation of capital focus?”
Kahlilah Dowe: That’s a good question. I would say— So I definitely agree with what he said in that we’re seeing more longevity now, which means that the portfolio needs to do more for you during your lifetime. I would agree with that. I think— I mean, even here, at Vanguard, in the models that we use, I would say about five years ago or maybe three years ago, we used 95 on the models that we ran, assuming that investors needed to have the portfolio last that long.
Amy Chain: 95 meaning 95 years of life?
Kahlilah Dowe: That’s right, 95 years old, and we’ve since changed that to age 100. And so, I think that does support either being more aggressive up front in terms of the mix of stocks and bonds or getting more conservative at a slower pace. And I would say, yes, we are seeing more of that. But I also say that the investor’s risk tolerance has to support that because some investors that I work with have longevity in their family, but they struggle with market risk. And so those clients are comfortable with spending less up front. So I know I may live until age 100. I’d rather spend less than what I know I can spend as opposed to being more aggressive, and that’s an option as well.
Amy Chain: We’ve got lots of folks writing back in, Irene included. Irene says, “I did not follow how you avoid taxes by contributing to a traditional IRA and immediately converting to a Roth.” Irene, you’re not alone. Let’s talk, again, about the backdoor Roth, what it means, how clients should be thinking about it. Start from square one.
Kahlilah Dowe: Sure. And I think I may have thrown her off a little when I said avoid taxes. So when you do a backdoor Roth conversion, you’re putting money into the traditional IRA first. That’s the first step, but you’re not taking the tax deduction. So, generally, when you put money into a traditional IRA, you can deduct that from your income, but you’re not doing that. And so, by not doing that, when you move the money from a traditional IRA into the Roth IRA, it’s not a taxable event. Otherwise, it would be. So let’s say I put $6,500 into a traditional IRA today, and I take the tax deduction. And then, next year, I decide that I want to move that into a Roth IRA, well, I’m going to have to take that money out, and I’m going to have to pay ordinary income taxes on that money before I move it into a Roth IRA. With the backdoor Roth conversion, you don’t have to pay the taxes on the money that you take out of the IRA because you never took the tax deduction. So that’s the key of the nondeductible contribution, and that’s really the only reason why you don’t have to pay taxes when you move into the Roth IRA.
Amy Chain: Good, great. Lots of folks asking questions about other guaranteed income sources. Colleen, let’s take one from William in Illinois who’s asking us about pension income. How should one be thinking about pension income?
Colleen Jaconetti: So, generally, when we think about pension income, we don’t really think of it as part of the portfolio. I know some people have a lot of questions come into us around that, “Should a pension be included as part of my asset allocation?” So, generally, we don’t include it as part of the portfolio, but it’s really an important consideration in figuring out what your asset allocation will be. So some people that have a pension—so, after Social Security, they lay the pension on top—they may not need anything more than that. So they could go one of two ways. They could either decide to be more aggressive in their asset allocation if they want to give money to their heirs or things like that. Or they may actually be more conservative and say, “Since I don’t need to take on the risk, I’m not going to.” So we don’t really treat pension income the same for everybody. It really depends on each person’s circumstances and risk tolerance.
Amy Chain: Is that the same or different as one should be considering taking Social Security?
Colleen Jaconetti: So taking Social Security, when to begin Social Security is a little bit different. And the reason why is when to take Social Security really depends on when do you stop working? Can you support yourself without substantially depleting your portfolio prior to 70-1/2?
Amy Chain: It gets back to this, what are your income needs, and what sources of funding do you have for those needs? Colleen Jaconetti: Right.
Amy Chain: Good, thank you. Kahlilah, I’m going to send one your way that I would imagine you answer more frequently in a day than we could imagine, and the question is, how do you know if you’re going to have enough? How do you know if you’re on track? How do you know if it looks like you’re going to outlive your assets, and how can we help?
Kahlilah Dowe: That’s the million-dollar question, right? How do you know that you have enough? You know, there’s no— There’s no science to it where you can say, like, “I hit this amount.” Like, I remember, at one point, the school of thought was you had to have a million dollars, right? And if you hit that $1 million mark, that meant that you weren’t going to run out of money. I see clients every day who have let’s say, half of that, and they’re probably going to end with half of that because they don’t spend very much. So I don’t think there’s a clear way to know when you’re 100% certain that you have enough money. I am an advocate for stress testing the portfolio to see how the portfolio could respond given the level of spending that you may have and given potential market conditions.
Amy Chain: How can someone do that? How can an investor stress test their portfolio?
Kahlilah Dowe: Yes. So there are different calculators that you could use online. Here, in Personal Advisor Services, that’s one of the main things that we do for all of our clients. We want to make sure that, regardless of what the market is doing, that they can spend what they need to spend to cover their lifestyle and that they’re not in significant risk of running out of money. And that generally means just, kind of assuming that your spending stays the same but the portfolio value fluctuates over as the market does and then seeing, you know, in the end, and just running different scenarios to see, in the end, or make sure that, in the end, you have money left over. So that’s one of the things, but I would say the main thing that I look at, for my clients who are going into retirement, is making sure that they’re not going into retirement with a lot of debt. I think that’s the biggest thing that clients can do. If you have a mortgage— And, again, and that’s one of the reasons why I said you want to try and look at this before you get to the point where you’re retiring or five years outside of retirement. If you have a mortgage, that should be paid off. Any other fixed debt that you have, if you can get that squared away before you retire, I think that’s going to go very far as far as setting you up for success and making sure that you have enough. I feel like I would be remiss if I didn’t add having a disciplined investment strategy because I think even clients who are on track with their spending, they don’t have a lot of debt, they can get derailed if they don’t have an investment strategy that they’re sticking to and they find themselves abandoning the strategy to go with dividend-paying stocks when they really should be a lot more conservative or selling investments that have declined and purchasing investments that have performed very well, kind of that cycle. So between the debt and making sure that you stick with a disciplined investment strategy, I think those are the two things that you do to ensure that you have enough.
Amy Chain: I’m glad you’re mentioning that. We have clients asking us about volatility, which you mentioned. And, if clients are finding themselves uncomfortable with volatility, should they be considering selling stocks, moving to bonds? How do you advise clients who are made jittery by the market fluctuations?
Kahlilah Dowe: So that’s a good question because, you know, you don’t want to be in a situation where you’re selling stocks once they’ve already declined, but I think it depends on how you’re invested. Because, the first thing I want to look at when I think about whether or not you need to make an adjustment is are you invested as you should be because the answer may be, you’re exactly where you should be; just hold on, you know, and try to resist the urge to make adjustments based on what’s happening in the market. And many clients work with us just for that reason because it’s difficult for them to keep the strategy in place when they see and hear that, you know, these things are happening in the market. So that’s the first thing. But then, I also work with clients who, you know, come to me, and they have way more in stock than what they should have, or they have the wrong stocks in the portfolio or too much in one particular stock. And so the question becomes do I make all of these changes at once, or do I do it over time? And, for me, I want to analyze exactly what are the stakes here? So if you have, let’s say, 20% of your stock in one company, I’m going to say that needs attention today. And even though the market is volatile and you don’t want to sell while the market’s down, the reality is that it could continue to go down, and you could risk a lot more. I think, and I—
Amy Chain: But you’re making that recommendation as a portfolio allocation recommendation, not a reaction to market volatility?
Kahlilah Dowe: That’s right. That’s right, and that’s a good point, though, Amy, because I would say that, even if the market was doing great, my response would be the same because I know that it’s cyclical, right. But then, like I said, you also have clients who just have more in stock than what they should have, and they’re at a point where they need to make adjustments to get from, let’s say, 70/30 to 60/40, and the market is volatile. And the question becomes, do I do it all today? And if you have some time before you need to spend from the portfolio, 5% increments is one thing that you could do. The only thing I would say is, you want to make sure that you have a plan in place on how it’s going to get done. So if it’s 5% a year or 5% every six months, I think that’s fine, but it shouldn’t be driven by what’s happening in the market. It’s more around your particular financial picture.
Amy Chain: Now, Colleen, for those— You know, we do know markets are cyclical, and, for those who do find themselves at the moment of retirement when the market is down, how do we counsel them about making their portfolios last when it’s potentially less than what they thought they’d be starting off with?
Colleen Jaconetti: Right. So I think the important thing is really to go back to see how much they need to spend. So if they found their portfolio down more, really, if they could even supplement their income with part-time income, if they thought their portfolio could provide $40,000, and it dropped to $38,000, $35,000, and they don’t feel comfortable, I mean, they could try to delay retirement. They could try to get part-time income, really, do what they can to cut back if they can. If they can’t cut back and they have to continue spending like that, it’s just really through time, as much as they can, try to moderate the amount that they’re going to take out.
Amy Chain: Our conversation about RMDs and IRAs seems to have spurred a lot of questions from our audience. Dennis is asking us about whether or not an RMD applies to both traditional and Roth IRAs and whether or not it’s advisable to be in one type of account or the other through the lens of taking an RMD?
Kahlilah Dowe: So the RMD generally applies to the traditional IRA, not the Roth IRA. Again, that’s one of the great things about the Roth IRA is that you get the tax-free growth. It’s your IRA, and you don’t have to take the money out at any time if you don’t want to. Many investors will use that as a way to pass on money to heirs for that reason as well. I think the second part of his question was which would be better?
Amy Chain: Would it be advisable to convert into one type or the other based on RMDs? He’s asking if he should put all or some of his money into the traditional?
Kahlilah Dowe: So many of my clients, we, together, implement a strategy of doing Roth conversions, it sounds like is what he’s referring to, when they know for sure they won’t need the required minimum distribution. And so, sometimes, it can be a burden, the RMD, or required minimum distribution, because it’s money that you know, for sure, that you’ll have to pay taxes on, but you may not need that to cover expenses. So sometimes, there are opportunities, especially if you find that they are years where you’re in a lower tax bracket, to take that money out, pay a lower tax rate than what you otherwise would have pai,; and then, just move it into the Roth IRA. So many clients will use that as a strategy to lower future income.
Amy Chain: And, Colleen, go ahead. You were going to add.
Colleen Jaconetti: Did he ask you— I thought he may have asked you about putting in a traditional IRA because there are contribution limits on each year. So it’s not something where you could take it from your Roth IRA and move it over to a traditional IRA.
Amy Chain: That’s a great point. That’s a great point. Another clarifying question is coming from Donna asking us to go over, again, the ways to invest RMDs if you don’t need to use them. Colleen, you want to take this one?
Colleen Jaconetti: Sure. So, if you don’t need to use them, really, I would say, invest them as tax efficiently as possible in a taxable account.
Amy Chain: How does one do that?
Colleen Jaconetti: Right. So, I guess, when you’re taking— And, again, when you take money out of the portfolio, you’re moving money, it’s a good time to look at rebalancing. So you could invest them in an index equity fund or ETF in your taxable account or, as Kahlilah had also mentioned, or municipal bonds if you’re in a high tax bracket. If you’re in a lower tax bracket, you could invest in taxable bonds. But, for the most part, the most tax-efficient vehicles, if you’re looking for equities, would be index equity funds or ETFs. And then, if you’re looking for a tax-efficient, if you’re in a high marginal tax bracket, put it in municipal bonds in your taxable accounts if you don’t need to spend the RMDs.
Amy Chain: And I’d love to spend the last few minutes we have here tonight going back to sort of where we started. We said, at the outset, we’d talk about the three-pronged approach to making your retirement portfolio last. Colleen, talk to us, at the highest level, about what are the three prongs that our investors should be thinking about?
Colleen Jaconetti: Sure, so the first one would be develop a prudent spending strategy, right, that will balance what you need to spend today with the fact that you could live 30 or 40 years or if you have bequest motives. The second one would be have a diversified portfolio, so broadly diversified portfolio that you can stick to in the best and worst of markets. And the third one to be is implement a tax-efficient withdrawal strategy, so spend from the portfolio in the most tax-efficient manner you can, which will either give you more spending or extend the life of the portfolio.
Amy Chain: Kahlilah, I’ll give the last word to you. Talk to us and any of your clients that might be watching out there tonight about what final thoughts you’d want to leave them with this evening.
Kahlilah Dowe: So, I’ll tell you, the tough part of what I do in terms of dealing with retirement spending is when—and we mentioned this a second ago—where I speak with investors who are very aggressively invested, and they’re going into retirement. And the question is, “How do I change this now?” And we’re at a point in the market where, you know, it’s down some. So I would just say, if you’re coming up on retirement— And I see this often, as well, where, you know, “I’m three years out, or I’m two years out, and I want to try and get as much growth as I possibly can,” and so, they’ll stay aggressively invested to try and capture that growth. I think, for most investors, that’s a bet that you don’t need to take. Start getting the portfolio as it should be before you retire. So if it’s more conservative, it’s 50/50, don’t wait until you actually retire to do that. So start doing that before so that when you actually retire, you don’t have to make any big shifts in the portfolio based on what’s happening in the market.
Amy Chain: That’s great. Well, thank you, ladies, for your contributions to our conversation this evening. For all of you out there, in a few weeks, we will send you an email with a link to view highlights from today’s webcast along with a transcript for your convenience. If we could have just a few more seconds of your time, please select the red survey widget—it’s the second one from the right at the bottom of your screen—and respond to a quick survey. We always appreciate your feedback, and we welcome any suggestions about topics you’d like us to cover in the future. And, a big surprise for all of you that hung on with us here tonight, be sure to join us for our next webcast, which is on June 15 with Vanguard’s founder, Jack Bogle. If you go to the green resource list widget at the bottom of the screen, you can register tonight. So, from all of us here at Vanguard, we want to say thank you for joining us this evening, and we’ll see you next time.
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