Annual Retirement Spending / Taxes / Dividends

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Mxguarisce
Posts: 2
Joined: Wed Jan 25, 2023 5:51 am

Annual Retirement Spending / Taxes / Dividends

Post by Mxguarisce »

Hi Jim and all:

Thanks for such a great tool. I have be using on and off for a few years. I have 2 questions, my apologies they might sound basic -- but I got a few doubts lately. I read the FAQ and a few forum entries here but I seem to be unable to find an answer.

Question 1 is about Annual Retirement Spending and Taxes: let's assume that I set the Annual Retirement Spending at 100,000. The taxes on income and investment are set at 10%. Question: is the Annual Retirement Spending always after taxes? In other words will those 100,000 be fully available to me as an after taxes amount -- ie net of the 10% taxes I pay?

Question 2 is about dividends: let's assume that in the last 20 years my portfolio has returned an average on 5% and that return dose not include dividends' income (it only includes the basis of the dividends in the performance). I also know that my yearly dividends are, let say, about 25,000 a year. I decide to use that 5% as a proxy of my future returns, so I use the Custom rate of return at 5%. (I am aware of the limitations for using the custom setting because the simulation will not take into account volatility etc). Then I add an annuity of 25000 a year (maybe with a little COLA reflecting the average dividend growth) to the Additional Input. Would that be conceptually correct? (Let forget for a second the killing the goose that lays golden eggs).

Thanks a lot for your great tool and for your help,
Max
jimr
Posts: 767
Joined: Thu Feb 28, 2008 6:48 pm

Re: Annual Retirement Spending / Taxes / Dividends

Post by jimr »

Mxguarisce wrote: Wed Jan 25, 2023 6:09 amQuestion 1 is about Annual Retirement Spending and Taxes: let's assume that I set the Annual Retirement Spending at 100,000. The taxes on income and investment are set at 10%. Question: is the Annual Retirement Spending always after taxes? In other words will those 100,000 be fully available to me as an after taxes amount -- ie net of the 10% taxes I pay?
The way the planner works, retirement spending itself isn't taxed, instead, the sources of any retirement income may be taxed depending on where they come from. Income is taxed as long as you configure it as taxable when you set it up. Withdrawals from tax deferred savings are also taxed (as are RMDs once they start). Finally, each year, any gains in your taxable portfolio are taxed at the investment tax rate. This happens whether or not you withdraw from that portfolio. The idea here is that the taxable portfolio is carried at a 100% cost basis, so gains are taxed as they happen and withdrawals are tax free. You can see how taxes are being applied in the detailed view (select more details on top right of window - also right click on any column header for options to see more columns).
Question 2 is about dividends: let's assume that in the last 20 years my portfolio has returned an average on 5% and that return dose not include dividends' income (it only includes the basis of the dividends in the performance). I also know that my yearly dividends are, let say, about 25,000 a year. I decide to use that 5% as a proxy of my future returns, so I use the Custom rate of return at 5%. (I am aware of the limitations for using the custom setting because the simulation will not take into account volatility etc). Then I add an annuity of 25000 a year (maybe with a little COLA reflecting the average dividend growth) to the Additional Input. Would that be conceptually correct? (Let forget for a second the killing the goose that lays golden eggs).
Couple things. First, using a custom return setting does allow for volatility (std dev) to also be entered. This isn't a limitation.

As for dividends, the planner isn't set up to have dividends broken out separately from other portfolio gains. The planner works on a "total return" model where interest, dividends, and capital gains are all lumped together into one portfolio return. The correct way to set this up is to figure out the overall portfolio return and portfolio volatility and enter those values. Then don't include dividends as a source of income.

You could try to break out dividends to handle them separately, but doing so sort of goes against the theory that underlies the simulation model. It might be possible to do this correctly and "bend" the model to your will. However, it's likely that one of the underlying assumption built into the model will be missed and cause your results to be inaccurate (for example how portfolio taxes are handled).
Mxguarisce
Posts: 2
Joined: Wed Jan 25, 2023 5:51 am

Re: Annual Retirement Spending / Taxes / Dividends

Post by Mxguarisce »

Jim, thanks a lot for your detailed reply. Very clear now.
FRPNewb
Posts: 3
Joined: Mon Jan 23, 2023 3:38 am

Re: Annual Retirement Spending / Taxes / Dividends

Post by FRPNewb »

The idea here is that the taxable portfolio is carried at a 100% cost basis, so gains are taxed as they happen and withdrawals are tax-free.
I was coming in to ask how you take the cost basis into account, as I wasn't sure how to parse this form the FAQ

The Investment Tax Rate determines the rate at which each year’s portfolio gains (from taxable investments) will be taxed. The simulation assumes that taxes on all gains in the taxable portfolio are paid in full each year and no taxes are deferred. This assumption will be incorrect in the case of a low turnover portfolio or when a plan starts out with a significant amount of deferred gains in taxable accounts. To compensate for these cases, it may be necessary to reclassify some percent of taxable investments as tax deferred investments or to run some experiments with different investment tax rates to see how sensitive the plan is to this input

Making some of it tax-deferred doesn't quite work since it would now be taxed as income, not long-term capital gains

On the other hand, taxable income seems to be taxed at the rate in the input form from the first dollar (no exemption or progressive tax brackets)?
In that case taxes would be overestimated if you enter your marginal tax bracket, it seems that an effective (average?) tax rate would be best. Outside of Roth conversions, I think it could be estimated based on the required expenses (Roth conversions to the top of some brackets will increase the average), but it looks like the Roth conversion entry allows you to set the tax rate for it (likely the marginal tax bracket you are trying to fill)

Obviously tax modeling is a guessing game anyway, brackets and limits will change over time, so you'd have to use tax numbers for this year. I suppose it's all happy medium between not ignoring taxes so the conclusions are not erroneous, but without pretending more precision than can be achieved in the first place.

I couldn't find good instructions on how to do Roth conversions, I'm going to play with it and maybe write a post on how I did it, either to help others or have you guys tell me why I'm doing it wrong.
jimr
Posts: 767
Joined: Thu Feb 28, 2008 6:48 pm

Re: Annual Retirement Spending / Taxes / Dividends

Post by jimr »

With Roth Conversions, the input there isn't a tax rate, but rather a taxable percent.

The taxable percent input specifies how much of the roth conversion amount should be taxed at the income tax rate. This is the same way the taxable percent input works with "income" type cash flows.
FRPNewb
Posts: 3
Joined: Mon Jan 23, 2023 3:38 am

Re: Annual Retirement Spending / Taxes / Dividends

Post by FRPNewb »

ah thanks, wouldn't it be 100% in most cases for Roth conversions? if you paid to a 401(k) or IRA pre-tax, then the "basis" is 0% or 100% taxable regardless of whether it came from contributions or growth
jimr
Posts: 767
Joined: Thu Feb 28, 2008 6:48 pm

Re: Annual Retirement Spending / Taxes / Dividends

Post by jimr »

As I understand it, some people make non-deductible IRA contributions and that means their iRA will have a basis other than zero.

Also, in general the taxable percent input can be used to adjust the effective tax rate on specific cash flows without changing the main "income tax rate" input.
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