Top of the Morning: A “Spending waterfall” to fund your retirement lifestyle
The desk posits that a strategic approach to tax management in retirement can significantly enhance an individual's after-tax growth potential, as highlighted by the UBS discussion featuring experts Justin Waring and Ainsley Carbone. Per the full note source, retirees are encouraged to effectively utilize tax-deferral strategies, especially around capital gains, to mitigate their overall tax burden. This perspective aligns with a wider narrative emphasizing the importance of tax-efficient withdrawal strategies in optimizing long-term investment growth. Current market consensus sees the EUR/USD tracking upwards, with expectations for rates to stabilize around the one-year mark, despite no pressing events on the immediate calendar.
What the desk is arguing
The desk argues that strategic tax management, particularly through a "Spending Waterfall" approach, is crucial for retirees looking to maximize their investment growth post-retirement. As discussed in the UBS podcast, this involves a delicate balance between taxable withdrawals and growth-oriented accounts to mitigate taxation effectively.
Significantly, the conversation stresses that deferring taxes—where possible—can lead to greater overall wealth retention over time. This is vital, especially when considering estate planning where heirs benefit from a stepped-up tax basis at death, a pivotal strategy for retirees aiming to leave a legacy.
Where it sits in our coverage
Our consensus target for EUR/USD is 1.075, with a range from 1.04 to 1.12 as we approach year-end valuations. The targets from notable firms include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
This view aligns closely with jpmorgan, sitting just below their forecast, while diverging from the more conservative stance held by bofa. Given that our projections are more optimistic than the lower bound, close monitoring of economic data could shift sentiment.
How other firms see it
Firms aligned with this tax management strategy include jpmorgan, which advocates for proactive wealth management approaches, while bofa takes a contrary stance, stressing caution against potential tax repercussions in the current regulatory environment.
In related currency developments, the strategic focus on tax might also influence USD/JPY trends, particularly how fiscal policies in the U.S. affect currency valuation dynamics. Thus, understanding this interplay is essential as we navigate forward.
What the calendar says
With the upcoming lack of scheduled events, market participants should prepare for volatility stemming from future economic releases that might impact currency valuations. Therefore, tracking economic indicators closely will be key in assessing early signs of trend shifts.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Effective tax management can enhance after-tax growth for retirees.
- 02Deferring taxation on capital gains allows for increased investment growth.
- 03Estate planning strategies like step-up basis significantly benefit heirs.
- 04Monitoring economic indicators is vital in the absence of upcoming significant events.
Market implications
As we look ahead, investors should watch for EUR/USD movement around the 1.075 resistance level, being mindful of any shifts in monetary policy that could emerge. Clarity on fiscal strategies will be paramount as it intersects with upcoming data releases potentially influencing market sentiment.
Risks to this view
Key risks to this outlook include unexpected changes in tax legislation or economic downturns that could alter capital gains strategies. A significantly adverse shift in fiscal policy or an increase in tax rates would force a reevaluation of current wealth management strategies.
Hi everyone, Dan Cassidy here. Welcome to Top of the Morning on the UBS Conversations podcast channel. For today, we will spend some time talking about how retirees can manage taxes when withdrawing from their accounts in retirement.
The goal of this framework, which here at the UBS Chief Investment Office, we've coined the Spending Waterfall, is to help families improve their after-tax growth potential. So to help us walk through this concept, joining us for the conversation today from the UBS Chief Investment Office, glad to welcome back Justin Waring, Senior Total Wealth Strategist as well as Ainsley Carbone, Retirement Strategist. With that, Justin, Ainsley, great to be on with you as always.
Thank you both for spending some time today with our listeners and our clients. I know there's a lot to cover with respect to this topic, so perhaps we can dive right into it. Justin, beginning with you, now when it comes to taxes in retirement, what do you feel is the best approach?
Should investors aim to defer taxes as long as possible or does that increase one's tax burden later? Thanks so much for having us, Dan. Yes, many retirees assume that the best strategy is to defer taxes as long as possible.
It's understandable why they think that, and this can be true in some areas. So for example, if you can defer realizing capital gains taxes, it lets you not pay the taxes today, so the money you would have given to the government is still growing in your account, and it allows you to grow those dollars in the future, and so paying the taxes later can help. Moreover, if you can defer realizing gains until you pass away, your heirs will get a step-up in cost basis when you pass away, which essentially forgives the tax that you would have paid on your unrealized gains, the difference between what you paid for your investments and the ending price.
You can also give appreciated securities to charities who don't need to pay capital gains taxes when they realize the gains, and so in the case of capital gains taxes, it's often a good strategy to defer capital gains taxes as long as possible. In other instances, tax deferral alone isn't the optimal approach. One main reason for this is that the U.S. income tax system uses marginal tax brackets that are progressive, so you may pay higher tax rates on the amount of your annual income that exceeds a certain threshold, so the marginal tax rates range from 10% to 37%, and only income in each of those brackets will be taxed at that rate.
So for example, if you have a million dollars of income in one year versus a million dollars of income over 10 years, you'll pay $322,000 in federal income taxes if you have it all in one year versus $140,000 if you spread it over 10 years, because more dollars are going to the higher tax brackets as opposed to the lower tax brackets, and the other reason why tax deferral isn't always good is because of required minimum distributions, or RMDs. These are withdrawals that you have to take each year in retirement, usually starting in your early 70s from your IRA and 401k accounts. This program exists because the government is happy to let you defer taxes on your contributions to your traditional IRA and 401k accounts, but they want to make sure that they get tax revenue on that eventually.
And so not only what you contributed, but also all the investment growth is going to be taxed as taxable income at least as quickly as you're required to take taxable distributions from RMDs. RMDs are calculated each year as a percentage of your account value. That percentage starts pretty small, around 3% or 4%, and then it goes up over time.
So more and more of your portfolio is going to need to be distributed and be taxed as income, and your portfolio is growing too. So if you just defer withdrawals as long as possible, this means that you're likely to face very large RMDs and other taxable income later in retirement, which could push you into higher tax brackets than you would have faced earlier. So in other words, deferring too much income can trigger tax torpedoes.
So not only the RMD issue, but also higher Medicare premiums, Social Security taxes, or what's known as the widow's penalty, because a married couple filing jointly tends to have a better tax situation than a surviving spouse, which is going to be considered a single taxpayer and might face higher taxes on the same amount of income. So by contrast to deferring taxes as long as possible, a strategy that we like to look at is spreading taxable income over time by filling up lower tax brackets each year. This can help you pay less tax overall and help you improve your after-tax growth potential.
And so this really can work by filling up lower tax brackets in lower tax years, for example, by implementing Roth conversions. So a Roth conversion involves taking assets from a pre-tax retirement account and moving into a tax-exempt Roth IRA. This conversion will be taxed as ordinary income in the year that you make the conversion.
But once the funds are in the Roth IRA, they'll grow tax-free and can be withdrawn tax-free in retirement as long as you meet certain conditions. So in conclusion, to answer your question, spreading your taxable income over many years can help to reduce your tax burden, improve your after-tax growth potential, and help you protect against the risk that tax rates will go higher, which is an outcome that seems likely given our country's high debt levels. Justin, thank you for that clarity and guidance.
Does make a lot of sense, and it does sound like minimizing taxes isn't the name of the game, so to speak. Instead, the goal is to smooth out your taxable income to avoid large tax bills in later years. With that in mind, let's welcome Ainsley Carbone into the conversation.
So Ainsley, can you take a few moments to walk our listeners through how to put this theory into practice? Thank you, Dan. Yeah, that's right.
So we've built a spending waterfall as a framework to help you decide which accounts to draw from and in what order when it comes to spending your retirement assets and making sure you're doing it in a tax-efficient way. So the objective of this framework is essentially to help retirees improve the after-tax growth potential of their assets. It's also to help avoid penalties and to also potentially leave a larger legacy to either the charitable organizations that they care about or their loved ones.
So this waterfall approach is designed to help families meet their spending needs while also managing tax brackets using strategies such as Roth conversions, which Justin mentioned earlier. But by ensuring that withdrawals are optimized year by year, families can fill up their lower tax brackets and keep income out of higher tax brackets in the future. So what we can do is just kind of walk through a general step-by-step process for the waterfall.
So first, we'd always recommend working with your financial planner, financial advisor, and tax advisor just to make sure that you're taking everything into consideration when determining what tax bracket you are hoping to target. So this would involve making sure you're reviewing your financial plan annually and, of course, when there are changes to either your spending needs or any changes to tax laws, this can just help you find which tax brackets you should be filling and which tax brackets you should avoid. And then as a next step, you'd want to make sure that you compare your plan spending against the guaranteed income that you're going to receive from either Social Security pensions and annuities, as well as the taxable income you are already going to receive from your required minimum distributions and your interest and dividends in your taxable accounts.
So these cash flow sources that I just mentioned are all going to be taxed regardless of whether they are spent, and so that's why we want to make sure we're earmarking them for spending first. And then the next step in this process is to fill in the gap between your taxable income and your planned spending. So in this step, we follow this list of priorities.
So it would be first, we take distributions from your IRA and 401k accounts, making sure that you're filling up lower tax brackets with taxable distributions and using tax-free Roth distributions to stay out of those higher tax brackets. Next we look to tap into assets held in taxable accounts. So if we can raise cash without realizing capital gains, that would definitely be the priority.
That would be ideal. Filing investments would require us to realize capital gains. We need to weigh that against the trade-offs of paying capital gains taxes versus the interest cost of tapping into a borrowing strategy, because borrowing strategies can help to defer capital gains taxes, but they do also introduce interest expenses, as well as leverage and repayment risks.
And then the last step, after you have all the cash that you need for spending goals, is to just make sure that you've filled up all of the tax brackets that you've wanted to. If your spending needs are not enough to do so, we suggest considering implementing Roth conversions and even maybe harvesting capital gains to fill up those desired tax brackets. Well thank you Ainsley, that makes a lot of sense.
So let's just recap for a quick moment. It sounds like the first step is to have a plan to know how much you plan to spend, how much guaranteed income you are receiving, and what tax bracket you want to target. Then you raise cash to make sure you will have enough liquidity for your spending needs.
Finally, you fill up your lower marginal tax brackets using strategies like Roth conversions. So before we move on to the last question, Ainsley, it may be helpful if you took a moment to share an example of this for us. Yes, absolutely.
There are definitely a lot of moving parts. So hopefully walking through an example will help. So let's assume that you plan to spend $300,000 per year.
Let's also assume that you are expecting to receive $200,000 from your guaranteed income sources, required minimum distributions, and interest and dividends. So this means that you need to raise about $100,000 of cash from your accounts to make sure you're filling that gap between the $200,000 of your guaranteed income sources, RMDs, interest and dividends, and also that $300,000 that you plan to spend. Let's also assume that your financial plan indicates that you should be targeting to fill up the 24% federal income tax bracket this year because this will help you bring forward taxable income that would otherwise fall in a higher tax bracket in future years.
So the top of the 24% tax bracket is at $394,600 for the 2025 tax year, assuming a married couple filing jointly. If you take $100,000 of taxable distributions from your IRA and implement a $94,600 Roth conversion, this will raise enough cash for you to be able to fulfill your spending and also for you to fill up the top of the 24% tax bracket. You may want to adjust those numbers so that you would have enough cash on hand to also pay the tax cost of the Roth conversion, which would be about $22,700.
So a lot of moving parts, but hopefully the steps that we went through earlier will kind of help you be able to implement this for yourself. Yeah, I do think this framework is pretty intuitive, but some of the details do seem a bit complicated, and it does make sense why you recommend one working with their financial advisor, planner, and tax advisor to coordinate this process on an annual basis. So before we wrap up, Justin, to welcome you back in, what are some practical steps or common pitfalls to watch out for when implementing the spending waterfall and tax bracket management strategies?
Absolutely. Thank you. So the most important thing is to review all of the relevant variables with your expert team.
You want to make sure you're aware of all your income sources, all the different account types you have, that you have a good handle on what your projected spending needs are going to be. Work with a tax professional and a fully-fledged financial plan that helps you map out your taxes for this year and for future years. The real reason we need to be able to look forward is because we're trying to smooth out your effective tax rate over time, and so we want to be able to identify opportunities to move taxable income from higher tax brackets in one year to lower tax brackets in another year.
This is also something that you should be thinking about even before retirement. When you have a high-income year during your working years, this is when you want to maybe consider doing a pre-tax IRA or 401k contribution that's going to be deductible against your taxable income that year, and defer taxes into your early retirement when you might face a lower tax bracket. If you're in a higher, if you're in a lower tax bracket at some point during your earning years and you have a huge amount of future taxable income from RMDs and things like this, you may want to look instead at a Roth conversion.
Roth contributions are more valuable for investors, especially in the very early years of their career when they tend to be, they haven't really gotten the income growth yet and they're at a lower tax bracket. But as you move into your highest earning years, that's when you're going to switch to traditional contributions. And of course, whether you're in retirement or in your working years, it's important to revisit your plan and adjust for changes in tax law, market returns, or personal circumstances.
As far as common pitfalls, don't forget about RMDs. You have to make sure that you make these taxable distributions, otherwise you can trigger a penalty. You may not want to stack too much income in one year, not just because it's going to face higher marginal tax rates, but it could also increase your tax on your capital gains that you realize and it can trigger higher Medicare premiums.
Don't forget about the benefit of Roth conversions, not only for saving yourself taxes during your lifetime, but also saving taxes for any assets you leave to your heirs. Not to mention the hassle, inheriting a Roth retirement account can be a lot less stressful than inheriting a traditional IRA, which currently under tax law is subject to a 10-year window for non-spouse beneficiaries or most non-spouse beneficiaries, I should say, where they have to take RMDs during a 10-year window, and then they also have to make sure all of it is taxed by the end of the 10-year period. It's probably not that harmful necessarily to pay those taxes, but it is kind of stressful to worry about having to make those tax payments and keep in the loop on what the exact RMD amounts are and things like that.
And then last but not least, don't forget to bear in mind any state tax implications. If you're in a higher tax state early in retirement, then you will be later in retirement. That is also something you want to factor in.
You want to try to shift more income into the lower tax years and shift income out of the higher tax years. And when it comes to borrowing against investments, which is one of those strategies that Ainsley mentioned, don't overlook the risks of that approach. It is a potential way to defer capital gains.
And if you're careful about managing the level of your leverage, this can help you to avoid paying capital gains taxes by deferring those gains realizations until the end of your life when your heirs will get a step up in cost basis. But you do need to make sure that you're not going to have a margin call or something that hurts you more than the tax benefit that you're aiming to get. And then the last tip I would just give is, obviously, this is a strategy that is very hard to do on your own.
You want to make sure that you're working with your financial advisor and your tax professional to optimize the waterfall as well as your tax bracket management. This is one of these things that can really make your tax, your hard-earned savings go further. And you've worked so hard to build up this portfolio and build up these assets.
It would be a real shame if you end up forcing yourself into a higher tax bracket than you need to do just because this can be a little bit of a complicated process. Well, Justin Ainslie, this has been very helpful. Thank you again for dropping by UBS Conversations to spend some time today with our listeners and their clients to share this valuable guidance when it comes to managing taxes when withdrawing from one's accounts in retirement.
Thank you again for your time today. Thank you, Dan. Great to be here.
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