Optimal Retirement Withdrawal Strategy
Most retirement calculators follow the conventional retirement savings withdrawal strategy of withdrawing all the funds from the After-tax Account first, followed by the Tax-deferred Account and finally the Roth IRA.
ORP withdraws money from all three accounts in parallel in order to reduce personal income taxes.
The question is: How much (in real numbers) does ORP improve over a conventional retirement calculator's withdrawal method?
There was no easy way to compare the results produced by an Internet accessible, conventional retirement calculator to those of ORP and vice versa.
To answer this question we implemented a conventional retirement calculator (named Naive) that produces results compatible with ORP. Naive follows the conventional withdrawal method of withdrawing all after-tax funds first and then withdrawing funds from the Tax-deferred Account. Naive does not model Roth IRA accounts.
Naive is a typical conventional retirement calculator except that instead of determining the year that the retirement funds are exhausted, it iterates to the stated estate amount by incrementally adjusting annual spending. Naive's after-tax, annual spending expressed in today's dollars is directly comparable to ORP's version of the same. Furthermore, the plan value for both calculators is the sum of all inflated, after-tax spending for the life of the plan.
Table 1 compares results between the two methods for a basic situation uncluttered by extenuating circumstances::
Table 1 the compares the performance of Naive's conventional withdrawal method to ORPís optimized schedule for various sizes of the After-tax Account and the Tax-deferred Account but always totaling $3M. The two Spending columns are expressed in today's dollars. The two Value columns are inflated dollars. The first and last rows of Table 1 are trivial cases that serve to indicate the computational discrepancies between the two implementations of the same model.
Ignore the fact that when reading down the columns the annual spending values get smaller as the After-tax Account gets smaller, giving the impression that the After-tax Account is outperforming the Tax-deferred Account. This illusion occurs because the After-tax Account pays its taxes as the income is incurred and pays no personal income taxes on withdrawals. Table 1 ignores the important fact that contributions to the Tax-deferred Account were not taxed as they were made and investment returns prior to withdrawal were not taxed.
The important message of Table 1 is in the two rightmost columns; the percentage improvement of ORPís optimized withdrawal strategy over the conventional approach. Annual Spend shows ORP's advantage for each year of retirement. The Value improvement is over the life of the plan.
Next in Table 2 Social Security benefits are added to the mix to give a more typical retirement situation. Table 2 assumes that both the retiree and spouse began receiving $24,000 annual Social Security benefits at age 65.
Table 2 shows that the largest percentage spending improvement (4.4%) for ORP over Naive comes for the 50/50 split between the two accounts. For a typical situation savings are heavily weighted toward the Tax-deferred Account, as shown in rows 8, 9 and 10 . We see that optimal withdrawal strategy will increase annual retirement spending from 2.4% to 3.5% per year. This turns out to be $163,000 to $320,000 over the span of the plan.
Comparing rows 8, 9 and 10 of Tables 1 and 2 shows that Social Security benefits lessen the percentage improvement of ORP over Naive. Other quantitive studies on this topic such as Horan and Spitzer and Singh  omit Social Security benefits from their computations and thus tend to overstate the advantage of their Informed withdrawal methods over the Naive methods.
Table 3 extends the Table 2 situation by including a $300,000 illiquid asset, the couples home, to be liquidated in year age 80.
Adding the home to the retirement mix increases the couple's assets to $3,300,000 and gives ORP more room to work in. Again rows 8, 9 and 10 are typical of most retirement plans. Comparing these rows between Tables 2 and 3 shows that ORP is able to take advantage of the additional asset.
Table 4 shows ORP's Withdrawal Plan for the 50/50 split scenario that includes the both Social Security benefits and an illiquid asset.
Table 4 shows that ORPís strategy is to do continuous withdrawals from the Tax-deferred Account in a manner that keeps taxes under control and takes maximum advantage of the Roth IRA. Early in retirement the After-tax Account (column 2) is being drawn down for spending without paying personal income taxes. Partial distributions are being annually rolled over from the Tax-deferred Account (column 1) to the Roth IRA (column 4) paying personal income taxes on each withdrawal.. When the After-tax Account is empty the Tax-deferred and Roth IRA accounts provide for spending.
At age 80 the illiquid asset is sold and the proceeds fund spending, along with a low level of withdrawals from the Tax-deferred Account. Once the house proceeds are exhausted then withdrawals resume from the Roth IRA for the remainder of the plan. Age 82 is particularly interesting because it shows withdrawals from all three accounts in the same year.
The Taxes column (column 7) tells the story. The highest taxes are paid early on during the IRA to Roth IRA rollover phase. The Roth IRA is stocked up early in retirement to provide tax free distributions to supplement the IRA distributions and keep them in a lower tax range, 15% in this case, for the rest of retirement.
Conclusion: ORPís optimal retirement withdrawal strategy increases the amount of money available for spending during retirement. ORPís strategy is to take advantage of the Federal progressive income tax code. ORP makes partial rollovers to the Roth IRA when they are only lightly taxed and then withdraws the money from the Roth IRA tax free later on when Naive's strategy makes large, taxable withdrawals from the Tax-deferred Account.