The Impact of Taxes on the 4% Rule

How do taxes impact the 4% rule for retirement spending? Most research on sustainable withdrawal rates assumes spending is either from a tax-exempt account such as a Roth IRA or a tax-deferred account such as a traditional IRA. In the latter case, spending is assumed to be gross of taxes, as any taxes due must be paid from the distributions.

For a taxable account, sustainable spending rates are negatively impacted by the need to pay ongoing taxes for interest, dividends, capital gains distributions, and realized net capital gains when assets are sold or rebalanced. These taxes reduce the potential for compounding growth.

Because individual tax rates vary greatly, as do interest and dividends supported by the portfolio and the cost basis of the taxable account, it is impossible to create one general number for a sustainable after-tax spending rate from a taxable account. It is even harder to speak generally about the impact of taxes because retirees will enjoy tax diversification between multiple account types.

Ultimately, the way to manage this tax issue is not necessarily to determine its impact on a sustainable withdrawal rate, but to test the circumstances of one’s spending plan with a more complete model that accounts for taxes in additional to after-tax spending goals.

While I cannot provide a generalized analysis to show the impact of ongoing taxes on sustainable spending, basic estimates show that the impact can be substantial. I will provide simple estimates of the impact that taxes can have on sustainable retirement spending with nine different case studies that involve having a differing amount of assets in either a taxable, tax-deferred, or tax-exempt account, with portfolio return assumptions that support 4% as a sustainable initial spending rate if taxes did not apply.

Federal income taxes will be calculated for portfolio distributions, the taxation of Social Security benefits, adjustments to Medicare premiums, and the net investment income surtax. I will estimate how much the after-tax distribution must be reduced compared to a no-tax scenario, to find the inflation-adjusted after-tax distribution strategy that is able to support required tax payments.