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Impact of compounding gains on after tax accounts SWR
assuming buy and hold, over the years a portfolio will consist in a growing ratio of accrued gains versus initial capital. If taxation is based on withdrawal of gains (as is the case in my country, but probably in other countries also), the more time goes by, the more taxes you will pay for a given amount of spending. As a consequence, the older you get, the faster you will deplete your portfolio with a constant (inflation adjusted) spending rate.
I did some (extremely basic 😉 calculations, and at least for my situation with marginal tax rates of up to 45% the effect is significant for a 35+ retirement timeframe. As you might have guessed, I am not a finance professional or any of the kind, so please correct me if this assumption is wrong.
If you are still following me, my question is: (How) could this be taken into account when using your (so very helpfull) spreadsheet to calculate a SWR? First thing I did was to subtract (projected) taxes from my real return projections - which seems to be necessary, but not sufficient in respect to the PROGRESSION of the impact of taxes over the years. What else would you recommend?
Context: I am a 64 year old German living in France for over 30 years now. For different reasons ;-), I will have a less than 18 K€/y "retraite" (equivalent of US social security I suppose). Fortunately I managed to build up a portfolio of now about 750 K€ to compensate (60/40 currently, planning to apply a glidepath as you recommend) and it looks ok to me - knowing that it mostly depends on my arbitrary even though very conservative projections. Unfortunately, the French tax and financial system does not really expect and support self funded retirement; as a result there are few relevant information sources (except so-called financial advisors who are actually sales people).
I have declared this topic as "private", not being sure whether it might be of interest to the other members. If you think it is the case, you can switch it to public, deleting the "Context" perhaps.
Greetings from Lyon and thanks so very much for your great content and tools
Very good question. Most investors will likely withdraw the highest-cost tax lots (with the lowest capital gains) first.
See Principle 2 in this post: https://earlyretirementnow.com/2021/03/22/retirement-tax-planning-swr-series-part-44/
But then over time, the tax burden will likely increase as you have to liquidate the lower-cost, higher-capital-gains chunks.
One way to account for that is to model the tax burden as supplemental (negative) cash flows in the Google SWR Toolbox.
Another option would be to use the "scaling" column in the tab "Cash Flow Assist" (column P). to account for the tax drag. For example, if you face an average tax rate of 5%, then one could use the scaling 1/(1-0.05) in that column. This would simulate gross withdrawals of 1/(1-0.05) per $1 of consumption to target a net withdrawal of $1.00.
You can now adjust that average tax rate to 10%, 15% or whatever the target might be later in retirement.
Of course, you will likely never face the full 45% marginal rate because you might use deductions, there might be lower marginal rates, etc. And keep in mind that only the capital gains portion will be taxable.
Thanks a lot for this comprehensive answer and solutions suggested.
FYI (if you are interested):
# My experience with your (fabulous) spreadsheet:
As a humanity PhD, I spent quite some time finding out what the impact of "inflation" (B7) in the "Cashflow Assistant" actually is. First I thought it would also continually adjust the SWR for inflation - and found the adjustment way too low. (Germans are obsessed with inflation 😉
To prevent other amateurs from erring, it might be useful to include a note in the guide or directly on the spreadsheet.
# Tax rates: Sure I will never actually pay 45%. Still, according to my projections, after 35 years at 5% nominal (!) return, I will pay over 25% on total withdrawals (interest + principal) from after-tax accounts - up from around 5% after 5 years- ... (In France, there is a 25% or 30% flat tax + income tax on capital returns. After 5 years, you get 4600€ income-tax free interests per year - but still paying the flat tax).
# Sequence of Return Risk: Thinking about the relationship between SRR and "tax-inflation". As a matter of fact, I am afraid "tax-inflation" could make matters worse: Without adequate adaptations, due to low tax rates in the beginnning, retirees could be tempted to (actually) overspend in early retirement. This might exacerbate Sequence of Return Risk after an early market downturn. (I don't believe at all in the theory of decreasing needs throughout retirement; at least for me - though it might be true for people going on cruises, eating out, playing golf etc. The closer your budget is to "survival level" the more your needs might even increase as you are going to need more help).
# Withdrawal strategy: I reread https://earlyretirementnow.com/2021/03/22/retirement-tax-planning-swr-series-part-44/ - and once again felt that investment modalities in the EU and especially in France are very different. Anyway, for various reasons I need to spend down on the lowest performing assets first. In France, portfolios often include several "contracts" ("contrats d'assurance vie", signed up for at different times), each requiring (!) a certain mix (!) of asset classes, taxable with all returns pooled together. (Making withdrawal strategy and rebalancing particularly cumbersome).