Your Money and Your Estate Taxes - Impacted Greatly by Your Withdrawal Rate

May 17, 2019

Historically, retirement worries have centered around two major questions: 1) Will I run out of money and 2) Will my heirs owe estate taxes? Withdrawal rates in retirement certainly have a huge impact on your money and, in the future, perhaps your estate taxes as well.

Let’s first look at a hypothetical couple, age 65, just starting retirement with $3,000,000 of liquid investments and assume:

  • They spend $12,500 per month on basic retirement spending, health care, travel and gifts.
  • Their social security, net of Medicare premiums and taxes is $2,500 per month.
  • So, they need $10,000 monthly ($120,000 annually) from their portfolio.
  • Their annual investment return is 6%.
  • The tax rate on investment income is 20%
  • Inflation is 3%.
  • Their “real return” is 3% (6% gross less 3% inflation).
  • They live 30 years.

Their withdrawal rate is 4% ($120,000 divided by $3,000,000 in year one). And, since this withdrawal rate exceeds their real return of 3%, over time their portfolio starts to decline. In their 95th year, they spend their last dollar.

It’s not surprising that if this couple’s withdrawal rate was greater than 4%, e.g., they take out $150,000 per year (5%), they would likely run out of money (in 23 years). If their withdrawal rate is less, e.g. they take out $90,000 per year (3%), their portfolio stays almost perfectly level over this 30 year at $3 million.

So, now let’s turn to couple #2 with twice as much money and a similar withdrawal amount initially of $120,000 per year. Their $6,000,000 portfolio starts with an annual withdrawal rate of 2%. In 30 years, their portfolio would be $13 million. This hypothetical couple doesn’t need to worry about running out of money, but they do need to worry about estate taxes.

The lifetime estate tax exemption is currently $11.4 million ($22.8 million per couple). The estate tax exemption has changed dramatically over the years. As recently as 1997, the exemption was only $600,000 per person. In 2007, it had risen to $2,000,000. In 2011 it jumped to $5,000,000 (plus annual inflation) where it stayed until the Tax Cuts and Jobs Act (TCJA) brought it to its current level.

If the so-called Blue Wave continues from the 2018 midterms into the 2020 general election, a Democratic majority in Washington could significantly change estate planning. Senator Bernie Sanders has suggested a reduction of the estate exemption to $3.5 million. Others have suggested a reduction to $2 million per person. Even assuming an inflation increase in the exemption, our second couple upon death could owe millions in estate taxes. Though taxpayers may be well under the exemption limits today, if their withdrawal rate is lower than their real return, their portfolio will increase and there might be a taxable estate in future years. Exemption amounts and tax rates are always subject to change.

One of the key tax strategies that will likely be employed to eliminate the estate tax for couples similar to couple #2 and others will be to use an irrevocable trust to freeze estate values. An irrevocable trust is a trust that cannot be changed or amended by its maker after it is signed. Irrevocable trusts are used to make gifts (often to children) “with strings attached.” Once the trust is funded, it is no longer part of the maker’s estate and appreciates for the benefit of the beneficiaries.

This effectively “freezes” the value of the gifted assets, since only the value when gifted may be added back to the maker’s estate, not the future value. Furthermore, while we are not attorneys, it is our understanding that certain gifts made while the lifetime exemption was $11.4 million may not be required to be added back at all.

A quick example. For simplicity, let’s assume couple #2 split their $6 million into two buckets, $3 million each. The first bucket is theirs to use for lifetime expense withdrawals. The second is in an irrevocable trust, gifted to their children. The first bucket is likely to be depleted in their lifetime (as we saw with couple #1). The second bucket grows to $13 million, as it has no withdrawals, other than taxes. Upon death, their estate would potentially only include the $3 million in gifts to the irrevocable trust 30 years earlier. Hence, no estate tax even with a future lifetime exemption of only $2 million.

Conclusions: Your withdrawal rate is a key metric. It requires a budget, financial plan and forecast. It will help you determine if you have enough money for your live(s) and if estate tax strategies may be needed in the future and how they might be designed. Please give us a call if you would like to discuss this very important topic in more detail.