What’s the real value – the spending power – of your portfolio?
Posted on November 1, 2024
I like to look at our portfolio in terms of its after-tax spending power. When I do this, the after-tax value of our portfolio is about 81% of the total value I see when I look at the summary statement for our brokerage account. That’s primarily because the amount in our traditional IRAs is 28% more than its after-tax value. This post describes the mechanics I used look at our portfolio in terms of its after-tax spending power.
Detail:
== Our portfolio mix ==
Here’s the rough mix of our current portfolio:
We don’t have much in Roth, and I’d guess this is similar for most retirees. Contributing to Roth and converting to Roth did not make much sense during our working years because marginal tax rates were high. You don’t want to pay the tax to contribute or convert to Roth if you think future tax rates will be lower. That was the right decision. Marginal tax rates are much lower now.
My Roth is from conversions in 2018, 2019 and 2020. I converted in the 22% tax bracket. This was not simple to do, since we were on Medicare then. I had to make sure that the conversion amount did not result in total income that crossed an IRMAA tripwire. That would have made those conversions more expensive.
== Our portfolio restated ==
I can restate the after-tax value – the spending power – of our portfolio. I’ll use a total portfolio of $1 million for this example. Our after-tax spending power is 81% of the total portfolio value I see on our Fidelity web site.
• Our taxable account is worth ~92% of its pre-tax value. The tax bite is 8.4% of the total: my Fidelity site shows we have 46% taxable gain in the index funds we hold. If we sold it all, we’d pay 18% tax rate on the gain – 15% federal and ~3% for PA taxes: 46% times 18% equals 8.4%.
• I owe no further federal or state taxes on my Roth. No state taxes distributions from Roth.
• Our pre-tax, traditional IRA accounts are worth 78% in after-tax spending power. I use 22% as the federal effective tax rate that we would pay. (It’s fair to assume heirs would be taxed at 22%.) I don’t have to add for state tax: PA is one of 13 states that does not tax distributions from traditional (pre-tax) IRAs. Our traditional IRAs are overstated in after-tax value by 28% (1/.78-1).
== 21% is the minimum to assume ==
As I describe here, the 10% and 12% marginal tax brackets are a myth for those 1) who distribute a meaningful amount from their traditional IRAs for their spending, and 2) are on Social Security and Medicare. Why? Added income from distributions from traditional IRAs increase other taxable income.
The culprit is the formula that increases the percentage of Social Security that is taxed. That percentage increases as other income increases – e.g., interest, dividends, capital gains and distributions from traditional IRAs. The math is a bit hairy, but you should conclude that each $1 distributed from your traditional IRA triggers another 85¢ of Social Security that is taxed in those two tax brackets. That turns the 10% marginal tax rate to an effective 18.5% rate. It turns the 12% marginal tax rate to an effective 22.2% rate. I average the two for a 21% effective tax rate.
== I use 22% and keep it simple ==
I use 22% effective tax that we will pay on distributions from our traditional IRAs. It’s more than 21% because other taxes increase from greater distributions.
• Greater distributions trigger more taxes when you are nearing the top of the 12% marginal bracket for ordinary income: total taxable income will cross a tripwire that triggers 15% capital gains tax rates rather than 0%. That can add several points to your effective tax rate.
• Greater distributions can cross tripwires of income that fall in the 22% and 24% marginal brackets can trigger IRMAA – higher Medicare premiums deducted from Social Security benefits; the higher premiums are effectively an added tax. As an example, if you cross the first tripwire (There are five.), the 22% marginal bracket is effectively more than 24% tax rate.
• Someday it will be just one of us – Patti or me. The RMD percentage that we pay now will be similar to what we pay now: Patti and I are close in age. Social Security will decline (The survivor receives the highest of our two benefits.), but the survivor will see the start of marginal tax rates at half of what they are for us as married, joint filers. The tripwire for 15% capital gains tax and IRMAA tripwires will be half of what they are for us a married, joint filers. I’d assume an effective tax rate then of at ~25% then. The after-tax value of our traditional IRAs falls and would be 75% of their pre-tax value.
== Asterisk ==
Patti and I see value in a portion of our traditional IRAs:
Over the ten years that we’ve been retired, our portfolio has grown and our age-adjusted Safe Spending Rate (SSR%, See chapter 2, Nest Egg Care (NEC)) has increased (We’re older!). We calculate that we have “more than enough” for our desired level of spending. (See chapter 10, NEC.)
We like donating to charities we care about. We use QCD from our traditional IRAs for all donations. We never paid tax on that money, and the charities don’t pay tax: our traditional IRA delivers more than 28% more spending power than if we had paid tax and then donated from a Roth account.
I segregate: Roth is best for spending by people: Patti and me and our heirs. We want traditional IRA for the money we want to donate.
Conclusion: I find it useful to look at our portfolio in terms of after-tax spending power. When I calculate the after-tax value of our portfolio, it’s 81% of the amount that I see when I look at the account summary in our brokerage account. Almost all of that effect is from the 22% effective tax rate that Patti and I will pay (or heirs will pay) on our traditional IRAs.