How do I address Gross-of-Tax and Net-of-Tax Retirement Income?

The dance between gross- and net-of-tax income is, without a doubt, one of the most complex (and, frankly, frustrating) parts of retirement planning. This is true no matter what software you use for planning (or even if you use no software at all). In some ways, Income Lab makes this dance much clearer than you’d see it in other software because Income Lab includes a way to easily and quickly answer the question “What can I spend?”. (In other software, you define what you want to spend and the software gives you a “score” for that idea. In software like this there's no way to quickly dial in a range of reasonable income options.) 

So, how can an advisor perform this dance between gross-of-tax and net-of-tax income?

Gross-of-Tax Income Talk is More Common than You'd Think

For very good reasons, many advisors are not fans of the “4% Rule” - the idea that retirees should take withdrawals of 4% of their beginning-of-retirement portfolio balance and then adjust that amount for inflation for the rest of their life. But, it is very well known and does focus people on an interesting question: how much can someone take from their portfolio? Strangely, though, not many people note that this is a gross-of-tax discussion. The 4% rule is gross of tax. If someone is taking money from an IRA, for example, the IRA will support a certain level of gross-of-tax withdrawals. The IRA doesn’t care what the person's tax rate is. If tax rate were cut in half tomorrow, the withdrawals the IRA would support would stay the same. If taxes were doubled tomorrow, the withdrawals you could take from your IRA would stay the same. So, answering the question “what can I withdraw from investment accounts?” just IS a gross-of-tax question. 

Incidentally, during our working years we tend to think of our income in terms of gross-of-tax wages. If someone were so uncouth as to ask you how much you make, and you actually answered them, you’d give them a gross-of-tax answer. So, it’s pretty natural for people to think of retirement income as gross of tax as well. But this only works when taxes are fairly uniform over time.

Workflows for Handling Gross-of-Tax vs Net-of-Tax Retirement Income

But, of course, people also want to know what they can spend in retirement NET of tax, especially during lumpy or temporarily high-tax periods, like during Roth conversions. Getting to a net-of-tax answer requires a few more steps beyond the initial question of “How much can I spend (gross of tax)?”.

First, let's remember the typical workflow for building an Income Lab plan. We start with the resources a household will use to fund their lifestyle in retirement, then add in crucial expense goals (other/variable expenses) and final portfolio legacy goals.

The next step (which is optional) is to address Tax-Smart Distribution Planning. Here’s a work flow for creating a retirement plan where the taxes from Roth conversions cannot simply be paid from surplus income. In a situation like this, you might see that, without Roth conversions, the plan's net-of-tax income comfortably covers the household's spending needs, but that once Roth conversions are added the net-of-tax income goes way down.

1. Build a “How much can I spend?” plan using the clients’ resources and important goals (variable expenses, portfolio legacy goal).
2. Look at the net-of-tax incomes that are available by choosing “Net” from the [Gross - Net] chooser in the view options menu. 
   NOTE: Ideally, you'll be including some level of taxation in this plan. So, you might want to try ordering withdrawals with qualified funds first (Tax-Deferred, Taxable, Tax-Free) but no Roth conversions. This forces all of the withdrawals to be taxable as ordinary income. That may not be what you’ll do in practice, but it pushes the taxes up. If, instead, you took from a high-basis taxable account first, you might see very low or no taxes.
3. Create a plan that targets one of these net income levels as the net-of-tax goal by putting this number in the Expenses > Baseline Expenses tab and switching the primary plan question to “How can I spend $X, net of tax?”.
4. Go to Tax Lab to evaluate whether Roth conversions are projected to help.
5. Apply the Roth conversion strategy to the plan.
6. Check that the risk level of this new plan isn’t too high.

You may need to repeat steps 3-6 a few times to really dial things in.

This is a multi-step process. But, even with today’s technology, it’s the best an advisor can do. The good news is that this kind of planning can make a huge difference and be incredibly valuable to clients.

Here is a small sub-workflow on working with tax planning. You'll notice here that Step 4 is to ask “Is net spending still enough?”. Some plans' resources can support income that is far higher than the net-of-tax spending needs of a household, even in the presence of Roth conversions or other high-tax events. If that is the case, you may be able to simply apply a Roth conversion strategy to a plan, but leave that plan in “How much can I spend?” mode and use the surplus income to fund the taxes associated with Roth conversions.