Academy of Financial Services, Orlando
Shawn Brayman, PlanPlus Inc. and Kira Brayman, Oxford University
The Common Rule (CR) for order of withdrawal of investment accounts prescribes deferring tax as long as possible. Research has shown that it is possible, in some cases, to reduce taxes and maximize terminal wealth by withdrawing tax deferred funds earlier at lower tax rates, rather than realizing this taxable income at later times and at higher marginal tax rates. This approach is often referred to as ‘topping up to band’ (1B).
This paper explores the hypothesis that a ‘top up’ to a single band is insufficient in its optimization and that topping up to different bands at different points in time is required to maximize terminal wealth. This is tested through the creation of a 2-Band (2B) optimization strategy and a comparison of the two models in a sophisticated retirement planning software.
We tested 92 different scenarios altering variables such as income type, adjusted cost base, election age of government benefits, proportion of tax deferred and tax free investments, and more. We found that the CR provided the greatest advantage in only 14% of scenarios, while 1B was optimal in 49% of cases and 2B was optimal in 37% of cases.
The fact that the 2B approach provided higher terminal wealth in a significant number of cases proves that a single band to ‘top up’ to is insufficient. We concluded that although both 1B and 2B approaches controlled the triggering of additional taxes, there was a degree of randomness as to where the ‘benefit’ accrued, since models reverted to CR after top up actions were executed. In order to address the inconsistency in these optimization
strategies, we have documented the theorization of a new multi-band top up strategy based on a ‘time value of tax’ (TVT). By altering the discount rate (DR), we demonstrate how we can maximize the taxable income that can be relocated from higher tax bands to ‘top up’ lower tax bands, ensuring maximum value by taking advantage of accumulated returns over time as well as the relative tax differential between bands.