Schwab Intelligent Portfolios January 8, 2020

    Retirees typically face several common questions when trying to figure out the best approach for taking withdrawals from their investment accounts for retirement income purposes due to the tax treatment of different types of accounts:

    • Which accounts should you withdraw from and in which order, to minimize the impact of taxes?
    • How much should you withdraw from each account type?
    • How will you know if your savings will last through retirement?

    Conventional wisdom typically recommends taking withdrawals first from taxable accounts, then from tax-deferred accounts such as a 401(k) or traditional IRA, and finally from tax-exempt accounts such as Roth IRAs. (Keep in mind that Required Minimum Distributions (RMDs) must be taken from tax-deferred accounts beginning at age 70½ for people who reached that age in 2019 or beginning at age 72 for those who reached 70½ in 2020 or later due to the SECURE Act signed into law at the end of 2019.) This approach seeks to maximize growth in tax-advantaged retirement accounts by delaying withdrawals from them. As with many things in life, however, conventional wisdom regarding retirement distributions might not always be the best approach.

    Rethinking conventional wisdom

    Recognizing the potential drawbacks of conventional wisdom when considering the tax implications of RMDs1 and Social Security2, Schwab Intelligent Income uses a proportional distribution strategy for enrolled accounts to take withdrawals in the following order:

    1. RMDs
    2. Proportional withdrawals from both taxable and tax-deferred accounts
    3. Roth IRAs

    This approach is based on research by Charles Schwab Investment Advisory, Inc. (CSIA) and the Schwab Center for Financial Research (SCFR) showing that taking distributions from both taxable and tax-deferred accounts in the same calendar year can help to better manage current and future tax brackets throughout retirement, leaving more money in your pocket after-taxes to enjoy retirement. A proportional withdrawal strategy also provides flexibility if tax rates or tax policy were to change again in the future. Leaving Roth IRAs until last maximizes the benefits of tax-exempt growth and provides flexibility in case a large lump sum withdrawal might be needed in the future and for purposes of legacy planning.

    Why a proportional withdrawal strategy makes sense

    Comparing the results of Schwab Intelligent Income's withdrawal strategy with a conventional approach illustrates why a proportional strategy can lead to better results. The example considers a 65-year-old individual planning for a 30-year retirement, receiving $27,000 annually in Social Security benefits and withdrawing $28,000 (total spending needs of $55,000) the first year from $600,000 of total retirement savings spread across three accounts: $150,000 in a taxable brokerage account, $400,000 in a traditional IRA and $50,000 in a Roth IRA. For this hypothetical example, RMDs begin at age 72.

    For the first year, Schwab's tax-smart proportional withdrawal strategy automatically withdraws $7,636 from the taxable brokerage account and another $20,364 from the traditional IRA totaling $28,000 of withdrawals from their retirement savings. Nothing is withdrawn from the Roth IRA, allowing it to keep growing. In fact, assuming average market returns, no withdrawals would be required from the Roth IRA to meet spending needs over the full 30-year period. Figure 1 shows the withdrawals from each account over the 30-year period.3

    Figure 1: Annual withdrawal amounts by account type

    Annual withdrawal amounts by account type

    Source: Charles Schwab Investment Advisory, Inc.

    Figure 2 shows the hypothetical results of the proportional withdrawal strategy of Intelligent Income vs. a conventional approach over the full 30-year period. As the chart shows, the estimated annual taxes grow each year with a conventional withdrawal strategy as a result of having a larger percentage of retirement savings held in a traditional IRA (leading to higher RMDs). By contrast, in Schwab Intelligent Income's proportional withdrawal strategy the estimated annual taxes start earlier in the withdrawal period, but grow at a slower pace and eventually decline in the later years. The result is cumulative estimated taxes over the 30-year withdrawal period of $132,490 for the conventional strategy vs. $106,769 for the tax-smart withdrawal strategy of Schwab Intelligent Income. That represents $25,722 less in estimated taxes in this hypothetical example, helping the retiree keep more money that can be used to enjoy retirement.4

    Figure 2: Estimated annual taxes for different withdrawal strategies

    Estimated annual taxes for different withdrawal strategies

    Source: Charles Schwab Investment Advisory, Inc.

    Conclusion

    The tax-smart withdrawal strategy of Schwab Intelligent Income is designed to overcome some of the drawbacks of conventional wisdom when it comes to retirement income. As demonstrated, a proportional withdrawal methodology can produce effective results when RMDs and Social Security are taken into account. Intelligent Income is designed to remove the guesswork in your retirement income planning and do the work for you in helping you plan, invest, distribute and monitor/adjust if needed, without penalty. That kind of confidence and control is what Schwab Intelligent Income is designed to deliver, so you can devote your time to focusing on fully enjoying your retirement.

    Please read the Schwab Intelligent Portfolios Solutions™ disclosure brochures for important information, pricing, and disclosures related to the Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium programs.

    Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are made available through Charles Schwab & Co. Inc. ("Schwab"), a dually registered investment advisor and broker-dealer. Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. ("CSIA"). Schwab and CSIA are subsidiaries of The Charles Schwab Corporation.

    Schwab Intelligent Income™ is an optional feature for clients to receive recurring automated withdrawals from their accounts. Schwab does not guarantee the amount or duration of Schwab Intelligent Income withdrawals nor does it guarantee any specific tax results such as meeting Required Minimum Distributions.

    Schwab Intelligent Income is available in both Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium. There is no advisory fee or commissions charged for Schwab Intelligent Portfolios. For Schwab Intelligent Portfolios Premium, there is an initial planning fee of $300 upon enrollment and a $30 per month advisory fee charged on a quarterly basis as detailed in the Schwab Intelligent Portfolios Solutions™ disclosure brochures. Investors in Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium (collectively, "Schwab Intelligent Portfolios Solutions") do pay direct and indirect costs. These include ETF operating expenses which are the management and other fees the underlying ETFs charge all shareholders. The portfolios include a cash allocation to a deposit account at Schwab Bank. Our affiliated bank earns income on the deposits, and earns more the larger the cash allocation is. The lower the interest rate Schwab Bank pays on the cash, the lower the yield. Some cash alternatives outside of Schwab Intelligent Portfolios Solutions pay a higher yield. Deposits held at Schwab Bank are protected by FDIC insurance up to allowable limits per depositor, per account ownership category. Schwab Intelligent Portfolios Solutions invests in Schwab ETFs. A Schwab affiliate, Charles Schwab Investment Management, receives management fees on those ETFs. Schwab Intelligent Portfolios Solutions also invests in third-party ETFs. Schwab receives compensation from some of those ETFs for providing shareholder services, and also from market centers where ETF trade orders are routed for execution. Fees and expenses will lower performance, and investors should consider all program requirements and costs before investing. Expenses and their impact on performance, conflicts of interest, and compensation that Schwab and its affiliates receive are detailed in the Schwab Intelligent Portfolios Solutions disclosure brochures. The cash allocation in Schwab Intelligent Portfolios Solutions™ will be accomplished through enrollment in the Schwab Intelligent Portfolios Sweep Program (Sweep Program), a program sponsored by Charles Schwab & Co., Inc. By enrolling in Schwab Intelligent Portfolios Solutions, clients consent to having the free credit balances in their Schwab Intelligent Portfolios Solutions brokerage accounts swept to deposit accounts at Charles Schwab Bank through the Sweep Program. Charles Schwab Bank is an FDIC-insured depository institution affiliated with Charles Schwab & Co., Inc. and Charles Schwab Investment Advisory, Inc.

    Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are designed to monitor portfolios on a daily basis and will also automatically rebalance as needed to keep the portfolio consistent with the client's selected risk profile. Trading may not take place daily.

    Tax-loss harvesting is available for clients with invested assets of $50,000 or more in their account. Clients must choose to activate this feature. The tax-loss harvesting feature that is available with Schwab Intelligent Portfolios Solutions™ is subject to significant limitations which are described on the Schwab Intelligent Portfolios Solutions website and mobile application (collectively, the "Website") as well as in the Schwab Intelligent Portfolios Solutions™ disclosure brochures (the "Brochures"), and the IRS website at www.irs.gov. You should consider whether to activate the tax-loss harvesting feature based on your particular circumstances and the potential impact tax-loss harvesting may have on your tax situation. You should read the tax-loss harvesting disclosures on the Website and in the Brochures before choosing the tax-loss harvesting feature. Neither the tax-loss harvesting strategy nor any discussion herein is intended as tax advice, and neither Charles Schwab & Co., Inc. nor its affiliates, including but not limited to Charles Schwab Investment Advisory, Inc., represents that any particular tax consequences will be obtained.

    Diversification, automatic investing and rebalancing strategies do not ensure a profit and do not protect against losses.

    The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

    1. Owners of tax-deferred accounts are required to realize a certain amount of ordinary taxable income every year from those accounts beginning at age 70½ for people who reached that age in 2019 or age 72 for people who reach 70½ in 2020 or after as a result of the SECURE Act signed into law at the end of 2019.. But distributions from a tax-deferred account are taxed as ordinary income, which is typically at higher tax rates than qualified dividends or long-term gains in a taxable brokerage account. That means that future RMDs from a large or growing balance in a tax-deferred account could trigger a higher tax bill than the retiree would have experienced had they taken distributions from a tax-deferred account earlier than required and smoothed out taxes over time. Depending on the size of an investor's balance in tax-deferred accounts relative to balances in taxable accounts, it might make sense to take distributions from both accounts in the same calendar year due to the preferential tax treatment of qualified dividends and long-term capital gains in the taxable accounts and to reduce future RMDs from the traditional IRA or 401(k) accounts.

    2. As taxable income increases, a growing portion of a Social Security benefit could be included as taxable income, potentially pushing an investor into a higher tax bracket. As a result, it might be helpful to consider the tax implications of current and future distributions from tax-deferred accounts to reduce the amount of Social Security taxed as well.

    3. Intelligent Income allows clients to schedule withdrawals not only annually, but also monthly, quarterly or at other frequencies depending on their needs and automatically deposits the money into an account of their choosing.

    4. The analysis uses Charles Schwab Investment Advisory, Inc. (CSIA) 2018 capital market estimates including average projected total return and investment yield for a globally diversified moderate portfolio within Schwab Intelligent Portfolios (45% stocks, 40.5% fixed income, 2% commodities, and 12.5% cash). The analysis assumes that withdrawals increase by inflation annually, using CSIA's 2018 10-year inflation projection. The analysis does not consider state and local taxes and assumes that the couple will take the standard deduction and pay taxes according to the 2019 federal income tax table. Estimates assume that current tax laws will be the same in the future; however, certain tax calculations and brackets are adjusted annually for inflation. Projected interest earned in taxable accounts is included as ordinary income along with a portion of Social Security benefits, depending on total income, and any distributions taken from the traditional IRA (including RMDs). Projected dividends earned and realized gains in taxable account are assumed to be taxes at preferential rates (i.e., qualified dividends and long-term capital gains) and cost basis used to calculate taxable gains assumes an initial basis equal to 100% that adjusts in subsequent years to account for projected investment returns and changes in account balance. Distributions from Roth's are not taxed.

    (0120-9Z0F)


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