I've just started with Pralana and posted a question under "feedback". Charlie's response suggested that I post something to this forum as perhaps someone else has run into the same issue as I. Attached for reference is most of Charlie's response - really a suggestion as to how to quantify the exposure. Here's my question:
If things go according to plan, I will have enough money when I die that my children will have a nice inheritance. Currently most of my equities are in my taxable account and most of my fixed income in qualified accounts (I have a small amount in Roth). My question revolves around how to optimize a withdrawal strategy (which account to withdraw from and when) that takes into account the fact that if my kids inherit equities, they will enjoy a step up basis and therefore zero capital gains will be owed. Conventional wisdom is that I hold onto my Roth and then Qualified accounts as they growth tax free as long as possible - which means liquidating taxable accounts as a priority. In fact this is what Pralana suggests - reducing taxable account first, then qualified and then Roth (if ever). But that strategy would leave less equities for the inheritance, and therefore less capital gain thereby increasing total taxes paid (either by me, my estate or my kids). And just to be clear, I'm not talking about when I die but my wife is still alive - Pralana does account for step up basis there.
So has anyone modeled this scenario before? Would it be helpful for Pralana to include such this consideration or is there a workaround that someone has developed?
Thanks all. BTW great program for long term strategy. I kinda wish it could be better at the tactical stuff (short term - what to do this year and next). To do this, you'd need account by account, investment by investment level detail which is not the focus of the program at the moment.
Not following the logic:
".In fact this is what Pralana suggests - reducing taxable account first, then qualified and then Roth (if ever). But that strategy would leave less equities for the inheritance,"
Not sure what you are envisioning. It sounds like you are conflating the account type with the asset type. But whatever account types you have, you should generally be holding your overall stock/bond asset allocation constant unless you have a life change that disturbs it. With a constant asset allocation, I don't see your concern.
The factor that drives a lot of what Pralana finds is tax drag in taxable. The $ you pay in taxes can't compound any further and it's that compounding that we want. Strategies that minimize taxable dividends are long term winners, and that means maximizing tax-preferenced accounts and keeping stocks instead of bonds in taxable. Of course, the lumps and bumps in the tax code and ACA premiums can mean deviations from this are possible and that's why we are glad to have a powerhouse tool like Pralana.
Pralana's evaluation stops at your death, but if we include the post-death 10 year period for withdrawing IRAs inherited from you, then Pralana's calculated benefit for withdrawing from taxable first, then tax deferred and finally Roth is understated if your heirs save the money as there are 10 more years for tax drag to act.
After the last spouse passes, your heirs have to start taking inherited IRA RMDs. Assuming your heirs are thrifty and don't blow all the dough, then the money comes out of the IRA evenly each year and winds up in their taxable accounts, accumulating tax drag and Pralana does not see that. To account for this in Pralana, increase the Effective Tax Rate above what you expect your heirs will face by about 2 percentage points if the assets are stocks and 3.2% if they are bonds.
Taxable accounts see the most tax drag per starting $ as the whole amount sits in taxable for the entire 10 year distribution period for the inherited IRA and of course Roth accounts don't have any tax drag for those 10 years.
The post-death tax drag for the taxable account is about 3% of the taxable account size at death if your heirs keep it as all stocks and a whopping 9% if it is all bonds. The same math can be applied to evaluate the change in tax drag in taxable when doing Roth Conversions, with one modification. Instead of 3%-9% of the taxable account value at death, use 3%-9% of the difference between the taxable account values in the No Roth Conversion case and the Roth Conversion case.
Richard - thanks for the reply - you bring up very good points. Keeping my asset allocations constant over time, even as I draw down the taxable accounts first, results in increased equities in my qualified and Roth accounts. Which in itself sound tax inefficient since there would be ever smaller amount of stocks in my taxable account and therefore benefits from a step up basis. My premise is that the tax free nature of equities passing through my estate is worth a lot more than the effect of maintaining constant asset allocation - but I'd love to test that out. And yes, my assumption is that my kids will indeed be able to save the money - they are each currently financially in good shape.
I guess I'm playing off the benefits of taking capital gains (lowest tax drag) for myself against the long term benefits of passing on equities to my kids. OR in the case I don't need to withdraw much from my taxable account, playing off Roth conversion (reduction of 22% tax bracket today and compounding tax free until death) against passing equities to my kids (15% capital gains). Was just looking for a way to simulate all this.
Mechanically I'm not sure how to extend the analysis an additional 10 years - past death. Nor do I understand the basis for your 3 - 9% rates. Perhaps you could explain.
For the post-death period, I took the balances at death with my planned Roth Conversion and without and made a spreadsheet showing the evolution of that 10 years. I assumed a tax rate for the heirs, which happened to be at least 22% just because of the inherited IRA withdrawals. I did a goal seek on the amount of withdrawal needed for the inherited IRA each year to draw it down in 10 years and took the estimated taxes from that, putting the residual in taxable. I set up taxes on the taxable account similar to what Pralana would do (bond dividend is ordinary income, stocks have mostly LTCGs and qualified dividends.
When you do Roth Conversions and pay taxes from taxable, you end up shrinking taxable throughout your life (because you puffed up your Roth balance) so taxable was quite a bit smaller by the time of our assumed death age. That shrunken taxable then generated less tax drag for 10 years. The shrunken inherited IRA that returned to taxable also had less tax drag in taxable for about 5 years.
I'd never looked at that before and Pralana doesn't cover it (for good reason, it involves projecting other people's future and estate situations can be even more complex than the income tax code). Anyway, it was a cool result and now kind of wish I had done conversions in cases where Pralana found only slight benefits.
Of course if your kids blow it all on trips to Vegas, jet skis and first class travel, then the post-death tax drag won't show up.
Interesting. I support the idea of having some basic inheritance projections options in Pralana, using some assumptions and users’ input. The tool may have 3 optional goals:
- Maximize end-of-life saving (the current goal (default)).
- Maximize inheritance after 10 years of death.
- Maximize consumption by death.
In the short to intermediate term, I think Charlie's plate is full building out Online.
I'm not sure how much of a quagmire it is to get into estate issues, but you are right that some insight into the extended tax implications on heirs would help folks decide on whether to do some conversions. It only recently occurred to me to do this analysis and frankly I was surprised that it was fairly important. I had been erring on the side of not converting if the math only showed small improvements, but those small improvements would grow to be not-so-small if I had looked at the whole 10 year IRA withdrawal timeframe, so I might have pursued conversions more aggressively if I had looked into it sooner. I still (hopefully) have some more years to work on conversions, but the tax drag reduction becomes most significant if you start early.
