Financial myth:  The bigger the pile of money you accumulate, the greater your spendable income.

John has done everything 'right'.  He's taken advantage of a tax-deferred 401(k), and has taken enough risk to merit above average returns.  He's sitting on top of a mountain of $2 million at retirement.  John's twin sister Sarah, on the other hand, paid her taxes as she went and shied away from anything remotely risky.  She has $1 million in a tax-exempt account.  John is fond of reminding his sister that she could have had twice the retirement if she had followed his advice.  Is he right?     

Of course you know that’s a trick question, or I wouldn’t be asking it.  The real answer is, it depends.  You see, traditional planning can work wonderfully well right up until the day you need it, when the very things that propelled you to the top of the mountain – volatility and deferred income taxes -- can turn viciously against you.

Has anyone explained to you the “safe withdrawal rate” from a balanced portfolio of stocks and bonds?  The safe withdrawal rate is the percentage of your retirement-date balance you can withdraw every year in retirement and still expect to have a dollar left at the end of 30 years.  A safe withdrawal rate of 4% on a $2 million portfolio would mean $80,000 a year in retirement income. 

Morningstar, the premier research firm in the financial industry, published a white paper in 2013 showing that a 4% withdrawal rate gives you a 50/50 chance of running out of money in retirement.  For a 90% chance of not running out of money, your safe withdrawal rate is 2.8%.  One of the authors of that study, Wade Pfau, published a follow-up in 2015 concluding that if you’re paying a 1% management fee, you really should reduce that withdrawal to 2.1%. 

Follow my reasoning here.  If you’re paying a 1% management fee (very common within the industry), your manager is costing you 25% of your retirement income.  If John wants a 90% chance of landing safely on the far side of retirement, he can safely withdraw $42,000 a year from his $2 million.  

Sarah, on the other hand, has a safe withdrawal rate of 6% on her tax-exempt account.  That’s because there’s no volatility, no taxes, and her balance grows compounded every year.  Sarah can safely withdraw $60,000 from her account.  And unlike John, her Social Security benefits are never taxed and her Medicare premiums are always the lowest possible.

Now let's follow the numbers.  John has $2 million, Sarah $1 million, and they each have a Social Security benefit of $40,000.  If John withdraws 4% ($80,000) and his effective tax rate is 12%, he wins with a net $100,320 to Sarah's $100,000.  Should he take less than 4%, he loses.  Should taxes rise above 12%, he loses.  Should his effective tax rate rise to 20%, he nets $91,200 to Sarah's $100,000.  He loses.  At 40%, he nets $68,400 to her $100,000.  He loses.  Should he invest in the S&P 500 and it repeats the pattern of the past 21 years, he loses half his $2 million in three years.  Recovery will be difficult, if not impossible.  Need I say it?

Now that you understand some of the problems associated with a traditional retirement plan, would you rather have $2 million in a tax-deferred account, or $1 million in a tax-exempt account?  

This hypothetical example is used for illustrative purposes only and is not representative of actual results