Try this out on your fin advisor. If they can't answer these questions, have them run MaxiFi before providing you financial advice. Or, like tens of thousands, run it yourself!
"With inflation running at 2.5 percent and mid-length Treasuries yielding around 4.5 percent, Ethel’s real return is 2 percent, which she can secure by investing in inflation-indexed bonds — TIPS (Treasury Inflation Protected Securities)."
Can Ethel secure her real after-tax return using TIPS?
First consider the brokerage account: Suppose she’s in a 25% tax bracket. If inflation runs at zero then her nominal pre-tax return is 2% and she pays tax of 25% of that, she has a net return of 1.5% over inflation. But if inflation runs at 50%, her nominal pre-tax return is 52%, and she pays 25% of that, or 13%, in taxes, so her net after tax return is 39% - well behind the inflation rate.
The IRA account is a bit better, but unless it’s a Roth, you still have the problem that when the money is withdrawn, it gets taxed, and the tax is based on the nominal return on the TIPS, not the real return. So if inflation is very high, the real after-tax return can easily be negative.
Does MaxiFi take this into account, or does MaxiFi simply assume the inflation rate remains fixed at whatever rate the user puts in – 2.5% in the example?
Hi Larry. That wasn't the question. The question was whether MaxiFi assumes the inflation rate is fixed for the indefinite future (in which case Ethel can lock in her real after-tax return using TIPS) or whether MaxiFi assumes some stochastic path of future inflation (in which case Ethel cannot lock in her real after-tax return using TIPS).
Because with zero dollars allocated for bequests, discretionary spending is 71K, if 100K allocated for bequests, discretionary spending is 34K. Therefore the cost for 100K bequest is the reduced (delta) discretionary spending between the 2 options you are comparing, not the absolute value of the bequest option.
$71K is the lifetime delta, not the annual discretionary spending with zero dollars allocated to bequests.
Ethel can sustainably spend $34.3K each year if $100K is allocated for bequests. But if she forgoes the bequests, then she can spend an additional $71,185 over the course of her remaining lifetime, "reflecting an increase of $3,449 in annual real discretionary spending." So without the bequest, Ethel can sustainably spend $37.8K each year. Ethel is forgoing $71K lifetime real spending in order to bequest $100K.
I guess what is actually interesting is how the $71K is calculated. An annual delta of $3,449 times 25 years would be $86,225. I'm guessing that a time-discounting factor (of about delta = 0.984) is applied.
"With inflation running at 2.5 percent and mid-length Treasuries yielding around 4.5 percent, Ethel’s real return is 2 percent, which she can secure by investing in inflation-indexed bonds — TIPS (Treasury Inflation Protected Securities)."
Can Ethel secure her real after-tax return using TIPS?
First consider the brokerage account: Suppose she’s in a 25% tax bracket. If inflation runs at zero then her nominal pre-tax return is 2% and she pays tax of 25% of that, she has a net return of 1.5% over inflation. But if inflation runs at 50%, her nominal pre-tax return is 52%, and she pays 25% of that, or 13%, in taxes, so her net after tax return is 39% - well behind the inflation rate.
The IRA account is a bit better, but unless it’s a Roth, you still have the problem that when the money is withdrawn, it gets taxed, and the tax is based on the nominal return on the TIPS, not the real return. So if inflation is very high, the real after-tax return can easily be negative.
Does MaxiFi take this into account, or does MaxiFi simply assume the inflation rate remains fixed at whatever rate the user puts in – 2.5% in the example?
Hi Gary, Yes, MaxiFi fully accounts for the taxation of phantom income in all but Roth accounts. best, Larry
Hi Larry. That wasn't the question. The question was whether MaxiFi assumes the inflation rate is fixed for the indefinite future (in which case Ethel can lock in her real after-tax return using TIPS) or whether MaxiFi assumes some stochastic path of future inflation (in which case Ethel cannot lock in her real after-tax return using TIPS).
In my experience, it is fixed. You can make one change.
“ One way to view these results is that the $100K terminal bequest costs Ethel $71 cents on the dollar.”
Isn't the bequest cost 71K minus 34K?
Don't follow. Why subtract $34K from the $71K? best, Larry
Because with zero dollars allocated for bequests, discretionary spending is 71K, if 100K allocated for bequests, discretionary spending is 34K. Therefore the cost for 100K bequest is the reduced (delta) discretionary spending between the 2 options you are comparing, not the absolute value of the bequest option.
$71K is the lifetime delta, not the annual discretionary spending with zero dollars allocated to bequests.
Ethel can sustainably spend $34.3K each year if $100K is allocated for bequests. But if she forgoes the bequests, then she can spend an additional $71,185 over the course of her remaining lifetime, "reflecting an increase of $3,449 in annual real discretionary spending." So without the bequest, Ethel can sustainably spend $37.8K each year. Ethel is forgoing $71K lifetime real spending in order to bequest $100K.
I guess what is actually interesting is how the $71K is calculated. An annual delta of $3,449 times 25 years would be $86,225. I'm guessing that a time-discounting factor (of about delta = 0.984) is applied.