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Author: Kevin Lao

Should I use an HSA for Retirement Planning?

"Should I use an HSA?"

In simple terms, a Health Savings Account, or “HSA,” is an account owned by an individual that can be used to pay for health care expenses, either now, or in the future.  The accounts are eligible for those who have a High Deductible Health Plan and are funded with pre-tax dollars.  If the funds are used to pay for qualified expenses, the funds can also be withdrawn tax free for those purposes.  If leveraged appropriately, it will be the most tax efficient vehicle you will utilize for retirement planning.

Why participate in a Health Savings Account?

 

Fidelity conducted a study that estimates a 65 year old couple will need $300,000 earmarked to pay for healthcare expenses.  This does not include costs for long-term care services.  $300,000 of course represents true expenses, meaning the funds used to pay for those expenses will be net of taxes.  If the bulk of your retirement savings are held in a traditional 401k or IRA, you will need close to $450,000-$500,000 in your account balance earmarked for healthcare costs alone.  Therefore, many of my clients are leveraging the HSA as part of their overall retirement planning strategy, and I’ll summarize some of the benefits in more detail below. 

1.  You recognize a tax deduction today. 

If you are single, the maximum contribution is $3,600 for 2021 ($3,650 for 2022).
If you are married and participating in a family plan for insurance, the maximum contribution is $7,200 for 2021 ($7,300 for 2022).  If you are over 55, there is a $1,000 catch up contribution available as well.  Unlike other tax efficient saving strategies, your adjusted gross income level does not phase you out of a contribution.   Also, you don’t need to worry if you itemize your deductions or take the standard deduction come tax time, all contributions will reduce your taxable income.  You will typically have the ability to make your HSA contribution before tax time.  This is helpful as you could wait until March or April before making your contribution from the previous year after you estimate what your tax liability might be.   Of course, consult with your tax advisor on federal and state tax impacts of making an HSA contribution. 

2.  Tax efficient growth

Once the contributions are made, the growth from year to year is not taxable.  Unlike a taxable brokerage account (investing in stocks/bonds/mutual funds), you will not receive a 1099 for interest or capital gains purposes.  Furthermore, the distributions are also tax free as long as they are used for qualified healthcare expenses.  Unlike a normal retirement account, you don’t have to wait until 59 1/2 to take those qualified distributions. We will cover what a qualified healthcare expense is later, but think about the tax power of this vehicle.  All other retirement vehicles that you take a tax deduction up front grows tax deferred, not tax free.  Furthermore, tax free retirement vehicles like Roth IRAs, Roth 401ks, etc., don’t allow for a tax deduction up front!  Therefore, the HSA has the best of both worlds from a tax standpoint in that it’s tax deductible, and grows tax free (as long as it’s used for qualified healthcare expenses). 

3.  Flexibility

A health savings account can be used for current medical expenses, or future medical expenses.  This means you are not required to “empty out” your HSA at the end of the year, unlike it’s cousin, the Flexible Spending Account.  This means that the HSA can be used in a year where you have abnormally high medical bills (major surgery, having a child, unexpected ER visit etc.), or can be used in future years, or better yet in your retirement years.  Furthermore, there is no limit on the timing of reimbursement.  Let’s say you had major surgery in 2021, but had some cash on hand to pay for the expenses.  Therefore, instead of taking an HSA distribution, you decided to let it compound and invest it for the long term.  Let’s say 15 years later, you needed to raise some cash.  Well, let’s say that surgery set you back $5,000 out of pocket, you could reimburse yourself for that surgery that occurred more than a decade ago.  This feature also allows you to grow the funds over time with compounding interest before reimbursing yourself.  Make sure you have a process to archive receipts, which often times can be done with your HSA provider.  The final component of flexibility is portability.  If you leave an employer, the HSA always remains with you.  You can even roll it over to a different HSA provider if your new company offers a plan that you want to participate in. 

4.  Growth opportunities

Given the ability to make contributions over your working years without the requirement of withdrawing funds, the HSA also offers an opportunity to accumulate a sizeable balance that can be used in your retirement years.  Additionally, you can even invest those unused funds in a basket of securities such as mutual funds or ETFs for even more growth opportunities.  Typically, the HSA provider will require some reserve amount that cannot be invested, let’s say $1,000.  Once you exceed the $1,000 mark, you can choose from a menu of investment options that suit your time horizon and risk tolerance. 

The tax deduction up front, the tax free growth, flexibility, and growth opportunity are all reasons why this vehicle is the most powerful vehicle you can utilize for retirement savings.  We already know healthcare is going to be a major expense during retirement, so why not get the most bang for your buck when paying for those healthcare expenses and leverage the HSA?!

 

Who is eligible?

Anyone who is not enrolled in Medicare and is enrolled in a high deductible health plan is eligible to participate in an HSA.  Most of you probably won’t worry about this, but you cannot be listed as a dependent on someone else’s tax return.  Some may view the high deductible health plan requirement as a downside, but most high deductible plans still provide your preventative care like annual physicals, child/adult immunizations, screening services and other routine check ups with little to no out of pocket charge.  The minimum annual deductible required to qualify as a high deductible is $1,400 for individual coverage and $2,800 for family coverage.  Additionally, the maximum out of pocket expense plus deductible needs to be $7,000 for individual plans or $14,000 for family coverage.  These are the basic requirements for the health insurance plan in order to be eligible for an HSA.  As you can see, the deductible may be slightly higher, but the tax benefits of the HSA contribution alone can help offset that slightly higher out of pocket cost.  Furthermore, that tax free compounded growth on your investments makes the high deductible plan worth it in many instances allowing you to build up that retirement health care nest egg. 

What are qualifying medical expenses?

The list of qualifying medical expenses is very extensive.  Chances are, anything that is non cosmetic is likely a qualified medical expense, including costs associated with dental and vision.  If the HSA distribution is deemed non-qualified, the funds are taxable and subject to a 20% penalty if you are under the age of 65.  Here is a link to a resource that provides a list of all qualified medical expenses:  CLICK HERE

Outside of the traditional list, I wanted to point out a few that might not come to mind initially.

1.  Long-term care services, and qualified Long-term Care Insurance premiums. 

This is monumental, given the likelihood of retirees needing long-term care.  The most recent statistic is 70% of those 65 and older will need some type of long-term care services during their lifetime.  On average, women receive care slightly longer at 3.7 years vs. men at 2.2 years.  Given the costs associated with long-term care, it is prudent to incorporate a plan well before you retire, whether it’s buying insurance, “self insuring,” or a combination of the two.  For those who decide to buy insurance, you can withdrawal funds from your HSA tax free to pay the premiums, as long as it’s a qualified long-term care policy.  Traditional, stand alone, long-term care policies without any cash value features are generally qualified policies, and HSA funds can be tapped to pay these premiums.  Hybrid policies, however, are a bit more complex.  These hybrid policies combine life insurance with a long-term care benefit, so if you never need long-term care services, typically your beneficiary will receive some sort of death benefit when you pass away.  These policies have historically been considered NOT qualified, and HSA funds could not be used to pay these premiums tax free.  However, companies are now identifying what is called a “separately identifiable long-term care premium,” which would be allowable as a qualified premium, and therefore HSA funds could be used in this situation.  Consult with your insurance agent and tax advisors to ensure you don’t make any mistakes here. 

If you decide not to buy insurance, or you plan on buying a small policy and “self insuring” for any additional long-term care costs, an HSA is a home run tool for this pool of dollars.  Long-term care services are in fact qualified expenses, and HSA funds can be tapped to pay these costs.  It’s estimated that a private room nursing home is upwards of $105k/year in the US (depending on where you live).  If you needed to tap $105k/year to pay into a nursing home and only had tax deferred accounts on your balance sheet, such as a 401k, you would need to make distributions in the amount of $125k-$150k/year depending on your tax bracket.  On the contrary, a $105k expense is a $105k distribution from an HSA given the tax free nature of these withdrawals.

I wrote an entire article on long-term care planning.  If you are interested in reading more, you can use the link HERE.

2.  Medicare premiums

This would apply to Medicare part B, C and D.  However, Medigap policies are not considered qualified expenses.  This is important because if you build up a substantial HSA balance, you could guarantee that you will have qualified medical expenses simply by way of being enrolled in Medicare.  Additionally, there might be years where your Medicare premiums go up based on your income (think selling a business or real estate property, Required Minimum Distributions etc.), and you can use the HSA to offset that increase in premium.

What happens to your HSA when you die?

If your spouse is named as beneficiary when you pass away, your spouse will take over and continue the tax benefits as an HSA.  Basically, there are no changes.  However, when the HSA is passed to a non spouse (adult child or other beneficiary), the account is no longer an HSA and the full balance is taxable income for that beneficiary.  Nobody has a crystal ball, but if you are building significant savings in an HSA, you might want to have a process to make regular reimbursements during retirement so you don’t create a tax windfall for your heirs.  Given the flexibility in the timing of reimbursements, you can very easily go back over the years and pay yourself for medical bills incurred in the past.  One other final disclaimer on that note.  You cannot reimburse yourself from an HSA for expenses that were incurred before that HSA was established!  If you set up an HSA in 2015, you can only reimburse yourself for expenses as long as that HSA was established (2015 and beyond). 

Final Word

Medical costs are pretty much a given, so why not take advantage of the IRS tax code and maximize your ability to pay for them now and in the future.  If you are young and healthy, I would strongly encourage the use of a high deductible health plan combined with an HSA.  If you have concerns about the higher deductible given your medical history or unique situation, simply do the math on the tax savings of making an HSA contribution vs having a slightly higher out of pocket expense for the deductible.  Most HSA providers even give you calculators to help you with that math.  However, the real power is in the ability to build up a substantial nest egg with tax free compounding and investment opportunity within the HSA.  This will allow for you to recognize some tax relief while you are working and contributing, but have another layer of tax free distributions to supplement your retirement income.  This is especially true if you no longer qualify for Roth IRA contributions or don’t have a Roth 401k/403b option available at your employer.  Even if are are closer to retirement, don’t let that discourage you.  You can still max out the HSA contribution every year, invest the funds in a well diversified portfolio, and have a decent account balance to pay healthcare costs in your retirement years. 

Be sure to consult with your tax advisors and financial planner before making any changes to your situation.  If you would like to schedule a call with me to review your situation and figure out what strategy fits in your overall plan, you can book a “Mutual Fit” meeting by clicking the button below. 

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Feeling charitable? Consider strategies that also boost your tax savings.

Tax Benefits of Charitable Giving

The Annual Report on Philanthropy from Giving USA estimates that individuals gave $324.10 billion to US charities in 2020.  This was an increase of 2.2% year over year from the 2019 report.  Despite all of the negative news the media likes to focus their attention on,  America is a very generous country.  However, I run into many people that are uncertain about how to maximize the tax impact of their charitable giving.  There are a few key points at play.  

-It’s estimated that older generations will transfer $70 trillion of wealth between 2018 and 2042 as a result of diligent savings and investing throughout their lifetimes.  
-In 2017 the Tax Cuts and Jobs Act passed, which doubled the standard deduction.  This is the amount individuals and couples can deduct automatically on their tax return.  This led to fewer people itemizing their charitable donations. 
-Finally, the SECURE Act of 2019 has increased the tax liability on qualified retirement plans that pass on to the next generation. 

As a result of all of these factors, many of my clients are interested in giving to charity during their lifetime, but at the same time finding ways it could improve their tax situation during their life as well as for their heirs.  QCD stands for Qualified Charitable Distribution, and DAF stands for Donor Advised Fund.  There are other ways to donate to charity by way of private foundations, establishing special trusts or gifting outright.  However, this article will focus on QCDs and DAFs as they are the most common solutions I see used for my clientele.  I hope you find it helpful!

Let's first talk about Required Minimum Distributions

When you turn 72, of 70 1/2 before 2020, you are required to take a portion of your qualified retirement plans as a distribution by way of the “Required Minimum Distribution,” or RMD.  The amount required is based on a life expectancy table published by the IRS.  Most individuals use the table below, unless their spouse is sole beneficiary and is more than 10 years younger.   The RMD is calculated by dividing your year end account balance as of December 31st, and simply dividing it by the Distribution Period associated with your age.  Example:  Let’s say your IRA account balance at the close of the previous year (December 31st) was $1,000,000, and you are turning 75 this year.  You will take $1,000,000 and divide it by 22.9, which gives you $43,668.12.  That is the amount you will be required to withdrawal before the year is over. 


You will notice that each year, the Distribution Period becomes smaller, and therefore the amount required to be withdrawn goes up.  If you turned 90 with a $1mm IRA, you would be required to withdrawal $87,719.30!  This equates to almost 9% of the account balance.  One exercise I will run through with my clients well before turning 72 is to calculate their projected RMD each year during retirement, and compare that to how much they will actually spend for their retirement lifestyle.  Over time, I often see the RMD increases at a much higher rate than annual spending, therefore creating a surplus in income over time.  

A common complaint I hear:  “The IRS is making me take out all of this income I don’t need!”  If you want to minimize the tax impact on unnecessary withdrawals, thoughtful planning must be introduced years before turning 72.  I often tell my clients that retirement income planning begins at least a decade before they retire in order to optimize their financial plan. 

All retirement plans including 401ks, 403bs, 457bs, other defined benefit plans and traditional IRAs have RMD requirements.  Roth IRAs do not have RMDs while the owner is alive.  Roth 401ks, however, do have RMD requirements. Therefore, many people opt to rolling over their Roth 401ks to their own Roth IRA once they have attained eligibility requirements to avoid the RMD. 

It’s critical to satisfy RMD requirements, otherwise you will be hit with a 50% penalty on the funds you did not withdrawal on time.  Example:  If your RMD amount was $50,000 and you failed to take any money out, you could be responsible to pay a penalty in the amount of $25,000!  

If you turn 72 and are actively employed, RMDs associated with their employer plan could be eligible for deferral.  Any other accounts not affiliated with that active employer will still have an RMD.  Once you separate from service from that employer, you will then begin taking RMDs based on your attained age for that year.  For your first RMD, you have the option to defer the distribution until April of the following year.  This is helpful if you expect your tax rate to go down the following year.  Just note that you will have to take two RMDs that following calendar year, one by April 1st, and the other by December 31st. 

I have some clients who wait until December to pull their RMD if they don’t have a need for the cash flow.  This way they can maximize their tax deferral and keep their funds invested as long as possible before taking the RMD.  On the other hand, if you have a need for the income to meet your expenses, you might opt to take an equal monthly installment to reduce the risk of selling out at the wrong time.  It also helps create a steady cash flow stream for budgeting purposes in retirement.  

Qualified Charitable Distribution

 

A Qualified Charitable Distribution, also known as QCD, allows for you to donate up to $100,000 of your IRA directly to a qualified 501c3 charitable organization.  The Protecting Americans from Tax Hikes (PATH) Act of 2015 has made the QCD a permanent part of the IRS code and allows you to count that distribution towards your RMD that year, but exclude it from your adjusted gross income!  The QCD must come from an IRA (traditional IRA, inherited IRA, or an inactive SEP or inactive SIMPLE IRA), it cannot come from another qualified plan like a 401k or 403b plan.  Of course, the account must also be in the RMD phase.

Example.  If your RMD is $100,000, normally you would be required to withdrawal $100,000 from the balance of your IRA and include the distribution in your gross income.  However, you could instead elect to donate up to $100,000 to a charity, or multiple charities, directly from your IRA and reduce your taxable income by up to $100,000.  Of course, the charity also receives that donation tax free as well.  This results in a significant amount of tax savings for the IRA owner and provides a larger donation to the charity of your choosing.  Also note that the $100,000 limit is annually per person.  If you are married, you would each have that $100,000 limit if you both qualify for a QCD. 

This has become increasingly more beneficial with the Tax Cuts and Jobs Act signed into law in 2017 (TCJA).  The TCJA doubled the standard deduction which for 2021 is $12,550 for single tax payers and $25,100 for married couples filing jointly.  The new law significantly reduced the number of tax payers who itemize their deductions.  Charitable donations are an itemized deduction, so if a tax payer is not itemizing their deductions, the charitable donation has zero tax impact to the tax payer.  Therefore, the QCD allows for the tax payer to essentially get a tax benefit for donating to charity without needing to itemize their deductions.   Excluding the donation from your adjusted gross income could have other tax advantages as it might reduce your Medicare premiums as well as your overall tax bracket. 

It’s important to note that the charity has to be a qualified 501c3 organization.   You cannot donate to a private foundation or a Donor Advised Fund.  However, there is no limit on the number of organizations you donate your QCD to.  Most financial institutions allow you to create a list of the organizations that you want to benefit from your donation, and they will send the checks for you directly from the IRA.

Planning Ahead

 

Many clients I serve run into what I call the tax trap of traditional IRAs and 401ks.  I wrote an article about this and you can read more about it here.  The gist is they are the victim of their own success.  They saved and invested wisely, and accumulated a bulk of their assets in tax deferred vehicles, among other assets.  At RMD age, they are forced to take distributions they may not need, thus creating a negative tax effect (higher tax brackets, higher Medicare premiums, increased social security taxes etc.).  QCDs can certainly help alleviate that tax burden for those that are charitably minded.  However, you still want to do some planning well before turning 72 to optimize your tax situation.  If you plan to donate to charity during retirement, make sure you leave some room in your tax deferred plans to make those QCDs.  On the other hand, make sure your RMD’s wont push you into higher than anticipated tax brackets or bump your Medicare premiums up substantially.   You may want to consider doing some Roth conversions, or leveraging a Roth 401k option in lieu of a Traditional 401k.  The point is, don’t be blindsided by RMD’s, but be intentional well before you begin taking those distributions so you don’t run into the tax trap!

Qualified charities do not pay taxes on distributions.  I mentioned the SECURE Act briefly and also wrote about it in more detail in the article I referenced earlier (link here).   The important thing to note is that it eliminated the inherited IRA for most non spousal beneficiaries.  Therefore, when you leave those 401ks or IRAs to your children, they will be forced to liquidate all of the funds within 10 years, accelerating taxes on those plans relative to the previous law.  This is a further validation for not only QCDs for charitable giving during lifetime, but also for naming those charities as a beneficiary for these tax deferred accounts.  Instead of leaving those assets to your children for your legacy goals, you may consider leaving other assets such as life insurance, Roth accounts, or taxable brokerage accounts that are more tax advantageous for those beneficiaries.   Again, thoughtful planning is critical to provide these opportunities before it’s too late to make any meaningful changes.

Donor Advised Funds

A Donor Advised Fund, or DAF, is an opportunity for individuals to donate cash or securities to these specified accounts, potentially recognize a tax deduction, and allow the funds to grow tax free to be used in the future for charitable giving.  Unlike donating to a specific charity outright, the DAF can benefit as many charities as the donor chooses.  Additionally, I’ve seen clients name their children as successor Donor Advisors in order to teach the next generation how to be a good steward of their dollars.  A big advantage of a DAF is the ability to front load donations.  As I mentioned earlier, many tax payers are taking the standard deduction given they don’t have itemized deductions that exceed the standard deduction amounts.  However, if you plan to donate each year for the next several years to certain charities, you might consider front loading a contribution to a DAF in order to qualify for an itemized deduction, and then spread out the actual donations over several years.  Let’s look at an example.

Brenda is married and normally donates $5k/year to a local animal rescue.  The $5k donation, along with other deductions, does not exceed $25,100 (standard deduction for married filing jointly).  Therefore, that $5k donation is meaningless from a tax standpoint.  However, Brenda will continue to donate $5k for at least the next 10 years.  She has cash savings in excess of $100,000, so she decides to donate $50k to a DAF ($5k x 10 years), which puts her over the standard deduction limit and gives her the ability to deduct that $50k donation!  Going forward, she will make a distribution from the DAF in the amount of $5k/year over the next 10 years to benefit the charity!  Additionally, she can choose to invest the dollars in the Donor Advised Fund, so she has the possibility of growing her account balance even more for her charitable goals.

The DAF also allows for contributions from appreciated assets, like stocks, bonds or mutual funds.  Let’s say you owned a stock that appreciated $100k over the original value.  This is obviously great news, but if you sold the stock, you would include that $100k in your adjusted gross income and would owe taxes.  However, if there is no need for that particular security for your retirement or other financial goals, you could donate that security to the DAF without any tax consequences.   Additionally, the DAF could sell the security and reinvest it into a more diversified portfolio without incurring any taxes either.  This is a powerful tool to utilize for those appreciated securities that don’t have a specific purpose for your own income needs. 

It’s very important to note that a DAF contribution is irrevocable.  Donors cannot access those funds except when used for donations to a qualified charity.  However, there is no time limit on when the funds need to be distributed.  Just like any charitable contribution, make sure it aligns with your financial goals and is coordinated with the rest of your financial picture.  

Conclusion

If you plan to make financial gifts to charitable organizations, make sure you consult with your tax advisor, estate attorney and of course your financial planner.  Make sure your charitable giving is coordinated with your overall plan, and also make sure you take advantage of tax benefits where possible.  There are certainly more ways than a QCD and DAF to satisfy charitable goals, so please be sure that you choose the right solution based on your unique circumstances.  If you would like to discuss your charitable giving strategy, or other financial goals, you can always start by scheduling a no obligation “Mutual Fit” meeting below to learn how to work with us.  We look forward to speaking with you!

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Stress Test Your Retirement Plan

Have you stress tested your retirement goals?

“When you retire, there are two doors in which you can walk through.  Door #1, the people outlive the money.  Door #2, the money outlives the people.  My mission is to help people walk through door #2.”  – Nick Murray

Karen and Pat had a goal to retire in 2009 at the age of 62.  They planned to take Social Security, start drawing Pat’s pension, and then supplement the difference with withdrawals from their retirement portfolio.  Who could have predicted that the Great Recession would wipe out 50% of the stock market value the year before they planned to retire?  They lost nearly 35% of their portfolio, and the decisions that followed ultimately pushed their retirement plans back 11 years!  Pat was a classic “Do-it-yourselfer” and seemed to have the financial house in order, and Karen relied on his handling of their financial affairs.  What I’ve learned is the closer major milestones become, such as retirement, the fear of loss is amplified.  The only way to mitigate the risk of loss is to have a disciplined process that can be followed during the good times, and the bad times, which would have helped Karen and Pat navigate through the Great Recession relatively unscathed. 

Since that experience, I have seen many different events play out that have derailed retirement goals.  On a more positive note, I have personally helped countless families prepare for and execute a successful retirement.  I have come to the conclusion there are 5 major financial risks that could seriously impact financial independence and put you in jeopardy of running out of money.  As part of our financial planning process, we stress test each of these risks to see how our client’s financial goals would be impacted.  The 5 stress tests are as follows: 

1.  Bear Market Risk (a 20% or more drop in the stock market)

2.  Longevity Risk (living longer than you anticipate)

3.  Inflation Risk (what if inflation is higher than we anticipate?)

4.  Prolonged Low Return Risk (experiencing lower returns than expected)

5.  Long-term Care Risk (the cost of needing custodial care later in life)

For a limited time only, we are offering a complimentary Retirement Review to stress test your retirement goals to see how we can help you on your path to financial independence.  By clicking the START HERE below, you will begin the process with a brief questionnaire.  My team will process this information and get in touch with you if we have any questions or initial thoughts.  We will then schedule a 30-45 minute Retirement Review to show you our findings to improve your probability of success.  We look forward to helping you!

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6 Stress Tests for a Bulletproof Retirement

You're invited to join us live on Thursday, September 30th @ 2pm - 3pm EST.

Free Webinar

Have you stress tested your retirement plans? If you are within 10 years of retirement, you must have a plan for the 6 “what-if” scenarios that could derail your financial goals.

The year was 2007, and my parents were all set to retire in just 12 short months. My Dad worked in IT and is a first generation American. My Mom was a preschool teacher and had no retirement benefits. She knew little about what was going on with their financial plans aside from listening to my Dad complain every time the market was down. As we now know, 2007 was the beginning of the Great Recession, which is the worst recession we’ve seen in our lifetime. Stock markets were down close to 50% and unemployment reached 10%. Like many other hard working Americans, the Great Recession of 2008 ended up pushing my parents’ retirement back 11 years. I made it my mission to help every day families prepare for the what-if scenarios when planning for retirement, including:

  • What if we go through a recession like 2008?
  • What if one, or both of us live longer than expected?
  • What if there are changes to Social Security?
  • What if market returns are lower than we anticipate?
  • What if there is higher than expected inflation?
  • What if there is a long-term care event during retirement?

These are the 6 most common concerns that keep my clients up at night.  My value proposition is to stress test each one of them and ensure their plans are bulletproof to and through retirement.  I look forward to meeting you live at our webinar.

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This is my wife, Jessica, and oldest son, Tristan. We have since welcomed twin boys to our family, Julian and Jackson!

Episode 5: What is a safe rate of withdrawal in retirement?

 

What is a safe withdrawal rate in retirement?

What is a safe rate of withdrawal in retirement

Kevin Lao 00:12

Hello everybody and welcome to the Planning for Retirement Podcast. I’m Kevin Lao [phonetic 00:15]. I’m your host. I’m also the owner of Imagine Financial Security, a fee [phonetic 00:22] only financial planning firm based here in Jacksonville and St. Augustine, Florida. Just a quick note, this is not intended to be financial advice so please consult your own advisors or financial planning needs before making any decisions on your own.

But today’s topic is super exciting for me personally because it’s super relevant especially today. But it is creating a safe withdrawal strategy or a safe withdrawal rate during retirement. And so the reason this is exciting for me is because typically folks I work with are planning for retirement or they’re recently retired and they’re trying to navigate a 20 or even 30 plus year retirement plan adjusted for inflation, which is a big concern for just about everybody now. Given the recent news, June of this year 2021, where the rate of inflation over the last 12 months has been 5.4%, the highest it’s been since August of 2008.

The 4% Rule

So naturally, people will do a little bit of research on their own, and they’ll find the 4% rule. But the problem and this is… I think a fine guideline. But the problem with it is that everybody has unique objectives. Everybody has a unique risk tolerance for their investment strategy. So the 4% rule should not be followed by everybody. And in fact if you follow the 4% rule over the last 10 years, your net worth is probably grown, which is fine if that’s your goal during retirement. But some people want to enjoy retirement, they want to spend in retirement, they want to travel, they want to gift to their grandkids, they want to pay for their college, they want to enjoy their lifestyle, they want to… they don’t want to feel like they’re just living you know paycheck to paycheck. So to speak in retirement years, they want to enjoy what they’ve accumulated. And what I’ve found is that many folks are very concerned about outliving their assets, and therefore, they kind of tighten up their spending in retirement. And so one of the things that I like to do for all of my clients is, once we’ve matched up their financial objectives and their risk tolerance and their financial goals, coming up with the rate of withdrawal [phonetic 02:25] that’s comfortable for them.

And ultimately that helps free them up to spend what they’ve worked hard to accumulate, and enjoy retirement, be happier in retirement, sleep better at night and so that’s what I’m all about. So what I’ve done is I’ve created a formula that should be followed… I think by just about everybody and every financial advisor out there. And certainly at our firm, we follow this formula. And the formula is very simple.

Our safe withdrawal rate formula

It’s financial goals plus risk tolerance minus income sources minus risk intolerance equals your rate of withdrawal. I’m going to repeat that again. Its financial goals minus income sources minus risk tolerance minus your income sources equals rate of withdrawal.

It starts with your retirement goals!

03:14

So I like this, because it starts with financial goals. And that’s what we’re all about here. Given we are a financial planning firm. First, we always start with the financial plan and the financial objectives. And so what I find is that people typically have three categories that they fall into as they retire and that’s replacing their income but preserving their principal. And this could be just for emergency purposes you know for health care costs down the road or long term care. Maybe they want to preserve a little bit you know to leave to their children or grandchildren. Maybe that’s not their primary goal. But it’d be nice to do that. But they like the security of preserving principal. But they want to say a nice withdrawal rate that still can replace their income, their pre-retirement income. So that’s the first category people typically fall into.

The second category is maximizing the wealth transfer or the legacy goal but still replacing income. Now, these are folks that… Yes, they want to replace their income but they also want to potentially grow their assets if possible over time to leave behind to their kids or grandkids maybe even a charity. So that’s another category… the second category that I find people fall into. The third category, which is really fun [laughter] in terms of working with these clients, is maximize spending and leave zero or bounce your last check so leave nothing behind. And this is obviously a little unnerving as a planner because we have to have an assumed end of plan dates meaning a certain age where they’re no longer living, and if they live past that date. We’re kind of screwed because we assume that they’re going to have zero at that point in time… so a little bit unnerving. It’s certainly something we have to kind of leave a little bit of a buffer for. But I typically find you know folks also fall into this category as well. And sometimes there’s a combination of these three categories but these financial goals are going to drive the random withdrawal.

Do you want to maximize your intergenerational wealth goals…or maximize retirement spending?

So for folks that want to maximize the legacy wealth [phonetic 05:13] transfer, their rate of withdrawal might be a little bit smaller or lower than someone who wants to maximize their spending and leave zero behind. So if we’re going to use the benchmark of 4% let’s say someone who wants to maximize the legacy and what’s left behind, they may want to err [unintelligible 05:30] at 4% or maybe even 3% a year in terms of the rate of withdrawal versus someone who wants to maximize their spending might be even closer to 5, 6, 7 or 8% a year, on average throughout the duration of retirement. Now obviously for those folks over time, what’s going to happen is your right of withdrawal is going to go up because you’re going to have fewer years to live. And so if you’re only taking a percentage of your portfolio for a year… you’re probably not going to burn through all your assets by the time you pass away.

06:01

So as you get older your right of withdrawal is going to go up obviously take into consideration, you want to have a buffer for the unexpected. But again, the financial goals are going to drive significantly the rate of withdrawal impact. But it’s not the only thing like we talked about. The second thing is the risk tolerance. Now someone who’s more conservative or concerned about market volatility is probably going to have a lower targeted withdrawal rate based on their financial objectives. Now, let’s use an example. Let’s say they want to preserve principal, okay, and they are very conservative with their investment strategy. They don’t want to see a lot of market fluctuations. And now that they have retired or they’re very close to retirement, the estimated return on a very conservative portfolio is less than 4% a year just because again, we’re now in this prolonged interest rate, low interest rate environment.

You know… yes, Powell has announced that interest rates could tick up now before 2023. But still, we’re in a very low interest rate environment, the 10 year sits right now at about 1.4% so there’s not a lot of places to get yield. So those folks that are very conservative, might only be getting 3 to 3.5% a year on average returns. So in order to preserve the principle, they should only be taking 3 to 3.5% a year as a rate of withdrawal. Conversely, as someone is more comfortable with taking risks you know maybe they’re more comfortable being in an equity position to the portfolio, maybe closer to a balanced portfolio or a 60, 40 blend, which is a very popular mix for my clients that are retired at drawing income, the estimated returns there, might be closer to 5% a year. So for those folks that want to preserve principle but are comfortable with being a little bit more aggressive in their accounts, they might be closer to that 5% a year in terms of rate of withdrawal.

Other income sources play a role…

So again, the financial goals work in conjunction with the risk tolerance in order to create that ideal withdrawal rate. Now the third part of the equation like I mentioned, let’s not forget about it, is the income sources. If you have Social Security coming in maybe also a nice pension whether it be from the military or the government or a company you work for a long period of time, you may not need a lot of money from the portfolio. So therefore you have more flexibility to figure out you know do you give this money during lifetime? Do you do some Roth conversion strategies to be more tax efficient in your legacy wealth transfer down the road? But this is a key component when figuring out the rate of withdrawal because for those folks that don’t have a pension maybe they just have social security and then their investment assets, they might need to rely a little bit more heavily on their investment portfolio to replace their income.

Okay so in essence that also might drive your risk tolerance in retirement. If you are relying solely on your investment portfolio and Social Security, you may not be very comfortable with a lot of market volatility in your investments and therefore that will drive your rate of withdrawal. On the flip side, if you have a nice pension, social security, and that’s covering a lot of your expenses… you may not be as concerned about short term volatility and therefore you might be more comfortable with taking on a little bit more risk in the portfolio.

 

09:20

Okay. And that will help potentially with that legacy wealth transfer goal that you might have, or charitable goal that you might have. Which brings me to another point I was reading an article the other day, beginning of July sometime and, the headline was at the end of this year, the first… at the end of this year’s first quarter… I’m sorry… Americans aged 70 and above had a net worth of nearly $35 trillion dollars according to the Federal Reserve data. $35 trillion of net worth for Americans ages 70 and over. There is no way Americans 70 and older are going to spend all of that money for the next however many years they live.

Okay, so there’s going to be this massive wealth transfer from now until they the baby boomers start to leave these assets to the next generation. I talked about this in an earlier podcast, the tax trap of these traditional 401ks [phonetic 09:35] and IRAs and the way they’re going to be treated now that the inherited IRAs are now going by the wayside, and there’s going to be a significant tax penalty leaving these assets behind. What I will tell you is if you have a goal to maximize your legacy transfer, and you are in this category of… you’ve accumulated more than you’ve needed for retirement, you’ve done a good job saving and investing. Be smart now from a tax standpoint… okay, a lot of the tax reform that was put in force in 2017 you know coming off the books in 2025… be smart for the next 3, 4, 5 years and do strategies with your tax plan or with your advisor to convert some of these assets into more tax efficient strategies because you know tax rates are not going down. Let’s put it that way. You know that’s… I don’t think that’s a bold prediction there. So be smart with those assets that you’ve accumulated especially in these retirement accounts… these qualified retirement accounts, 401ks, 403bs, IRAs, before tax reform rolls off the books. And frankly it could change earlier you know there’s already about you know changing those tax you know tax rates earlier than 2025.

Summary

So be smart now but again, let’s recap. Financial goals plus risk tolerance minus income sources equals a safe rate of withdrawal. I hope this is helpful for everybody. I’m happy to talk to anyone who has questions about their own situation or you know… wants to you know run something by me you can always contact me directly at [email protected]. If you like this podcast, please subscribe. Maybe even leave a review only if it’s five stars, and hopefully you can tune in for more episodes to come. Thanks, everybody.

What is a safe withdrawal rate for retirement?

What factors go into retirement withdrawal strategies?

The primary concern for just about everyone I meet with is how to retire with the same lifestyle they currently enjoy.  “Retiring” has a different meaning now than it did 20-30 years ago.  Nowadays, people retire TO something.  Whether it be to travel the world, spend time with family, volunteer, start a hobby, or work a dream job without compensation concerns.  Naturally, income replacement is the primary topic for those that are approaching retirement.  With pensions becoming less common, Social Security and income from investments have become the primary drivers to support the retirement lifestyle.  My most recent article (link here) was about Social Security and how to maximize the benefits for retirement.  Studies have shown Social Security represents approximately 40% of retiree’s income.  Therefore, I get a lot of questions on how much clients should withdraw from their portfolios to subsidize the income gap.

It depends.  There are two primary questions that we begin with to come up with the right answer.  First, what are the main spending objectives in retirement?  And second, what level of risk is acceptable?  These factors work in tandem and create many hypothetical “right answers” depending on each unique client.  This is why starting with a strategical financial plan with meaningful spending goals and meaningful stress tests is critical.  All future financial planning decisions will be influenced by these goals, which I find evolve over time.   As I continue to work with my clients, naturally new goals are added, and former goals are either accomplished or removed.  What I find is that as folks are approaching retirement, we typically focus on the “needs.”  Once they start to experience retirement and feel the plan is working, they can begin to relax and think more about their wish-list goals.

I want to clarify two housekeeping items first that are very important.  First, there are a number of “what-if” scenarios that can impact anyone’s retirement. We could have a beautifully designed income plan that is completely wiped away from a significant healthcare or long-term care expense.  I wrote about four of the stress-tests I run for my clients as they plan for retirement here.  This article, however, will be focused solely on navigating a safe withdrawal rate, all else being equal.  Second, I want to change the method of thinking from a safe withdrawal percentage to a safe withdrawal dollar figure.  Using a safe withdrawal dollar figure ensures that the client’s spending goals can be achieved throughout their life (adjusted for inflation), regardless of short term swings in the market.  I have found this method of withdrawals, known as a flexible withdrawal strategy, resonates with clients as they sleep better at night knowing they have a set income each month.  In order to accomplish this, or any prudent income plan for that matter, we must have a defined distribution process to avoid a big mistake.  I once met a client that had a dozen or so securities in his portfolio, and was selling his investments pro rata to meet his income needs.  This is often a default method for big brokerage firms, but not a prudent distribution process.  The reason being it will just about guarantee you are selling certain securities at the wrong time each distribution you make.  Having a prudent distribution process is a critical assumption when we begin the stress tests, as a big mistake can completely negate years or even decades of growth.  With that being said, I will reference withdrawal rates as an average percentage over the life expectancy of a plan, but understand they will fluctuate each year in practice.

Most people I meet with have one of the following primary income goals for retirement:

  1. Replace income to maintain their current lifestyle, but without depleting the principal of their investments.
  2. Replace income, but with the goal to maximize the legacy transfer to the next generations, or to charity.
  3. Maximize spending and die penniless.

Replace income without depleting principal

I find most people strive for this in retirement, mainly because of the psychological benefits it provides.  If you are burning through your principal in your early years, you might naturally have concerns about running out of money.  I had a client I worked with years ago that was consistently needing about 8%-10% of the portfolio each year to supplement his Social Security.  Each time we had market volatility, it was pretty much guaranteed I would get a call from him in a panic.  Over the years, his portfolio was consistently declining in value.  I kept reminding him that his burn rate was too high, but instead of looking at his own expenses, he blamed performance despite wanting to have a relatively safe portfolio.  Conversely, my clients that are in a sweet spot for distributions don’t panic when we go through bouts of volatility.  They are out enjoying retirement knowing we have a solid process and plan in place, which is my goal when I take on a new client. 

In order to accomplish principal preservation while drawing income, we must first understand the objectives for income and the risk capacity for each individual.  I started working with a client a few years ago that had a solid nest egg built up for retirement and wanted to see how to maintain her principal while replacing her pre-retirement income.  However, she was in the mindset (like many folks approaching retirement) of making the portfolio ultra conservative before this transition period.  After running some hypothetical scenarios, I showed her the results of our models.  Looking at the illustration below, the results on the left show a moderate risk portfolio, which as you can see falls in the green zone, or the Confidence Zone.  On the right, we modeled the impact of moving to a conservative risk.  As you can see, becoming more conservative causes this plan to fall below the green zone, or Confidence Zone, which is not ideal.   In some situations, clients that have saved more than enough for retirement can afford to reduce risk without jeopardizing the longevity of their plan.  However, in other situations like the one below, one might need to maintain some risk in the portfolio in order to achieve their income goals and maintain principal over time.  It’s critical to find that sweet spot of portfolio risk when implementing your distribution plan.

Why does reducing risk impact the probability of success negatively for this client?  The reason is somewhat simple.  Given the prolonged low interest rate environment we are still in, the more conservative investments are not yielding much in the way of annual returns.  Therefore, the expected returns annually from a more conservative portfolio are going to be lower than a portfolio taking on a reasonable amount of risk.  This resulted in a conversation of her wanting to maintain some risk in the portfolio so she didn’t have to worry about going through her nest egg too quickly.  After all, she does have longevity in her family and we could be planning for a 30+ year retirement!

I have found that in general, if someone is more conservative, the average withdrawal rate needed to preserve principal will be in the range of 3%-4%/year.  If a client is comfortable with some risk, 4%-5.5%/year can achieve the goal of income and principal preservation.  Finally, someone who is comfortable with a significant amount of risk may even be able to get away with 6%/year or perhaps higher in average withdrawals.  Inherently, the more risk one takes, the less probable the outcome is.  I typically find folks that want to take on more risk will fall into the next category of replacing income but also maximizing legacy. 

Replace Income but maximize legacy

For those who are looking to maximize legacy, of course we need to first make sure their income goals are taken care of.  Once we have tested all possible outcomes and have a solid baseline average of withdrawals, we can then determine how this will impact their legacy objectives.   Naturally, the lower the withdrawal rate the better.  Sometimes, clients may only need 2%-3%/year from the portfolio.  If they are generating an average of 5%/year in returns, this will allow them to grow their net worth over time and potentially keep pace with inflation.  However, in other situations folks still need a reasonable amount of withdrawals to meet their spending goals.  In any event, I will outline three strategies below to help with maximizing returns while drawing down retirement income. 

  1. Asset location strategy
  2. Spending strategy
  3. Tax efficiency

Asset Location is a buzz term used in our industry, but many clients I speak with don’t fully grasp what this means as they are more familiar with the term asset allocation.  Asset allocation is the method in which you determine what percentage of your net worth is dedicated to a variety of asset classes to create the properly diversified investment strategy.  Asset location is more specific on what asset classes you would own based on the different types of accounts you have.  I’ll give you an example.  I am working with a client who has one  Traditional IRA  (which is tax deferred) and another account that is a  non-qualified brokerage account (which is taxable each year).  We strategically own the tax efficient investments in the taxable account, and the tax inefficient investments in the IRA.  This makes sense because the more tax efficient an investment is, the less in taxes you would pay on that particular investment.  It’s like the old saying, “it’s not what you earn, it’s what you keep.”  In this case, it’s not what her before tax rate of return is, it’s her after tax rate of return.  Having an efficient asset location strategy can help with maximizing retirement income simply by taking a holistic view on what investments you should own in each type of account you have.

Having a spending strategy may feel like a given, but rarely do I hear people talk about this the right way.  Many folks focus solely on what percentage of the account they can reasonably draw down.  However, in order to maximize long term performance while drawing retirement income, you have to be strategic based on the timing of withdrawals.  Let me explain.  I have another couple I work with that has three buckets of accounts.   One is a non-qualified brokerage account, the next are Traditional IRA’s, and finally they each have a ROTH IRA.  Sequentially, most experts would agree that you should tap your brokerage account first, your IRA second and your ROTH IRA last.  The reason is to maximize your after tax income as you’ve already paid taxes on the cost basis for that non-qualified brokerage account.  Once you turn age 72, you will then be forced to make withdrawals on your Traditional IRA or 401ks.  For your ROTH IRA, you won’t ever have mandatory withdrawals and they will be tax free if/when you do take money out (as long as they are considered qualified withdrawals).  Therefore, we are taking the most risk in their ROTH IRAs, and the least amount of risk in their non-qualified brokerage account.  By using this approach, we will experience less volatility on the account they are likely to withdrawal in the short term (brokerage account), and will be able to maximize the growth potential on the accounts they won’t be tapping into until longer term, if ever (ROTH IRA’s).  I have found this approach works more effectively than incorporating a singular investment strategy across all accounts.

I talked a lot about tax efficiency in a previous article called the Tax Trap of Traditional 401ks and IRAs here.  This goes hand and hand with a smart spending strategy.  If you want to live a nice lifestyle but also maximize your legacy goals, consider what accounts are more or less tax efficient for that wealth transfer goal.  With the new rules around the elimination of the stretch IRA, leaving your Traditional IRA or 401k to your children is not as tax friendly as it was before The SECURE Act was passed.  Therefore, spend those during retirement and consider leaving the ROTH IRAs (if you have one) or even non-qualified brokerage accounts as your legacy assets.  Currently, non-qualified accounts have the benefit of a step up in cost basis upon the owner’s passing, although this is currently in the cross hairs in Washington to potentially eliminate.  However, under the current rules, a non-qualified account is a great tool to use for those wealth transfer goals.  Therefore, you may want to try to preserve these assets more during retirement and increase spending on those traditional 401ks or IRAs.  Another tool you could add to your arsenal, if you don’t have it already, is a permanent life insurance policy.  This works beautifully with several clients I work with where legacy is an important objective.  It allows for them to leverage the death benefit, which is passed on tax free, while only paying a relatively nominal premium while they are living.  One theme I hear from these folks is there is a psychological benefit in knowing you have something that is guaranteed to pass along to the next generation regardless of what the stock market brings.  It also gives them freedom to spend their retirement accounts without guilt knowing this legacy goal is taken care of by the insurance. 

With all of this in mind, these strategies should apply to all three types of clients who are preparing for retirement.  Those who want to spend income and preserve principal, those who want to generate retirement income and maximize inheritance, and those who want to spend it all while they are living.  All prudent retirement plans should employ these three tactics.  By not following a disciplined plan, the margin for error increases dramatically and the more prone the plan is to risk of failure.

Max spending with no inheritance

For the client who wants to maximize spending without leaving any inheritance, it can sometimes be unnerving as a financial advisor.  However, we start with the same process of unpacking the goals and stress testing those goals based on the income sources and risk tolerance.  The challenge is to figure out a scenario where the withdrawal rate in their last year of life is nearly 100%.  Obviously, I say this tongue-in-cheek as that would involve knowing exactly how long the client will live.  However, we will use our best guess based on longevity in their family history and our life expectancy calculators.  Once we see how much cash can be raised from the portfolio, I will show the client the withdrawal rates over time, assuming an average expected return.  Let’s take a look at this client below.  She doesn’t have children and wants to spend it all while she’s alive.  There are some charities she could leave it to, but she will probably give them money during her retirement years, especially when Required Minimum Distributions kick in.  So, we went towards the path of max spending and dying without any assets left. 

For this client, you can see the withdrawal rates start around 6%-10%/year the first 4 years.  At age 70 she will begin taking Social Security and the withdrawal rate goes down a bit.  However, looking into her late 80s and 90s, you can see how the withdrawal rates ramp up and at the last year of life expectancy, she is taking out nearly 100% of the portfolio balance.  Obviously, you can see the reason this is unnerving.  What if she lives longer than 94? What if there is a long-term care need or major healthcare expense?  What if we have lower than expected average returns?  What about inflation?  All of these stress tests failed miserably in this type of scenario.  Therefore, after sharing these results and discussing the potential risks, we backed down the rate of withdrawal slightly to create a buffer for those unexpected events.  The good news is, I will continue to revisit this with her and track our progress as time goes on.  If we run into some challenging conditions, we can have that discussion about trimming the withdrawal rate.  Conversely, if we are going through periods of significant growth, we can potentially spend more or gift more in those years.  I find this is a nice balance between maximizing spending, but also not doing something that will impact her ability to be financially independent.  Nobody wants to be a burden on others!

In summary, withdrawal rates are not static in our world.  We need to be dynamic to adjust to the cash needs of our clients.  Additionally, the withdrawal rates will be driven by the primary goals of the client, the income sources available to achieve those goals, and the capacity for risk.  This formula will bring to light what a reasonable amount of income that can be taken from the portfolio would be, adjusted for inflation over time.  There is not one right answer, and it’s important to take all of your financial planning considerations, tax considerations and investment considerations before making any decisions.

My firm specializes in this type of planning and we are happy to help you prepare for retirement. You can schedule a no obligation initial consultation here, or by giving us a call at 904-323-2069.

I hope everyone enjoyed the article.  Follow us on Facebook and LinkedIn for updates and resources. 

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Episode 4: Maximizing Social Security Benefits for Retirement

 

Maximizing Social Security in Retirement

Maximizing Social Security Benefits for Retirement

Kevin Lao 00:12

Hey everybody welcome to the Planning for Retirement Podcast. I’m Kevin Lao, your host. Social Security is a big topic nowadays especially because people are living longer and pensions are pretty much going by the wayside. And I oftentimes get the question from clients you know… Kevin, when should I take Social Security to maximize my benefit? And so I decided to do this podcast today to address that question but also to challenge the traditional method of thinking with regards to claiming Social Security benefits. And so I hope everyone finds this helpful today. If you like what you hear, please subscribe to our podcast. And be sure to tune in for more episodes to come. So let’s dive in.

Is Social Security In Trouble?

So I hear a lot of things about people talking about Social Security being bankrupt by the time 2041 comes around. And you know I definitely understand that concern you know there’s a projection that’s been done, where if there’s no changes that happen, so security is set to run a deficit by that year. But you know obviously what’s going to happen is they’re going to change the way benefits are paid, they may means test it, they might change the ages in which you can start drawing Social Security, they also very likely might raise taxes to pay for the Social Security deficits. So there’s a lot of things that are likely to be done well before 2041. But the reality is social Security represents 40% of all retirement income for individuals aged 65 and older. So it’s naturally a very important part of the plan when I am working with clients to figure out you know what is the proper funding strategy and using social security?

There is no RIGHT or WRONG answer, because we don’t know the exact life expectancy

So what I will first say is there’s no right answer to this. And you know I typically joke with clients and say if you have a crystal ball and tell me exactly when you’re going to pass away I can tell you exactly when to don’t [phonetic 02:08] draw Social Security. And you know if you look at life expectancies, and you know, people living longer and you look at maybe your own genetics, your own health, the natural breakeven point that people think about is… Well Kevin, if I delay Social Security, what is the point in which I will breakeven? Meaning I will be receiving more in cumulative benefits than if I were to draw Social Security at my full retirement age? So I’ll answer that question. But what just for those of you that don’t know social security, your full retirement age will vary between age 65 and 67, it depends on when your year of birth is. And you can look that up by doing a Google search or going on the IRS website or social security.gov, ssa.gov. You can early… you can draw Social Security early at 62. And then you can also delay Social Security until 67. So if you take it at 62, your benefits probably going to be about 35 to 40% lower per month. And if you were to take it at your full retirement age and if you delay it until 70… your benefit increases about 8% per year after you hit full retirement age. So for example, if your full retirement age is 66 and you delay it until 70… you can increase your Social Security benefit by 8% a year for roughly four years, and essentially at 70… You will receive your maximum Social Security benefit possible.

What’s the break even for delaying Social Security?

03:41

So again, the natural inclination is for people to think about taking Social Security at 70 in lieu of full retirement age or of course, early retirement age. And the reason is because many financial professionals are pundits on the media, they talk about delaying until 70 because you’re going to get the most bang for your buck. So the breakeven point that I was referring to earlier usually happens around 82 to 83. So if you retire at 66, and you decide to say… hey you know what, I’m going to delay my Social Security until 70. By the time you hit 82, 83, you would have received more and cumulative benefits by delaying it until 70 than if you were to take it at your full retirement age. So again, I go back to the crystal ball, if you think… hey you know I’m very likely to live longer than 82 or 83. I have longevity in my family. I’m healthy, I keep in shape, you know, by all means. That is one method of thinking is to say… Hey, your maximum benefit lifetime is going to be recognized by deferring Social Security until 70. So that addresses the first. Again, this is the… what I would call the traditional method of thinking when it comes to drawing Social Security. But there are two other things to think about when drawing Social Security at your full retirement age or early or late and I want to address that next…

Consider longevity in your family history

Alright, the second thing I want you to consider outside of longevity when deciding on when to take Social Security is your required withdrawal rate from your investments. So what I mean by that is if you retire at let’s say 65, and you would like to not take Social Security, you’re more than likely going to have to take some sort of withdrawal from your retirement accounts whether that be a 401k or an IRA or an investment portfolio unless you have a really nice pension that’s going to take care of most of your expenses. But if you’re like most people that I talked to, they don’t have a pension or the pensions may be really small. And they’re going to need to take some money out of their investments, whether it’s retirement or non-retirement accounts to meet their living expenses.

How does delaying Social Security impact your safe rate of withdrawal in retirement?

05:51

So what you need to do is figure out how much income you need to maintain a standard of living that you’re comfortable with. And you’re going to need to figure out how much you need to withdraw from your portfolio in order to meet that need. And again, if you’re not taking Social Security, most if not all, of your income is going to be coming from your investment portfolio. And so if you’re required to withdrawal rate by delaying Social Security is let’s say 7% a year or 8% a year or 9% a year, it’s going to be very difficult to maintain that rate of return in your investment portfolio to meet that required withdrawal rate. So in essence, what’s going to happen in those early years in retirement is you’re going to be depleting your principal early on, which I would argue is a big risk for clients that are… are planning to live in long retirement or long life in retirement simply for the fact that you’re going to deplete your liquidity over time. And if you need that liquidity down the road for health care expenses or long term care costs, which are rising at an extremely rapid rate that’s something you really… really want to consider again, the impact of delaying that Social Security.

Let’s say your withdrawal rate is much lower even by delaying your Social Security let’s say it’s only 3% or 4% a year then by all means certainly consider delaying that social security payment because your required withdrawal rate is within what I would call a safe withdrawal rate, anything less than maybe 4.5%, 5% if you’re a little bit more aggressive. But 4, 4.5% is a safe withdrawal rate. So again, think about your required rate of withdrawal. And if it’s unacceptable, meaning it’s outside of that safe withdrawal rate, you might want to consider taking Social Security upon your retirement whether that’s at 62 or 64 or 65 or your full retirement age, take that Social Security because ultimately what that’s going to do, it’s going to reduce your required withdrawal rate from the portfolio to preserve those assets long return.

 

Especially if you are concerned about your health or longevity, you may not think you’re going to live longer than 82 or 83… you can always pass your portfolio on to your beneficiaries. You can’t pass security on to your beneficiaries. Now I know there’s rules if you’re married you know your spouse can take either their benefit or your benefit but I’m talking about an inheritance can be achieved through your investment portfolio cannot be achieved through passing on a Social Security benefit. So hopefully that is helpful in helping you make that decision of do you take it on time? Do you wait until seven years you take it early? Because many times people think well if I delay it till 70… I’m going to maximize my benefit. And ultimately they don’t realize their burn rate on the portfolio is going to severely deplete their assets over time, which can then impact your legacy goals as well as liquidity on their balance sheet to pay for those unexpected expenses in their old age.

Will you ever rely on Social Security?

08:58

Another thing to consider when making this decision is whether or not you need social security at all for income. So what I mean by that is if you are retired and you do have a pension or investment income or real estate income and it turns out your required withdrawal rate is 0% from Social Security. So, so many people will think that… hey you know what the natural reaction is to delay social security because they don’t need the income. So might as well get the best bang for your buck or the highest bang for your buck by deferring it until 70. Now I do want to challenge that method of thinking because the alternative to delaying it until 70 is actually taking Social Security on time or even early and using that income not for your expenses but to invest in the market long term.

Claim Social Security and invest it!

So by doing so, the benefit there is you actually build up this liquidity on your balance sheet that otherwise wouldn’t be there because you’re not taking social security income… you don’t have that surplus cash flow coming into the picture. So you’re building up this liquidity on your balance sheet to either a, use to pass this on as a legacy to your to the next generation or your beneficiaries or b, use for unexpected expenses you know like medical costs or long term care expenses or c, just use for return you know whether it’s travel or big ticket items that come up like home renovations or maybe it’s a major purchase like a boat or a second home or rental home. So I did a calculation on this one. And I wanted to see… well, if someone took social security let’s say at 65 and they retired at 65 and they took that income and just simply invested it at let’s say 5% a year. And another situation they took it at 70 and invested at 5% a year, what would the difference be in the portfolio? what I found is that the break-even point happens somewhere around 91 or 92 meaning that you would have to live at least until 92 to have a larger investment portfolio by taking such security at 70 and reinvesting that cash flow every single month earning 5% a year versus if you took it at 65. So in other words, for about 25 years, you’re much better off taking it at 65. And investing the difference because you’re going to have more assets on your balance sheet to use for unexpected expenses or pass on a legacy if you don’t make it until 91 or 92 like a lot of people. So again take this into consideration even if you don’t need so security don’t automatically think… hey, I’m going to delay it until 70. Because what you could do is take the Social Security now put it away, get it diversified, invested for the long haul, and use this as an asset and leverage on your balance sheet for the long term.

Summary

I hope you all learned something today and feel better prepared for the social security decision. Remember, there are many tax investment and planning considerations unique to each situation so please consult your own advisors before moving forward. I have a financial planning firm here in Florida and we can help with this. We serve clients here locally and also remotely across the country. So if you’re interested in speaking with me about your situation, you can contact me directly at [email protected] or you can go to our website and book a meeting at www.imaginedfinancialsecurity.com. Thanks everyone for tuning in. Until next time…

 

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