Kevin Lao, Author at Imagine Financial Security

Using the Guardrail Withdrawal Strategy to Increase Retirement Income

What is a safe withdrawal rate for retirement?

There will be ongoing debates on what a safe withdrawal rate is for retirees. It’s the Holy Grail of retirement planning. After all, wouldn’t it be nice to know EXACTLY how much you could withdraw from your portfolio, and most importantly, for how long? Unfortunately, there isn’t a one-size-fits-all solution. The most popular research in this arena is Bill Bengen’s “Determining Withdrawal Rates Using Historical Data,” which coined the “4% Rule.” However, what if you need more than 4%/year to enjoy retirement? Or, what if you want to spend more early in retirement while you still can? Or, perhaps you can make other adjustments over time to improve outcomes. This is where the Guardrail Withdrawal Strategy, or a dynamic spending plan, really helps retirees’ incomes.

In Michael Stein’s book, “The Prosperous Retirement,” he categorizes retirement into the following three phases:

“Go-go years”
“Slow-go years”
“No-go years”

The idea is that spending tends to go up in the first phase of retirement, and then continues to go down as we age. Sure, healthcare costs could go up later in retirement, but not at the same rate that discretionary spending goes down.

Another example where adjustments to spending occur is during a recession or bear market, like in 2020. Spending was down significantly due to global lockdowns, and for retirees, this meant a significant drop in travel expenses.

On the other hand, some years might require higher spending because of unexpected medical expenses or home repairs.

The point is, life isn’t a linear path, so why should your retirement income plan be?

Justin Fitzpatrick, the co-founder of Income Lab, and I talked about retirees’ spending powers in “Episode 14 of The Planning for Retirement Podcast.” Those of us who specialize in retirement income are familiar with the Guardrail Withdrawal Strategy. This involves setting a specified rate of withdrawal but understanding when to pivot during good and bad times.

In this article, we will discuss the background of the 4% rule and its impact on retirement planning. We will also review some of the drawbacks of the 4% rule when implementing it in practice. And finally, we will discuss the Guardrail Withdrawal Strategy, and how it can improve retirement income by simply allowing for fluidity in withdrawals.

Let’s dive in!

The 4% rule

Bill Bengen was a rocket scientist who received his BS from MIT in aeronautics and astronautics. After 17 years of working for his family-owned business, he moved to California and began as a fee-only financial planner. He couldn’t find any meaningful studies to showcase what a safe withdrawal rate in retirement would be. So, he began his own research and discovered the 4% rule, or “SAFEMAX” rule.

He looked at historical rates of return and calculated how long a portfolio would last given a specified withdrawal rate and portfolio asset allocation. In layman’s terms, he figured out how much could reasonably be withdrawn from a portfolio, and for how long. This helped solve the #1 burning question for pre-retirees; “Will I outlive the money? Or, will the money outlive me?”

The Findings

There is a ton of amazing detail in Bill’s research, the most famous being the 4% rule. The main takeaway is if a portfolio withdrawal rate was 4% in the first year and adjusted for inflation each year thereafter, the worst-case scenario was a portfolio that lasted 33 years. This worst-case scenario was a retiree who began withdrawals in the year 1968, right before two recessions and hyperinflation. This confirms that the timing of retirement is important but completely uncontrollable!

The hypothetical portfolio within the 4% rule consisted of a 50% allocation in US Large Cap Stocks and 50% in US Treasuries.

Bill later acknowledged that adding more asset classes and increasing stock exposure would increase the SAFEMAX rates. For example, adding small-cap and micro-cap stocks increases the SAFEMAX to 4.7%!

The downsides of using the 4% rule in practice

First and foremost, I must first acknowledge that Bill Bengen’s research has made a huge impact on the retirement planning industry, and certainly in my practice personally. Every planner who focuses on retirement knows who Bill Bengen is and knows about the 4% rule.

One common mistake is most people assume the 4% rule means multiplying the portfolio each year by 4%, thus providing the withdrawal rate. Instead, 4% is the FIRST year’s rate of withdrawal. Each subsequent year, the dollars taken out of the portfolio will adjust for that year’s inflation rate. Let’s look at an example.

Let’s say you have $1mm saved. If we used the 4% rule, your first withdrawal would be $40k (4% x $1mm). In year 2, assuming inflation was 3%, the withdrawal would be $41,200 ($40k + 3% or $40k x 1.03). Well, what if year 2 involved a steep drop in your portfolio value? If you retired in 2008, and your portfolio dropped by 35%, the rate of withdrawal in year 2 would equal 6.33% ($41,200/$650k).

What about the mix of stocks and bonds?

Some clients are more risk-averse than others. However, most people assume the entire study was based on a 50/50 stock and bond allocation. This is TRUE for the 4% rule, or SAFEMAX, but he also ran scenarios based on all types of allocations. He discovered that 50% is the minimum optimal exposure to stocks. However, he found that the closer you get to 75%, the more it will increase your SAFEMAX. So, in addition to adding more asset classes, as mentioned above, increasing your percentage of stock ownership could also increase the safe withdrawal rate.

Word of caution: increasing your stock exposure could certainly increase your rate of withdrawal, but it will also increase the volatility and the risk of loss in your portfolio.

This is where “risk capacity” comes into play. The more risk capacity you have, the more inclined you might be to take on more risk. The inverse is also true.

The 4% rule is also based on the worst-case scenario of historical rates of return and inflation.

The majority of the time, stocks have positive returns (80% of the time). But, what if you pick the worst year to retire, like 1968? This was a perfect storm of bear market stock performance combined with high inflation (sound familiar?). So, does that mean you should plan for the worst-case scenario? If you do, in most of the trials within Bengen’s research, the portfolios lasted well beyond 50 years resulting in a significant surplus in assets at death.

In fact, he cited that many investors did very well with a 7% withdrawal rate! My goal is to encourage my clients to ENJOY retirement, not worry about the worst that could happen!

How much of your retirement income are you willing to sacrifice just to prepare for the worst-case scenario? After all, $70,000/year is a heck of a lot more than $40,000/year from the same $1mm portfolio.

What about the impact of tax planning?

Bill Bengen’s study assumed the entire portfolio was invested in a tax-deferred IRA or 401k plan. This means that all income coming out of the portfolio was taxed at ordinary income rates! But what about those who have brokerage accounts with favorable capital gains treatment? Or better yet, what about Health Savings Accounts or Roth IRAs? These accounts have TAX-FREE withdrawals assuming they are qualified!

If smart tax planning is implemented, this could also enhance retirement income!

If you are like many of the clients we work with, the majority of your retirement savings likely consists of pre-tax 401ks and IRAs (aka “tax deferred” accounts). You might be wondering if you should take advantage of the Roth conversion strategy to improve tax efficiency during retirement. You can read more about that topic in a previous post (link here).

Sometimes, if you have a period of time with very low taxes (typically in the first 5-10 years of retirement), you can be aggressive with this strategy and significantly save on taxes in retirement and Medicare surcharges (aka “IRMAA”).

Do retirees' expenses increase with inflation?

Another challenge of the 4% rule is the assumption that spending continues to increase at the pace of inflation each year. But what about later in retirement when travel slows down? Or, perhaps you sell the RV after years of exploring the national parks. Wouldn’t discretionary spending go down, thus resulting in a lower rate of withdrawal?

According to Michael Stein and his research, he cites that retirees go through three life stages

Go-go years
Slow-go years
No-go years

In the Go-go years, spending may actually go up slightly due to the simple fact that you have more free time! You’re able to take several big trips a year, visit the grandkids often, and so on.

In the Slow-go years, expenses go down a bit and also tend to increase at a slower pace than the consumer price index. During this phase, spending can drop up to 25% and increase at a slower pace than the Consumer Price Index.

In the No-go years, spending continues to drop with the exception of the healthcare category. Healthcare expenses tend to increase in the No-go years, but proper planning can help mitigate these costs.

If we assume a static spending level and therefore a reduced SAFEMAX, this could mean clients would potentially miss out on more spending in the “Go-go years” in order to have a surplus of available spending later in retirement!

Of course, we need to have a plan to address longevity and inflation risk, as well as a plan for unexpected healthcare expenses, such as Long-term care. However, if we have those contingencies in place, I’m all for spending more early in retirement while good health is on your side.

Social Security and other income sources aren't counted

Finally, the 4% rule never accounted for a reduction of portfolio withdrawals due to claiming Social Security or other retirement income.

Let’s say you plan to retire at age 60 and delay Social Security until 70 in order to collect the largest possible benefit. Your portfolio withdrawals in the first 10 years might be 30% or even 40% higher until you begin collecting Social Security!

The 4% rule does not account for those adjustments, and therefore will result in far less spending early on.

Word of caution. Accommodating for a higher than optimal withdrawal rate for an extended period of time, like 10 years, requires significant due diligence and risk management! A downturn during this period puts your portfolio at much greater risk, so ensure proper contingencies are in place if we go through a “Black Swan” event.

What is the Guardrail Withdrawal Strategy?

At a high level, the Guardrail Withdrawal Strategy allows for adjustments based on economic and market conditions. For simplicity purposes, this means reducing or increasing spending ONLY if a withdrawal rate guardrail is passed.

If you picture a railroad track, the initial target is the dead center of the track. We will then set “guardrails” on each side (positive and negative) to ensure we stay on track and make an adjustment to spending ONLY if we cross over the guardrail.

The guardrails we like to use involve an increase or decrease in the rate of withdrawal by 20% before a change needs to be made. If the rate of withdrawal crosses over the 20% threshold, either spending goes down 10% (Capital Preservation Rule) or up 10% (Prosperity Rule).

Let’s say we started with a rate of withdrawal of 5%; the lower guardrail would be 4% and the upper guardrail would be 6%. Due to market conditions outlined earlier in 2008, let’s say that caused us to pass the upper guardrail of 6%.

This would result would trigger the Capital Preservation Rule and the client would reduce their spending by 10% during that year.

Conversely, let’s say in 2021 the lower guardrail was hit given the extreme overperformance by stocks. This would result in the Prosperity Rule and spending increasing by 10% the following year.

This research was back-tested for a retiree who began withdrawals in 1973, which hit the perfect storm of high inflation and bear market returns. Despite these challenges, the maximum initial rate of withdrawal for a retiree that year was 5.8%! (assuming the portfolio was allocated to 65% in equities and 35% in fixed income). Increasing the stock exposure to 80% increased the initial rate of withdrawal to 6.2%!

Key factors to consider when implementing the guardrail withdrawal strategy

Risk tolerance

A client’s tolerance for risk will impact the “tightness” of the guardrails as well as exposure to stocks in the portfolio.

If a client is extremely risk-averse, perhaps you set “tighter” guardrails. This will increase the number of adjustments needed over time, but it could provide some peace of mind to the client. Additionally, reducing the stock exposure close to 50% (or in some cases lower) reduces volatility in the portfolio, but will also reduce the initial rate of withdrawal.

Conversely, if a client wants to achieve a higher rate of withdrawal (or income) and is comfortable with volatility in the market, up to 80% exposure to stocks could very well be appropriate. Additionally, you could widen the guardrails in order to limit the number of adjustments in spending.

What is the desire to leave a financial legacy?

The desire to leave a financial legacy is one of the major factors when considering the initial rate of withdrawal. If this is a high-priority goal, reducing the initial withdrawal rate could certainly improve the ultimate legacy amount.

On the other hand, if leaving a financial legacy isn’t a big priority, allowing for a much higher initial withdrawal rate is a viable option.

This is also where certain insurance products could be considered. For many, using a well-diversified investment portfolio with systematic withdrawals is more than appropriate. Fixed income would be used to protect withdrawals in a bear market, and stocks would be used as income during bull markets.

However, maybe having a guaranteed income stream is important to a client. In that case, consider purchasing a fixed annuity. One positive to rates increasing is that these annuity payout rates have also increased. I’ve seen quotes recently between 6%-8%/year. Many of the rate quotes, however, will not adjust for inflation. But if structured properly, this could be a nice solution to create an “income floor” over and above Social Security income.

For those of you who have a strong desire to leave a financial legacy, perhaps purchasing a life insurance policy could solve this challenge. In essence, this creates a legacy floor that can free you up to enjoy your retirement assets!

Finally, for those who have major concerns about Long-term care expenses down the road, purchasing Long-term Care Insurance could create some peace of mind. That way, the retirement income for the surviving spouse and/or legacy goals aren’t completely destroyed by a Long-term Care event.

Key takeaways and final word

There is no one size fits all retirement income plan. The 4% rule, the Guardrail Strategy, and the spending stages, all tie in differently based on your personal goals, risk tolerance, and financial situation.

Here are some key takeaways:

The 4% rule is a sound benchmark, but following it may result in a significant surplus of unspent retirement capital over a normal life expectancy
Retirement spending isn’t static, and using the Guardrail Withdrawal Strategy can ultimately improve your retirement income by allowing for flexibility in spending
Successful withdrawal rates have ranged anywhere from 4%/year to 7%/year
Risk tolerance and risk capacity drive the guardrail ranges as well as the exposure to equities in the portfolio
Personal goals and risk factors further determine what the initial safe withdrawal rate should be
Insurance products can help increase peace of mind and protect retirement income streams

We hope you enjoyed this article!

If you are curious about how you might incorporate guardrails into your retirement withdrawal strategy, we’d love to hear from you! You can use the button below to schedule a “Mutual Fit” meeting directly with me.

Make sure to subscribe to our newsletter so you don’t miss out on any of our retirement planning content.

Last but not least, share this with someone you know who is approaching retirement!

Thanks for reading!

Kevin Lao

February 7, 2023

Podcast

Ep. 15 – 2023 Market Outlook

2023 Market Outlook

2022 was a tough year for both stocks and bonds. In fact, it was perhaps the worst year for a 60/40 portfolio, period. For retirees and pre-retirees, this makes income planning very difficult! How do you combat record inflation when both stocks and bonds are falling? Additionally, the risk in stocks is likely not over as the fed continues its rate hike strategy, and a recession is likely.

The good news is, there are opportunities for retirement investors! Tune in to hear more about our key opportunities for 2023.

-Yield is back in fixed income

-The value vs. growth story

-International stocks time to shine?

-Bucketing strategy!

Kevin Lao

January 31, 2023

2022 Market Recap and Opportunities for 2023

As we start 2023, it’s important for us to take some time to reflect on this past year before turning the page.
That way, we can bring in the new year with a fresh perspective on where the opportunities are.
In addition to investment opportunities, the SECURE Act 2.0 passed in December, which brings about some exciting tax and retirement planning strategies.
Let’s start with a recap of 2022!

2022 Was a Tough Year for Investors

We started out 2022 with record-high inflation at 7.5%, but the Fed Funds rate was still at 0%. In order to respond to the COVID-19 pandemic in 2020, the Feds not only cut interest rates but also injected mass amounts of stimulus into the economy. The more money in people’s hands, the more inflation you get. Additionally, unemployment skyrocketed in the short-term following temporary layoffs in 2020, but those workers were largely seasonal and got their jobs back later in 2020 and early 2021. Many worked remotely and never skipped a beat. As a result of record stimulus coupled with historically low unemployment, inflation began to persist in the summer of 2021. Instead of the Fed acting at that point (potentially increasing rates and/or reducing their balance sheet), they insisted that inflation was transitory and that it would be short-lived. After several months of PERSISTENT inflation, the Fed announced its strategy for 2022: Rate Hikes and Quantitative Tightening (reducing the assets on the Fed’s balance sheet).

Meanwhile, Russia invades Ukraine, which is of course a tragedy simply due to the unnecessary loss of life. Financially, this sent an energy shortage throughout Europe and Asia that impacted the global economy (and fuels MORE inflation).

And finally, the second largest economy in the world, China, continued its improbable journey to a zero-tolerance policy for COVID-19.

In essence, the biggest global economies in the world each had their own economic headwinds to deal with, which has now led us to where we are today.

After raising rates by 4.25% in 2022, the Fed feels like its work is starting to pay off. However, Jay Powell believes more work needs to be done and needs “substantially more evidence” that inflation is abating. Therefore, we should expect to see more rate hikes this year, but not as steep. This year, the market is pricing in two 25 basis point rate hikes which will bring the Fed funds target to nearly 5%.

The ongoing conflict in Ukraine as well as China’s rocky start to “reopening” will not help the fight against inflation. Additionally, unemployment FELL in December to 3.5% from 3.6% in November. Wage growth also remains above historical averages at 5.8% given the tight labor market.

Therefore, despite further rate hikes, inflation might remain above the Fed’s goal of 2% for quite some time.

For some positive news of 2022, let’s remember that the pandemic has brought about a tough 2 1/2 years. But finally, it looks like everyone is moving forward into the new “post-pandemic normal.”

Asset Class Returns 2008 - 2022

Here is a summary of the asset class returns from 2008 – 2022. For your reference, here is some clarification on some of the acronyms:

“Comdty.” = commodities
“EM Equity” = emerging markets
“DM Equity” – developed markets (excluding US)
“Asset Alloc.” = 60% equity / 40% fixed income portfolio

2022 was a tough year. All of the major asset classes were negative, and mostly by double digits. However, looking at the past 15 years since 2008, a 60/40 portfolio (“asset alloc.”) returned 6.1%/year, and Large Cap US Stocks returned close to 9%/year! I would argue the last 15 years the market has outperformed its historical average, so it’s not unreasonable to think we might have a down year (or two). After all, when we have a long-term investment strategy, we are signing for up occasional volatility. However, the only way to guarantee not getting to your destination is by bailing out of your long-term plan.

Despite these factors, here are the opportunities we see for 2023 and beyond. Additionally, the SECURE Act 2.0 passed in December of 2022 and brings about new tax planning opportunities for retirees and pre-retirees. We’ll discuss all of this below.

Yield is Back in Fixed Income

Since 2008, we have seen rate cuts to historic lows, which remained unnecessarily low for too long. As a result, yields on bonds were paying next to nothing, unless you were willing to take on substantial risk. As a result, you were lucky to earn 2% on an investment-grade portfolio over the last decade. Now that rates have skyrocketed, we are seeing yields on bonds push past the 4% and even the 5% range! At the beginning of 2022, I talked about the risk of rate hikes on existing bond portfolios. For this reason (among others), we elected to stay short term in duration within the fixed income positions for our clients. This didn’t eliminate the volatility within bonds, but it reduced the price risk substantially and paid off well. Now that these bonds are maturing, we have an opportunity to reinvest at the highest rates we’ve seen since before the global financial crisis in 2008.

For retirees out there, this is a great opportunity to take advantage of purchasing bonds that can not only act as a stabilizer from equity volatility but provide meaningful returns for retirement income. After all, inflation is expected to abate, which could lead to an intermediate to long-term term bond strategy outpacing inflation by 2% or even 3% per year!

I wrote about 4 bear market income strategies in my last article where I also discussed the value of a bond ladder as part of a retirement income plan. Given the expectation that rates are likely not to remain this high for very long, the next 1-3 years will be a great opportunity to add duration and yield to your fixed-income portfolios.

I might add that shorter-term bonds are yielding higher coupon payments than longer-term bonds. As of today, the 2-year treasury is yielding 4.157%, compared to the 10-year treasury yielding only 3.449%. This means that the market is pricing in rate decreases over the next few years. As we mentioned earlier, bond prices go down when rates go up. The opposite is true when rates go down, bond prices go up. This means that fixed-income investors will not only benefit from higher yields but might also benefit from potential appreciation if/when bond prices do go up.

Value Stocks vs. Growth Stocks

With all of the talk about how great yields are on bonds and how poorly stocks did in 2022, we love the outlook for stocks over the next 5 years. The question is, what kind of stocks will outperform? Well, being an advocate for a well-diversified portfolio, we won’t be taking any big bets on any one asset class. However, we talked about overweighting toward value stocks in 2022, and we think the same for 2023.

Companies that rely on leverage for growth typically reap the rewards of the low-rate environment we saw since the Great Recession. Therefore, the “growth” sectors within equities outperformed for much of the last decade. Towards the end of 2021, we talked about the risk of being overexposed to growth-oriented stocks (tech stocks, consumer cyclical stocks) during a rising rate environment. Just think about it; the more expensive debt becomes, the tougher it is for these companies to borrow at the pace they need for growth.

Instead, we liked value stocks to be overweight in the portfolio, as investors would flock to safety during volatile times (think dividend-oriented, cash-flow healthy companies).

Growth stocks took the biggest hit in 2022 and lost about 30%. Some of the biggest names in tech were down even more.

Google (GOOG): -39.1%
Amazon (AMZN): -49.6%
Tesla (TSLA): -65%
Facebook (META): – 65%
Netflix (NFLX): -50%

On the contrary, value stocks were down only 6% in 2022.

We do believe there is more volatility ahead, as corporate earnings might disappoint in the first half of 2023. However, when stocks take a big hit like this, it’s a buying opportunity, NOT a selling opportunity. As we re-balanced portfolios in 2022 and at the beginning of 2023, we were buying stocks, not selling! And if history is an indicator, after we hit bear markets, the performance of stocks tends to be very promising in the years ahead. After all, bear markets typically experience a -37% decline, but bull markets experience a 209% increase, on average!

Don't ignore International Stocks!

International stocks have been underperforming relative to US stocks for over a decade. However, international companies have looked relatively cheap for quite some time now. These stocks were set to outperform in 2020 until COVID-19 shut down the global economy. International stocks have taken a bigger hit since the pandemic but outperformed US stocks in the second half of 2022. With cheap valuations, a stronger outlook for growth relative to the US, and a strong dollar, it’s important NOT to ignore international exposure within your portfolio. For our clients, we are focusing on quality companies with steady cash flows and strong balance sheets, very similar to the story for the US sectors. Additionally, we are limiting our exposure to companies that are owned by foreign governments, as they create additional geopolitical risk.

Of course, there are still significant risks with China’s reopening, as well as the Russian invasion of Ukraine. These factors could certainly create lots of volatility for the asset class, which is why US stocks will continue to remain the majority asset class within our equity portfolios.

For you historians out there, the chart below shows international stocks outperformed much of the 70s and 80s during hyperinflation. I’m not suggesting this will be the same story, but a prudent investment strategy will certainly incorporate international stocks going forward.

Bottom Line

Stocks and bonds both declining at a double-digit pace is unprecedented. However, staying diversified and disciplined served our clients well in 2022 and will serve them even better when things begin to recover.

It’s important to always start with “why.” Why are you investing?

For our clients, it starts with a financial plan which includes their personalized goals, risk tolerance, and financial assets.

Each investment strategy is tailored to its goals and involves a process to stay on track for those goals. It’s extremely dangerous to try to guess or time the market, as it’s virtually impossible to do consistently over time.

SECURE Act 2.0 Highlights

The Setting Every Community Up for Retirement Enhancement (SECURE) Act was passed in 2019 and went into effect on January 1^st of 2020. The SECURE Act 2.0 was officially passed in December 2022. Some aspects go into effect in 2023, whereas others will go into effect in the years to come. We will focus on the SECURE Act 2.0 and the major changes we believe will impact retirees and pre-retirees.

Changes in Required Minimum Distributions

Required Minimum Distributions, or RMDs, is the amount required to be taken out of a qualified retirement plan once the beginning date starts. Before the SECURE Act of 2019 was passed, the RMD beginning date was the year in which you turned 70 1/2 . However, for those who had not yet turned 70 ½ as of January 1^st 2020, the new RMD beginning date was the year in which you turned 72.

The SECURE Act 2.0 now pushes the beginning date back further. The table below illustrates the beginning date based on your year of birth.

The amount required for the distribution is based on the IRS life expectancy table. For most participants, the Uniform Lifetime Table will be used. If your spouse is more than 10 years younger, you can use what is called the “Joint Life Expectancy Table.” There is also a single life expectancy for stretch IRAs (no longer allowed after 2020).

For illustrative purposes, let’s take a look at the Uniform Lifetime Table below, which also shows the corresponding percentage and dollar amount required to be taken from a $1,000,000 retirement account.

As you can see, for a 72-year-old, the account balance is divided by 27.4 (the divisor balance), which is equal to $36,496.35 (or roughly 3.65% of the account balance).

You will notice the RMD goes up over time. This is because there are fewer years of life expectancy remaining. By the time a retiree reaches 80, the RMD is approximately 5% of the portfolio.

Uniform Lifetime Table
Age	Divisor Balance	% of Account	RMD for a $1,000,000 retirement account
70	29.1	3.44%	$ 34,364.26
71	28.2	3.55%	$ 35,460.99
72	27.4	3.65%	$ 36,496.35
73	26.5	3.78%	$ 37,735.85
74	25.5	3.93%	$ 39,215.69
75	24.6	4.07%	$ 40,650.41
76	23.7	4.22%	$ 42,194.09
77	22.9	4.37%	$ 43,668.12
78	22	4.55%	$ 45,454.55
79	21.1	4.74%	$ 47,393.36
80	20.2	4.96%	$ 49,504.95
81	19.4	5.16%	$ 51,546.39
82	18.5	5.41%	$ 54,054.05
83	17.7	5.65%	$ 56,497.18
84	16.8	5.96%	$ 59,523.81
85	16	6.25%	$ 62,500.00
86	15.2	6.58%	$ 65,789.47
87	14.4	6.95%	$ 69,444.44
88	13.7	7.30%	$ 72,992.70
89	12.9	7.76%	$ 77,519.38
90	12.2	8.20%	$ 81,967.21

For those of you turning 72 in 2023, you were probably planning to have your beginning date start this year. However, this new legislation is in effect NOW, so your beginning date is 2024 when you turn 73! Happy Birthday to those born in 1951!

The next group of individuals born in 1960 or later will have a beginning date of the year they turn 75.

For the first RMD only, you can delay the distribution until April 1^st of the following year.

For example, you turn 73 in 2024 (born in 1951). You can either take your first RMD in the calendar year of 2024 OR take that RMD by April 1^st of 2025. Just remember, if you decide to delay until April 1^st, you will have TWO RMD’s for 2025 (one for 2024, and one for 2025). However, this is helpful if your taxable income will drop substantially after your beginning date due to retirement or other reasons.

Planning opportunities for RMDs

First and foremost, SECURE Act 2.0 gives account owners more time until they are required to start taking RMDs. For many of you, you might be dreading RMDs as you might not NEED those distributions for income. Perhaps your Social Security, Pension, and other investment income is more than enough to live your lifestyle. Therefore, RMDs are more of a tax liability than anything else.

For some, considering a Roth conversion strategy could be advantageous.

Consider someone who is retiring at 62, and their earned income goes to 0. Perhaps they plan to live on their investment assets until reaching 70 (their Latest Retirement Age for maximum Social Security benefits). Assuming the beginning date is the year in which they turn 75, they have 13 years of potentially low income.

Therefore, instead of continuing to defer their retirement account balances until 75, one might consider converting portions of those existing tax-deferred account balances for the next 13 years. Yes, a Roth conversion would trigger taxes now based on the amount converted, but this also reduces the calculation for the RMD each year. Roth IRAs do not have RMDs, and distributions from Roth IRAs are tax-free (assuming they are qualified). Therefore, this could result in tax savings beginning at age 75, and could potentially last for 20+ years based on one’s life expectancy. I wrote an article on Roth conversions and if you should consider them that you can read here.

Another positive change is the elimination of the RMD from Roth 401ks and other Roth-qualified retirement plans. In the past, ONLY Roth IRAs were excluded from RMD calculations. Beginning in 2024, qualified plans with Roth balances will NOT be required to take an RMD.

Qualified Charitable Distributions (QCDs)

QCDs are a great tool for those over the age of 70 ½ and are charitably minded. For 2023, the limit for a QCD is still $100,000, which means you can gift up to that amount from your Traditional IRA to a charity without paying taxes. However, this limit will begin to index with inflation beginning in 2024 (finally!). The initial $100,000 limit was set in 2001, so it’s about time they began to increase the amount allowed.

This works extremely well if you are already taking RMDs, as that income is not counted towards your Adjusted Gross Income. Instead, it’s an above-the-line deduction regardless if you itemize or take the standard deduction.

Example: Susan typically donates $10,000/year to her favorite animal shelter, which operates as a 501(c)3 charity. However, her total itemized deductions don’t exceed the standard deduction for her and her spouse, which is $27,700 for 2023. Therefore, she technically does not receive any tax incentive for donating the $10,000. Last year, she turned 72, so she now has an RMD of $50,000 in 2023. Instead of taking the $50,000 as income, paying taxes, and writing a $10k check to the animal shelter, she elects to do a $10k QCD. The QCD form is filled out through the custodian, and the custodian will write the check directly to the charity. Now, her RMD is only $40,000 (instead of the full $50k). The net result is a reduction in taxable income of $10,000, and the standard deduction is still in effect! Win-win!

There is a provision in SECURE Act 2.0 that allows for a $50,000 one-time contribution to fund a Charitable Remainder Trust (CRUT or CRAT). Most individuals funding Charitable Remainder Trusts are funding them with much larger increments, as essentially you are giving away those assets to a charity, in exchange for a lifetime income and a generous tax deduction. In most cases, $50,000 is not going to provide very much in the way of lifetime income, and that asset is no longer available on the balance sheet.

Therefore, QCDs are mostly unchanged with the exception of inflation adjustments, but keep in mind the Charitable Trust strategy as it could come into play for some charitably minded individuals.

Roth SIMPLE IRAs and Roth SEP IRAs

Traditionally, these small business retirement plans could only be funded with pre-tax dollars. With the SECURE Act 2.0, these businesses can now allow for Roth contributions for both SIMPLE IRAs and SEP IRAs. This will be effective immediately starting in 2023. However, I’m expecting some challenges and delays from the custodians of these accounts given the need to update forms, processes, and procedures.

Just remember, a ROTH contribution into a SEP or SIMPLE IRA is non deductible, but can benefit from tax-free growth. A Traditional (pre-tax) contribution into a SEP or SIMPLE IRA is deductible and grows tax deferred.

The driver of what kind of contribution to make is based on what your current tax bracket is vs. what it might be in retirement (any crystal balls?). If you are in a high tax bracket today and don’t plan to be during retirement, you might benefit from Traditional SEP contributions that are deductible. If you are tax neutral or you might be in a higher tax bracket in retirement, you might benefit from tax-free growth (Roth contributions).

If you have no idea, perhaps you should consider contacting a fiduciary financial planner and/or tax professional. (or just split it 50/50!)

529 Rollovers to a Roth IRA

Yes, you read this correctly! Parents tell me all the time that they are worried about overfunding their child’s 529 because their kid is going to be the next Mark Zuckerberg, drop out of college and become a billionaire. So, what about those dollars that are left inside the 529?

Most parents (and grandparents) will just liquidate the account and pay taxes and/or penalties, or simply let the account sit there indefinitely. Beginning in 2024, 529 plans that have unused funds can be rolled over into a Roth IRA. However, it’s NOT too good to be true as there are hoops you need to jump through.

The Roth IRA receiving the rollover must be the same beneficiary as the 529 plan
The 529 plan must be open for at least 15 years
Contributions to the 529 within the last 5 years, and earnings on those contributions, are ineligible for rollover
The annual limit for how much can be moved to the Roth IRA is the same as Roth IRA contribution limits (not including contributions directly made to the Roth IRA)
The lifetime maximum that can be moved from a 529 plan to a Roth IRA is $35,000

If your child is the beneficiary, this would mean you would have to rollover their 529 balance to a Roth IRA in THEIR name. However, could the rule allow for a change of beneficiary to name either you or your spouse, then proceed with a rollover to a Roth IRA in one of your names? And if so, does that reset the 15-year clock?

The law is unclear about this, but it should be addressed by the IRS before it comes into effect in 2024. Until then, just know there is a potential solution for these unused 529 funds over time, and is perhaps one of the most interesting developments with the SECURE Act 2.0!

Spouses who inherit IRAs

The current law allows spouses to;

Rollover the IRA into their own IRA
Elect to treat the decedent’s IRA as their own
Or simply remain as the beneficiary of the IRA

Beginning in 2024, the SECURE Act 2.0 will now allow for the surviving spouse to essentially treat the IRA as if they were the deceased spouse.

This could be beneficial if the surviving spouse is older than the deceased spouse, as they could potentially delay RMDs for longer. Additionally, if the surviving spouse passes away before the initial owner would have reached RMD age, their beneficiary would have some flexibility with the 10-year rule.

IRA and 401k Plan Catch-up Contributions

When you are over the age of 50, you are eligible for “catch-up” contributions. IRA catch-up contributions have been $1,000 for 15 years! Finally, they will be indexed for inflation, I guess in response to record-high inflation all around. Makes sense to me!

This will begin in 2024, and adjustments will be made in increments of $100.

Starting in 2025, SECURE Act 2.0 will allow for additional catch-up contributions for certain qualified plan participants. Those who are 60-63 have their plan catch-up contribution limit increased to the greater of $10,000, or 150% of the regular catch-up contribution. This limit applies to plans like 401ks, 403bs, 457bs, and TSP accounts.

SIMPLE IRA participants ages 60-63 also have their catch-up contributions increased to $5,000 or 150% of the regular catch-up contribution.

Catch up contributions for high income earners

Starting in 2024, catch-up contributions for workers with wages over $145,000 during the previous year will be automatically characterized as Roth contributions, not traditional. There are several key planning considerations with this change.

There are income phaseouts that ultimately eliminate participation in a Roth IRA for individuals (for 2023, a single filer is phased out at $153,000, and married filing jointly at $228,000). Given 401k catch up contributions have NO income phaseouts, this is a BENEFIT to some 401k/403b participants who prefer Roth contributions over Traditional
1. If a participant between the age of 60-63 prefers Roth contributions, they could in essence max out approximately $41,250 into Roth accounts starting in 2025!
  1. $22,500 for Roth 401k/403b (regular deferral max)
  2. +$11,250 catch up contribution for ages 60-63 (new catch up limit beginning in 2025)
  3. +$7,500 Roth IRA contribution or backdoor Roth IRA contribution (if done properly)
If the plan does NOT allow for Roth contributions (which are becoming less and less common), then the catch-up contributions will be pre-tax instead.

Some higher income earners might actually PREFER traditional (pre-tax) contributions, especially those who believe their tax bracket will go down in retirement.

We still need clarity on a few provisions within this section, so stay tuned as we get closer to 2024!

Final word

There are many investment and tax planning opportunities in the years ahead, it makes me excited to serve our clients!

It has been a tough couple of years, and many of you might be wondering if you should be making adjustments to your portfolio. Or, perhaps you have an advisor that focuses mostly on investments and not retirement and/or tax planning.

We will be accepting 12 more clients for 2023, and we would be more than happy to see if you are a good fit to work with us (and vice versa). Feel free to schedule a “Mutual Fit” Zoom Call using the link below.

Also, make sure to subscribe to our newsletter to get our latest insights delivered to your inbox.

Until next time!

Sources:

https://www.schwab.com/learn/story/fixed-income-outlook

https://am.jpmorgan.com/us/en/asset-management/protected/adv/insights/market-insights/guide-to-the-markets/economic-and-market-update/

https://www.schwabassetmanagement.com/content/quarterly-chartbook-video?segment=advisor&mkt_tok=MTUzLUhSWS0xOTQAAAGJRvqWZCYGXBuEWVz_t_XSlK7BQxQAOMXvT6fTv83rV-gsKVFRoHkDUz6kKLN0Dr2XVP1hu2NGVBA_byzsRl-MbS8BpR9k0N0DAYvWLe_g5pFg

https://www.kitces.com/blog/secure-act-2-omnibus-2022-hr-2954-rmd-75-529-roth-rollover-increase-qcd-student-loan-match/

https://www.finance.senate.gov/download/retirement-section-by-section-

Kevin Lao

January 17, 2023

4 Bear Market Retirement Income Strategies

The 2022 bear market hits retirees the hardest

As we prepare to close out 2022, retirees and pre-retirees are facing the worst possible scenario, a triple bear market. US stocks, along with international stocks will likely be down double digits. US bonds will close in the red 10%+ year to date. And cash, although yields have risen, are experiencing negative returns net of inflation. All in all, the traditional 60/40 investment portfolio model for retirees has many questioning whether this strategy is still viable.

Many of you will need to take a distribution to satisfy your RMD (“Required Minimum Distribution”) for 2022 and 2023, or simply need income to live on during retirement.

But, you have probably heard the old saying, “Buy Low and Sell High.”

Well, how do you implement a retirement income strategy during a bear market, particularly one in which both stocks and bonds are experiencing record losses?

Here are 4 retirement income strategies to consider during times like these. Let’s not forget that bear markets, on average, happen every 5 years. So, in a potential 30 year retirement time horizon, you will experience roughly 6 bear markets!

Let’s dive in.

#1: Asset Dedication

One way to hedge bear market risk involves what is called the “Asset Dedication Strategy.” This strategy incorporates aligning a CD or individual bond ladder with specific cash flows, in this case retirement income. Let’s say your RMD is estimated to be $50,000 in 2023. A basic example would be to purchase a high quality bond or CD for $50,000 (or a combination), that will mature at the time the cash flow is needed. This is my personal favorite when working with clients because it eliminates the uncertainty of where interest rates might go in the future. In general, when interest rates rise (like in today’s market), the value of bonds go down. If you own an individual bond and hold it to maturity, the par value is redeemed in addition to the interest payments you received. Therefore, who cares what the price fluctuation was along the way?

The challenge for bond mutual funds or ETFs is they have to deal with redemptions (other investors selling), which will inevitably impact the price of that particular fund, and ultimately its performance.

Depending on your time horizon and risk tolerance, we would create a bond and/or CD ladder to satisfy 2-10 years of those expected distributions.

If done properly, you will never have to sell your stocks when markets are down. As your bonds mature and are paid to you as retirement income, you would then re-balance your portfolio (sell some of the winners) to add the next “rung to your ladder.”

The frequency of the re-balance will depend on market conditions and how well your other investments are performing. So, if markets rise rapidly, you might find yourself adding several rungs to the fixed income ladder by taking gains off the table. That way, when markets are down, you have plenty of wiggle room to wait until things recover.

If the strategy involves a taxable account (non-retirement), you might consider municipal bonds, depending on your tax rate. These interest payments are exempt from federal income taxes, and could also be exempt from state income taxes depending on the bond you purchase. If the strategy involves a tax free or tax deferred account, investing in corporate bonds and/or government issuers will work just fine, as taxes are not a concern.

BONUS Strategy

I have to add a bonus strategy as not all bond mutual funds and ETF’s have done poorly in 2022. In late 2021, with the help of our friends at Wisdom Tree Asset Management, we added the ticker AGZD as a core bond holding for all client accounts. The more conservative the account, the more exposure to AGZD. This strategy involves using traditional fixed income securities coupled with derivatives within the treasury market to hedge against interest rate increases.

Sound complicated? Well, it is somewhat. But in essence, when interest rates do rise (like in 2022), this strategy helps preserve principal unlike your traditional bond mutual fund or ETF.

Year to date this strategy has returned a positive return of 0.63%! Compare that to the average bond mutual fund at -12.79%, wow! This strategy, coupled with individual bonds, has allowed our clients to protect their retirement income during this particular bear market.

#2: “Income Flooring”

“Income Flooring” with annuities is another strategy that works extremely well during volatile markets. This involves purchasing an annuity to generate an income floor that can be relied upon regardless of market fluctuations. Social Security might represent a portion of your fixed income needs in retirement, but what makes up the gap? If you are relying solely on securities that have price fluctuations, what do you do in a market like 2022?

An income floor will invariably reduce the amount of cash needed from a distribution, and therefore will allow your riskier assets to recover during a downturn.

The beauty of this strategy in today’s market is that interest rates have risen sharply. Therefore, insurance companies have been able to increase their payout rates, thus making income flooring much more attractive than it was 3-4 years ago.

I like to compare this to purchasing an investment property designed to pay a fixed income stream. The difference is there are no repairs, unexpected maintenance costs, or tenant vacancy gaps.

On the flip side, it’s not an asset you can “sell back” to anyone to recoup your principal. Additionally, there is no price appreciation like you would expect from buying real estate.

For the most part, these annuities are not liquid and should not be relied upon for an unexpected expense or emergency fund. Therefore, I typically would not recommend exchanging a large majority of your investible assets for these contracts given the lack of flexibility.

However, if structured properly, it can serve as a compliment to Social Security and other guaranteed income streams.

A good rule of thumb is to calculate your non discretionary expenses, and compare that to your projected fixed income payments (Social Security and Pensions). If there is a shortfall, you might consider backing into how much money would need to be exchanged into an annuity to fill that gap.

If you have yet to claim Social Security, this strategy can be even more powerful so you avoid tapping into longer term investments for current fixed income needs.

Caution

These contracts are complex and not all annuities are created equal. It’s important to consult with a fiduciary financial advisor who can work with you and multiple insurance carriers to select the most appropriate product. Caring.com has a great article on annuities that you can read here.

#3: Cash Value Life Insurance

Cash Value Life Insurance is one of the highly debated products in the financial services industry. Insurance companies tend to “sell the sizzle” and often fall short on fully educating the consumer.

On the other hand, most investment advisors tend to default to the advice of “buy term and invest the difference.”

I started my career at a large insurance company, and now run my own fee only financial advisor firm, so I have sat at both sides of the table.

I wrote an article titled “5 reasons to own life insurance in retirement” that I would recommend reading to get my insights on the topic. For this article, I want to focus on using the cash value as an income strategy to hedge a bear market.

Here are the basics:

Cash values within a fixed life insurance policy have a guaranteed interest rate + a non guaranteed interest rate. They are paid to the policy owner in the form of annual dividends that can be used to purchase more life insurance, increase the cash value (or both), and pay premiums.
Cash values can be surrendered, at which point taxes will be due on any gains (if applicable)
Cash values can also be borrowed tax free while also keeping the policy in force

Example: Let’s say you have a policy with $100k in cash value. You are also retired (or planning to retire) and need $50,000/year from your investment portfolio to supplement other income sources. In a market like 2022, you might find it difficult to take a distribution from your investment portfolio, unless you implemented strategy #1 or #2 as previously mentioned. Therefore, instead of selling a stock or bond at a loss, you might consider borrowing $50k from your $100k cash value on a tax free basis. The loan will be charged interest, but there is still interest credited to you on the loan. My personal policy with Northwestern Mutual has a net charge of 3%, which isn’t bad in today’s market.

Let’s say you borrowed from the policy and avoided selling your longer term investments. Now what?

You have two options.

One, you can let the loan ride, and simply ensure that the policy doesn’t run into issues down the road. This involves reviewing your policy on an annual basis using an “In Force Illustration.”

When you pass away, the loan proceeds will be subtracted from the death benefit paid to your beneficiaries.

Or two, pay the loan back once the market recovers.

I prefer option two if you plan to utilize this strategy again in the future. At some point, this market will recover, and we will set new market highs. Who knows if that will be in 2023, 2024, or even 2025. But at some point, you might experience substantial gains within your stock portfolio that you are comfortable with taking $50k off the table and paying back that policy loan.

In essence, you are using the cash value as a re-balancing tool in lieu of other fixed income assets.

Here’s the challenge.

You need to have the cash value in the policy to take advantage of the strategy in the first place. This involves buying life insurance and funding the policy adequately to build up adequate cash value.

Therefore, this strategy is best suited for those of you approaching retirement that have adequate recourses to fund a policy for at least 5 years, and you’re healthy enough to buy it. If it’s designed properly, this will give the policy time to work properly and set you up for this defensive hedge that you may need 4-5 times throughout an average retirement time horizon.

Caution

Much like annuity contracts, life insurance policies are also not created equal. The design of the policy is key and will impact the viability of policy loans as well as the tax implications of using the cash value.

Furthermore, this strategy works best if you have a legacy goal of transferring assets to the next generation, and the cash value is more of an ancillary benefit.

Consult with a fiduciary advisor and licensed agent to create an optimal strategy best suited for you!

#4: Tap into Home Equity

Leveraging a HELOC (Home Equity Line of Credit) or Reverse Mortgage to access home equity is my fourth and final strategy.

With home values shooting up the last few years, you might find yourself with a large chunk of cash available to tap into via a home equity line of credit or reverse mortgage. This should be done carefully as it involves leveraging one of your most important assets, your home. However, if done properly, it could create an infusion of cash while letting your longer term investments recover.

A reverse mortgage could be tapped into as a form of life income payments, a line of credit, or both. At death, the loan amount would be offset by the sale of the home. For a HELOC, the loan would generally need to be repaid within a specified term. With rates increasing, you might be hard-pressed to find a HELOC for less than 6.5%. However, some of you might already have a HELOC established at a lower rate and can tap into the funds cost effectively.

Also, the challenge with reverse mortgages is that a higher interest rate will result in a more expensive loan and thus a lower payment. However, if you are in a bind, it’s worth consulting with your financial advisor and mortgage specialist to see if it’s a viable option.

In Summary

2022 has brought unique challenges to retirees. However, a well thought out retirement income plan is critical to weather this storm, and future storms during a 20-30 year retirement time horizon.

If you have questions about your retirement income plan, or are wondering how this bear market has impacted your long term goals, feel free to book a 30 minute initial conversation with me by clicking on the Schedule Now button below.

Also, make sure to subscribe to our email newsletter below so you don’t miss out on any of our future insights!

Retirement planning = reduce stress and worry less!

Kevin Lao

December 2, 2022

Blended Families – You Need a Long-term Care Plan!

Don't have a Long-term care plan? You are not alone!

Nobody likes to think about the possibility of a family member caring for them later in life. However, the number one concern I hear from my clients is “I don’t want to be a burden on my children.” When I ask about how a long-term care event would impact the family, most people have never thought about it. Or, they’ve thought about it but have yet to create an actual game plan.

Now, what about long-term care for blended families? If there are adult children from previous marriages, how does that impact the actual long-term care plan for Mom/Dad?

In this article, we will dive into the facts about Long-term Care planning, the challenges for blended families, and the top solutions to consider!

The basics

Despite the fact there is a 70% chance you will need long-term care later in life, less than half of retirees over 65 have Long-term Care insurance. Furthermore, 70% of caregivers are NON paid family members. So what does this mean?

Even though the probability of needing care is high, people simply ignore long-term care planning. Or, they simply assume buying insurance is too expensive or they will simply pay out of pocket.

And despite not wanting to burden their loved ones, they many end up doing just that. In fact, more than 60% of caregivers have other full time jobs in addition to being the primary caregiver!

Many people believe Medicare or Medicaid will cover Long-term Care expenses.

Medicare does not pay for custodial care after 100 days. Sure, if you are in a rehab facility and expect to improve, you can rely on Medicare to help subsidize those costs for a very short period of time. Medicaid, on the other hand, does pay for custodial care. However, most of you will probably not qualify for Medicaid given the financial requirements of income and assets. And sure, you might assume that your family members will hire help, but the reality is they are NOT hiring help. Perhaps they believe they can’t afford it, or they are afraid they will burn through assets too quickly and won’t be able to maintain financial independence for themselves. Both of these are legitimate concerns.

Long-term Care Planning Challenges for Blended Families

Blended families are becoming much more common nowadays. In fact, 40% of weddings today will form a blended family! For blended families planning for retirement with adult children, this can provide challenges in three ways:

Who’s assets will be used to pay for long-term care expenses?
How does a long-term care need for your spouse impact your ability to maintain financial independence?
Who’s children will be available to coordinate care?

Who’s assets will be used to pay for long-term care expenses?

What if you remarried and brought a much larger pool of assets to the marriage than your spouse? You might have the goal of passing on a financial legacy to your children, but at the same time making sure your spouse is taken care of for life.

As I discussed in my previous article, 4 Retirement and Estate Planning Strategies for Blended Families, the functionality of a trust for blended families is important. A trust would allow for you to pass on assets to your spouse, but making sure the next beneficiary is your children once your spouse passes away.

But what if your spouse needs long-term care later in life? Perhaps they don’t have their own pool of funds to pay for that care. Inevitably your trust will have to be invaded to pay for those long-term care costs. The question is, how does this impact your intergenerational wealth planning goals?

What about your financial independence?

If your spouse needs care and you spent down a large chunk of your assets to pay for it, how does this impact your ability to maintain financial independence after your spouse dies?

When your spouses passes away, the household will automatically have a reduction in Social Security income. There could also be a reduction in pension and annuity income, on top of assets being spent down for long-term care.

If you were cruising along and on track to meet your retirement and estate planning goals, how does a long-term care event impact your ability to maintain those goals?

As we illuded to earlier, most of the time the spouse will care for the other. Remember, 70% of long-term care is provided by unpaid caregivers. This means you might forgo hiring professional help in efforts to save your financial resources, but this could negatively impact your mental and physical health. We’ve seen caregivers get sick after their spouse passes away, simply because they took on the lion’s share of caregiving and are flat out worn out.

Who’s children will be available to coordinate care?

This is the most difficult part of the equation. Sure you might have enough resources to pay for care. But, like Jean Ausman shared in our retirement readiness checklist, “a checkbook is not a long-term care plan.”

Who is going to manage the care?

Who is physically going to provide the care? What if that person is a stepchild?

Who is going to manage the financials and decide which accounts to tap into for care?

These are all touchy subjects, especially with a blended family where the adult child handling these issues isn’t the biological child of the one needing care.

What is a Long-term Care Plan?

As I discussed in a previous article, Long-term Care Planning, I mentioned the fact that 40% of retirement aged clients have long-term care insurance. If you read that article, you understand that I am agnostic as to what the solution is, but we need to have a plan.

These are some questions to get you started:

Where will care be provided? If care is provided at home, you will likely have family providing the bulk of the care. On top of this, you might hire some professional help to give relief for the family members. If you need specialized care in a nursing home or memory care, the price tag goes up substantially. Check out Genworth’s stats on this below.

What assets will be used to pay for care? Different accounts will have different tax consequences. Additionally, certain accounts are better to spend during your lifetime instead of leaving to your children. Make sure you designate which accounts (in order) should be spent down first if there is a long-term care need. Take a look at our article on how to divide assets in a blended family.

What’s the strategy to mitigate the tax impact of accelerated withdrawals? You might have multiple accounts to draw from, and accelerated withdrawals on certain accounts like 401ks or IRA’s might push you into a higher tax bracket. Additionally, it could result in higher Medicare premiums as a result of “IRMAA” (income related monthly adjustment amount). Therefore, you might work with a fiduciary financial planner who also does tax planning to ensure you are making tax efficient withdrawals.

Who is the caregiver coordinator? This job can feel like a full time job, even if the individual isn’t the one providing the care. The ongoing hiring, firing, financing, and other issues can result in major headaches for the coordinator. For blended families, what if that coordinator isn’t your biological child? Or, what if your biological child is the coordinator for your new spouse (their step parent)? These are touchy issues and can cause a divide amongst the family. It’s very important to be proactive with all of the children on who is responsible for what. You also might consider hosting a family meeting so all of the children are on the same page.

Who is going to manage the assets? If you plan to hire professionals to provide the care, some additional asset management will need to be considered. Which investments are being sold when? How does selling those investments impact the long term viability of the portfolio? What’s the tax consequence of selling an investment to pay for care? How does selling an asset impact your legacy goals?

For traditional families with shared estate planning goals, it can be perfectly acceptable to “self-insure,” as long as the plan is laid out for the decision makers.

With blended families, particularly those with separate estate planning goals, I highly recommend Long-term Care Insurance.

The potential challenges for the adult children and your spouse are endless depending on the relationship dynamics, and insurance removes them from the equation (for the most part).

The benefits of Long-term Care Insurance for Blended Families

Caregiver Coordinator benefit

Immediately after a triggering event, a Long-term Care policy will most likely have a caregiver coordinator benefit. This allows for the client to call the carrier, and request a specialist to come out to the home. This specialist will help create a plan to provide care within the framework of the insurance policy’s terms and budget. Additionally, they can help make recommendations on home modifications to suit the needs of the family. From there, if there is additional care needed, the family will then decide if they will pay out of pocket or coordinate efforts to provide care. Nonetheless, the family will have an objective third party to help them with these major decisions.

A long-term care benefit pool

Some policies provide for reimbursement, some provide cash benefits immediately upon the triggering event. Either way, there is a defined pool of dollars that are specifically meant for long-term care needs. In addition, the payouts are income tax free, which will eliminate unnecessary tax increases from accelerated retirement account withdrawals. Why do you think ultra high net worth individuals own Long-term Care Insurance? Of course they could “self insure,” but they would rather keep their long term investments on their balance sheet instead of liquidating them for care.

The best part is, having a defined pool of assets will eliminate the question of “do I hire help or provide care myself?” Instead of putting your spouse or adult children at risk of carrying the weight of caregiving, the insurance essentially forces the family to hire professional help. You can’t put a price tag on preventing that burden.

Hybrid policies

Over the years, I’ve had clients bring up the concern of “what if I never need care?” Statistically speaking, there’s a good chance you’ll need care. In fact Genworth estimates 70% of those 65 or older will need care at some point in life. But the question is valid. What if you don’t?

Hybrid policies were designed to address this issue. The gist is there is a life insurance benefit with a long-term care benefit. Some policies are life insurance focused with a long-term care rider. Others are long-term care focused with life insurance rider. Either way, if long-term care is not needed. Or, if only a portion of the benefit pool is used, there will be a death benefit when you pass away that can be left to your beneficiaries. These policies are certainly more expensive, but you get what you pay for. What’s also nice is all of the policies I am familiar with are guaranteed to not increase in premiums. This has been another pain point for the long-term care industry and these policies were also designed to eliminate that concern.

For those that are interested in leaving a financial legacy to their children, these hybrid policies are a great solution!

Final thoughts

All in all, if you are a blended family with adult children, you must absolutely have a long-term care plan. If you are similar to a traditional family in the sense of having shared estate planning goals, long-term care insurance might be optional for you. However, the tax benefits and having a dedicated plan for care makes insurance extremely appealing for all families.

For blended families with different estate planning goals, long-term care insurance is the top solution! It’s important to consult with a fiduciary financial advisor that specializes in retirement planning and specifically long-term care planning to create a plan that’s right for you. An objective third party who can review your goals and balance sheet is invaluable.

If you are interested in discussing your long-term care plan, feel free to start with a no obligation Zoom call with us! (see the link below)

Make sure to subscribe to our blog and join our Facebook group to get the latest retirement planning insights delivered to you!

Kevin Lao

October 18, 2022

Podcast

Ep. 14: “Retirees – Stop Under-spending in Your Go Go Years”

Kevin Lao

September 16, 2022

The 7 Most Tax Efficient Retirement Income Strategies

Tax efficiency maximizes retirement income!

When I started my first job as a soccer referee at 12 years old, my Mom used to tell me; “it’s not what you earn, it’s what you keep!”

I’m not sure if working at 12 years of age is legal any longer, but I’ve had a job ever since. My Mom instilled in me the value of forced savings and paying yourself first. (thanks, Mom!)

I’ve been practicing financial planning now for over 14 years, and I find this quote is highly relevant for taxes.

Tax inefficiency of retirement income is one of the biggest drags on returns. In fact, taxes are likely the largest expense for retirees, even more so than healthcare costs!

While we can’t control the stock market, we can control our taxable income (to a certain extent).

This article will outline the 7 most tax efficient retirement income withdrawal strategies so you can maximize spending on your lifestyle, not the IRS.

1. Roth IRAs + other Roth Accounts

As you know, this is one of my favorite tax efficient income strategies for retirement. Sure, you will forgo the tax deduction for contributions, but in exchange for a lifetime of tax free (“qualified”) withdrawals. I’ll take that tradeoff any day!

Here is the nuts and bolts of how these accounts work:

You make a contribution (whether it’s payroll deductions with work or IRA contributions).
You invest the money according to your goals and risk tolerance.
Enjoy tax free withdrawals, assuming they are “qualified”:
- The account is at least 5 years old (for an IRA)
- You are 59 ½ or older

Your contributions in these accounts are always tax and penalty free, but you might have taxes and penalties on earnings if your withdrawal is “nonqualified.”

There are some exceptions like for first time home purchases, educations expenses, etc. But if you are reading this, these will likely not be of interest to you anyhow! Why would you cash in your most tax efficient retirement vehicle for anything other than retirement?

There are some limitations on these accounts.

Contributions:

For Roth IRAs – the max contribution for 2022 is $6,000/year (if you are over 50, you can contribute $7,000/year)
For a Roth 401k/403b – the max contribution for 2022 is $20,500 (if you are over 50, you can contribute $27,000/year)

These contribution limits are per person. If you are married, your spouse has their own limits to take advantage of.

Income phaseouts:

If you are over a certain income threshold, you might be phased out completely from a Roth IRA contribution (don’t worry, there may be a loophole).

Roth 401ks/403bs etc. are NOT subject to income phaseouts. You can make $1million/year and still max out a Roth 401k. Check out your 401k plan rules to see if there is a Roth option in lieu of the traditional.

Enter the backdoor and mega backdoor Roth contributions

In 2012, the IRS lifted the income limits for “Roth conversions.” A Roth conversion simply means you convert all or a portion of your Traditional IRA to your Roth IRA. You will then be responsible for any taxes due at that time. However, you may find this compelling based on your expectations on where taxes might go in the future.

Here’s the loophole…there is no income cap for non deductible IRA contributions. Therefore, savvy tax planners can make non deductible IRA contributions, and immediately convert those dollars into their Roth IRA! This is known as a backdoor Roth contribution!

Pro tip – be careful of the IRA aggregation rule or your conversion may not be tax free!

Now, companies are starting to allow for “Mega Roth 401k/403b conversions!” Depending on your plan rules, you can not only contribute the maximum to a Roth 401k, but you can make an additional non deductible contribution up to the 402g limit. That non deductible contribution can then be converted to your Roth 401k to enjoy tax free growth!

Sound too good to be true? Well, lawmakers are looking to shut this down ASAP, so take advantage while you can and read your plan rules to see if it’s allowed.

2. Health Savings Accounts (HSA)

Healthcare will likely be one of your largest expenses in retirement, so why not pay with tax free income?

In order to participate in an HSA, you must have a high deductible healthcare plan. Talk to your HR team about which plans allow for these accounts.

In general, if you are going to the doctor frequently or have higher than average medical bills, a high deductible health care plan may not be right for you. However, if you are pretty healthy and don’t go to the doctor often, you might consider it so you can take advantage of the tax free HSA.

HSA’s have a triple tax benefit:

Tax deductible contributions
Tax free growth
Tax free distributions (if used for qualified medical expenses)

This triple tax benefit is the reason it’s one of the most tax efficient retirement income strategies!

You can also use an HSA to help pay for long-term care costs or even pay long-term care insurance premiums tax free.

Try not to tap into this account early

You might be tempted to reimburse yourself the year you have a major surgery or other medical bill. If you can pay out of pocket, do that instead! As your account grows, you can even invest it according to your risk tolerance and time horizon. This helps amplify the benefit of tax free compounding!

Save your medical bill receipts

There is no time limit on when you reimburse yourself. You could have surgery in 2022, and reimburse yourself anytime in retirement tax free!

Planning a major trip in retirement? Take a look at some medical bills you paid 20 years ago and reimburse yourself from the HSA…now you have more money to enjoy that trip instead of paying Uncle Sam!

Don’t leave this as a legacy

Your beneficiaries (other than a spouse) will have to liquidate the HSA the year you pass away, which could create an unnecessary tax bill for your heirs. Spend it while you can, name your spouse as beneficiary, and enjoy this triple tax advantaged account!

3. Life Insurance

Life Insurance is an often misunderstood, misrepresented, and misused financial tool for retirement. However, it can be used as a tax efficient retirement income strategy, or a tax efficient intergenerational wealth strategy (dual purpose!).

I started out with a life insurance company and am so thankful I did. First and foremost, I was taught to load up on life insurance while I was young and healthy (even before needing it), to lock in my insurability and health profile.

Secondly, I was taught the benefits of permanent insurance and loaded up on this as well. Again, before having any insurance needs at all!

Over time, the cash values have grown, and I’ve been able to tap into this asset class at opportune times when other asset classes were temporarily at a discount!

Ever hear of the concept “buy low, sell high?” Well, how do you buy low if all of your assets are down at the same time?

As we’ve seen with the market in 2022, bonds are not immune to significant drops in performance. Life insurance keeps on keeping on!

Long term, my plan is to keep the insurance as a tax free legacy for my three boys (and hopefully grandbabies!). There is no other financial vehicle that provides an amplified tax free death benefit like life insurance.

Which type of insurance should I own?

Raising children is expensive. Inflation has made it even more difficult! If you are strapped for cash and are worried about making rent or your mortgage on time, you should buy some inexpensive term insurance and protect your family.

Pro tips:

Buy lots of coverage – a rule of thumb is 10x – 16x your gross income, but some insurance companies allow you to buy 25x your gross income!
Make it portable. If you are healthy, buy a policy NOT tied to your workplace, as you never know how long you will stay there.
Make sure it’s convertible. Even though you may not be a good candidate for permanent insurance today, that may change over time. Perhaps when your kids are out of the house, or your mortgage is paid off, or your income has skyrocketed. Being able to convert to a permanent policy without medical underwriting is extremely helpful.

For those of you comfortably maxing your tax advantaged retirement plans and HSA’s (as discussed previously), overfunding a permanent life insurance policy can be a great supplemental savings tool.

There are multiple flavors of permanent life insurance that we won’t go into detail on in this article. But in general, you can invest in fixed products or variable products. This feature will impact the performance of your cash value, and potentially your death benefit.

You can also add a long-term care rider on some policies to kill two birds with one stone. That way, if you are someone who never needs long-term care, your family will still receive the death benefit.

What I have found is that the intention might be to use this cash value as a tax efficient retirement income strategy, more often it’s used for the death benefit. All of you diligent savers will accumulate assets in your 401ks/IRAs, taxable brokerage, HSA’s etc., and you might realize that this amplified death benefit is best used to enhance your intergenerational wealth objectives. Plus, it gives you a license to spend down your other assets in retirement “guilt free.”

Don’t worry about making that decision today, but just know this asset can be a flexible vehicle throughout your lifetime.

4. Taxable Brokerage Accounts

This bucket is one of my favorite tax efficient retirement income strategies for three reasons:

There is no income restriction on who can contribute
There is no cap on contributions
There is no early withdrawal penalty

The title of this account sometimes leads people to believe it’s not tax efficient.

And this can be true if you invest in certain securities within the taxable brokerage account.

However, if you are strategic with your security selection, you can have minimal tax liability during the accumulation phase.

In retirement, you can then use losses to offset gains, sell certain blocks of securities with limited capital gains, and use tax free income as cash flow by investing in municipal bonds (if appropriate).

I find this tool is great to maintain flexibility for funding college, saving for retirement, or any other major expenditures along the way.

Intergenerational Wealth Planning

Certain assets are better used during your lifetime instead of passing on to your heirs, as we discussed with the HSA. However, taxable brokerage accounts are extremely tax efficient for intergenerational wealth planning.

When you pass away, your beneficiaries will get a “step up in cost basis” which will limit their tax liability if/when they sell that asset themselves.

All in all, this can be a great multi functioning tool for retirement income, legacy, or any other major opportunity that comes along!

5. Non Qualified Annuities

I find consumers have a negative connotation associated with the term annuity. And, rightfully so. These products, like life insurance, are often oversold or inappropriately utilized.

In it’s purest form, annuities are used to provide a guaranteed income stream in retirement. Think Social Security or a Pension.

Creating a “retirement income floor” is one of the most powerful things you can do for yourself. Believe me, when the markets go south, you don’t want to be worried about how to fund your basic living expenses in retirement.

However, if Social Security + Pension + Annuity income covers your basic necessities, you can avoid losing sleep at night when the markets do take a dive (which they will!).

The tax efficiency components are twofold:

Tax deferred growth, much like a traditional 401k or IRA
Exclusion ratio for lifetime annuity income

For you high income earners, you will want to limit tax drags on your savings. However, once you are maxed out of your qualified retirement plans, you’re going to be wondering where to go next. One of the benefits for annuities is the tax deferred growth. You won’t receive a 1099 until you start the income payments in retirement!

In retirement, instead of the gains being withdrawn first (“LIFO”), you can take advantage of the exclusion ratio. This allows for a portion of your retirement income to be a return of basis, and a portion to be taxable income. Therefore, it’s a great way to spread the tax liability over your lifetime.

In retirement, if you decide you don’t need this income stream, you can flip on the switch to fund other tax efficient vehicles like life insurance or long-term care insurance.

Intergenerational Wealth Planning

In years past, annuities were a terrible way to leave a legacy for your children. Beneficiaries were often forced to take a lump sum distribution or take payments over a short period of time. Now, some annuity contracts allow for the children to turn their inherited annuities into a life income stream. This can also help spread out the tax liability over a much longer period.

I still recommend using these accounts during YOUR retirement phase and leave other assets to your children. Having your beneficiaries deal with the death claim department within annuity companies can be a nightmare!

6. Reverse Mortgage

One of the largest, if not the largest, asset on your balance sheet over time will be home equity. However, many retirees don’t maximize their home equity as an income tool, which could be a mistake.

In simple terms, a reverse mortgage allows the homeowner to stay in their home as long as they live. These products essentially flip your home equity into an income stream. The income stream now becomes a loan with your home as collateral.

Because it’s a loan, the income is not taxable to the borrower!

Instead, the loan will be repaid from the home sale proceeds when you move, sell your home, or pass away.

Creating this essentially tax free income stream can allow you to preserve other liquid assets on your balance sheet, like the ones mentioned above.

It can also be a part of the “retirement income floor” concept that we mentioned previously.

7. Real Estate Income

You often hear of real estate investors paying little to no taxes. The basic reason is the ability to deduct ongoing expenses from the income.

mortgage payments
taxes
insurance
maintenance
property management fees
And the “BIG D” – Depreciation!

This depreciation expense is the real wildcard as it can essentially wipe out any taxable income you would otherwise have to report. Depending on the property type, this can amount to approximately 3.6% of the cost basis year after year! There is some “true up” at the end when you go to sell the property, but it’s a huge advantage to minimize taxable income while your property still cash flows!

And once you sell the property, you can even take advantage of a 1031 tax free exchange and buy another investment property that better suits your overall financial goals.

Investing in real estate is not for everyone. And it’s certainly not a passive activity, even if you have a property manager. Studying your market, analyzing trends, upgrading your property and dealing with bad tenants are ongoing challenges.

However, if you do it right, this can be an extremely tax efficient retirement income strategy.

Final word

Minimizing taxes in retirement is one of the most impactful ways to maximize your cash flow!

However, most people don’t think about taxes in retirement…until they are about to retire!

These strategies only work if you begin building the framework 10, 20 or even 30 years before you quit your day job. Furthermore, not all of the strategies discussed will make sense given your goals and financial circumstances.

It’s important to consult with a fiduciary financial advisor that can take a comprehensive look at your financial plans.

If you are interested in scheduling a call, feel free to use the calendar link below for a 30 minute “Mutual Fit” meeting over Zoom.

Also, make sure to subscribe to our mailing list so you don’t miss out on any retirement planning insights!

Until next time, thanks for reading.

-Kevin

Kevin Lao

September 9, 2022

Podcast

Ep. 13 – Planning for Healthcare Costs in Retirement – Medicare Considerations

(transcription) - Planning for Healthcare Costs in Retirement - Medicare Considerations (featuring Ari Parker, Lead Medicare Advisor @ Chapter)

Kevin Lao (KL):

Hello everyone, and welcome to the planning for retirement podcast, where we help educate people on how retirement works. I’m Kevin Lao, your host. I’m also the lead financial planner at imagine financial security. Imagine financial security is an independent financial planning and investment firm based in Florida.

However, this information is for educational purposes only and should not be used as investment legal or tax advice.

This is episode number 13, called planning for healthcare costs in retirement. Hope you enjoy the show. And if you like what you hear, leave us a five star review and make sure to subscribe or follow and stay up to date on all of our latest episodes.

I’m very excited today to be joined by Ari Parker. Ari is the head Medicare advisor of Chapter, and is one of the country’s leading Medicare experts. He’s helped thousands of Americans sign up for Medicare, breaking it down into simple bite size pieces. I like that simple. His work has been featured in Forbes, CNBC, CBS money, watch market watch Huffington post, and many other publications.

He’s a graduate of Stanford law school. He trains and leads Chapter’s team of 30 plus licensed Medicare advisors and lives in Phoenix with his wife and two dogs. His book is coming out in September.
“It’s not that complicated” is the title of the book, the three Medicare decisions to protect your health and money.

Their website is ask chapter.org and Ari’s email is Ari@Ask chapter.org. Ari. Thank you so much for joining today. Appreciate it.

Ari Parker (AP):

Pleasure to be with you, Kevin.

KL:

So I am excited to have you on mainly because my firm, obviously being in Florida, I specialize in retirement planning and oftentimes healthcare and Medicare questions come about.

And I’ve been doing this for 14 years now and I still feel like Medicare confuses me. How do you feel about that?

AP:

Absolutely. It can be very confusing. People aren’t sure which enrollment deadlines apply to them, whether they need to sign up for it or not.

This is why I wrote a book on it. And it’s something that our team helps people with every day.

KL:

Love it. Love it. Well, for this episode I reached out to you earlier this week. I like to do episodes based on real life questions that I field from my clients. This one, I’m gonna call them Jack and Diane. Jack is 66. Diane is 57. Okay. Their daughter just had twins. I can relate, I’ve been there.

We had twins a couple of years ago, understandably so it takes a village to raise twins. So now they want to sell their house here in Northeast Florida and move closer to their daughter. Um, so instead of Jack working a few more years and getting Diane closer to that age, 65, that magical age, 65 of Medicare eligibility, and also his age 70, which would be the full social security benefit.

They’re wondering, Hey, you know what if Jack retired tomorrow and they moved closer to their daughter to be near their twins? Now the decisions are what do they do with healthcare, right? I mean, we’ve got Diane who’s eight years away from turning 65 and being Medicare eligible.

And then we’ve got the decision for Jack and he needs to then enter into this world of complexity of Medicare, which hopefully you can break that down. So what I thought we would do is maybe start with the Medicare decisions, and then we can transition into Diane’s decisions around healthcare pre-Medicare. So why don’t we just start with the basics of Medicare?

Let’s pretend I’m Jack, what would you say to me?

Basics of Medicare

AP:

I’d like to summarize. Jack is 66 years old and has retired. Diane is 57 years old, but isn’t working.

KL:

Correct.

AP:

It is very likely that Jack should enroll in Medicare. Jack by virtue of having retired from a large group employer, which is defined as 20 employees or more has a special enrollment period to start Medicare, that enrollment period lasts eight months.

Jack probably doesn’t want a gap in his coverage. So it’s important to do it sooner than later. You don’t wanna wait until the end of the eight month period. You don’t wanna miss that period either because then you’re in a whole world of pain.

KL:

You get slapped with penalties, right?

AP:

Yes. I’m happy to get into the penalties, but it is very likely that Jack should enroll in Medicare. It’s a five minute process. He can do it online through his ssa.gov portal. And then yep. Happy to get into what Medicare covers.

KL:

It’s very easy to enroll in Medicare. But you hear all of these questions like, okay, what you do with original Medicare versus Medicare advantage? I think I read a trend recently that the number of people buying Medicare advantage plans has been going up by roughly 34% per year which is substantial.

So it’s gaining traction. Why don’t we talk about the differences between traditional Medicare versus the Medicare advantage route?

Medicare Original vs. Medicare Advantage

AP:

Original Medicare has two parts, part a is hospital insurance, which covers you when you’re inpatient. It also covers hospice care, skilled nursing facilities. It means you’re inpatient.

Part B is outpatient coverage. It’s visits to the doctor to specialists, ambulance services, durable medical equipment, even outpatient surgery, all covered under Medicare part B. For Jack because he’s paid federal income taxes for at least 10 years. Part a hospital is premium free. There’s a charge for part B.

However, that charge will be $170 and 10 cents per month for 2022 and might go up for next year. We don’t know yet those numbers will be released in the fall. But there’s a charge for part B and most Americans pay $170 and 10 cents. Mm-hmm what Jack will get in return is 80% of his medical services covered.

He’ll owe the other 20% out of pocket with no cap. My mom just had a knee replacement, $40,000 procedure. Original Medicare picked up $32,000. If she hadn’t had any additional coverage, she would’ve owed eight, $8,000 out of pocket, plus all the pre-op post-op physical therapy. Which is why you would then think about that.

KL:

They call this medigap coverage, right? The supplemental coverage, correct?

AP:

Exactly. There’s only two types of additional coverage (or Medicare advantage. Medigap sits on top of original Medicare and covers the 20% remainder. Here, we’re talking about plan letters like plan F plan G, or plan N.

Those are the three most common types. And what those do is preserve the flexibility of original Medicare. There’s no PPO or HMO restriction. You can see any doctor who accepts, accepts Medicare nationwide. If you live in St. Augustine, but wanna see a doctor in Houston, it’s no problem. You can go and see that doctor as long as they accept original Medicare.

So it’s really flexible for someone who likes to travel or has a second home outside Florida, for example. Also importantly, the Mayo clinic accepts Medigap, which is a very important consideration for people who live in Florida.

On the other hand, you have Medicare advantage.

Medicare advantage is managed care. These are also known as all in one plans or part C. William Shatner talks about it on television, Jimmy Walker, they’re advertised heavily and they’re going be advertised even more heavily as the fall approaches. Now, what people like about these plans is it comes with additional benefits like prescription drug, coverage, vision, dental, hearing, transportation benefits.

What people like less about it is that it’s managed care and here there’s prior authorization that’s there’s restrictions. And so it, it’s just important to understand the trade offs involved in the decision between Medigap and Medicare advantage.

KL:

So the advantage, just to clarify for the listeners, the advantage would be replacing the original Medicare route.

Plus that supplement, and there’s some advantages to that in terms of additional benefits. I’ve also heard some advantages in terms of simplicity. But there also could be some disadvantages, that managed care piece that you mentioned.

So with Medicare advantage, you might actually have to go see a primary doctor before going to get a major procedure done or getting an MRI done or knee replacement, things like that. Is that what you’re saying?

AP:

Exactly. What people really like about Medigap is the flexibility. You can see any doctor nationwide who accepts Medicare.

You don’t have to ask for permission, you don’t need a referral. It also has coverage outside of the United States. In fact, I had a client who was vacationing in Paris and suffered a heart attack. They had Medigap plan G and their plan G has 80% coverage abroad for the first 60 days.

You’re outside the United States. Now the great news, it was a $35,000 hospital bill from the heart attack, but he recouped 80% of the cost because he had coverage. And so it’s a big decision to make, and it really depends on your lifestyle factors, which is something you can be useful to discuss with an independent advisor.

There’s no charge to work with one now. And the industry is set up that way. It’s great. You get the same price, whether you work with an independent advisor, as you would, if you call the carrier.

KL:

I went through the same situation being pre-Medicare and launching my own business. I had to go out and buy my own insurance.

It was nice to work with someone who’s an expert. My premiums are the same, but I can get someone to give me advice on those little things that I would’ve never thought about.

AP:

And you have a dedicated point of contact it’s not as if you call the carrier you wait for customer service to answer, and then you get a different customer service representative every time.

No one likes that experience. Instead, when you work with an independent advisor like chapter, we’re an example of one, then you get a dedicated contact and that is your person who will help you troubleshoot any issues that come.

Medicare decisions if you travel or are a snowbird

KL:

You mentioned an interesting point about travel. It seems like if I’m working with someone or you’re someone who is big into traveling, whether it’s domestically or, or overseas, or perhaps you’re a snowbird. Maybe you live six months minus a day in Maine or New York or New Jersey, and then the other six months plus a day in Florida.

You might have a little bit more flexibility in the networks with the original Medicare, right? Rather then going with the Medicare advantage coverage there’s is that correct?

AP:

There’s no network restriction with original Medicare. So if you wanna preserve the flexibility of original Medicare, then you ought to strongly consider a Medigap plan.

If you’re comfortable with managed care restrictions and you’re not planning to travel too far away from your home. Then a Medicare advantage plan might work really well.

KL:

Now Medigap has a higher premium than Medicare advantage plans, right?

AP:

Cost depend on where you live, they can cost anywhere from $90 to about $185.

And if you live in New York, it’s a lot more expensive than that. But in Florida’s around 175 to $185 per. Medicare advantage plans on the other hand have a very low premium, in fact, many plans have a $0 premium, but there are trade offs.

KL:

And the trade offs from what I understand, it’s more like your traditional health insurance with the deductibles and copays and things like that.

So if you’re, if you’re going to the doctor a lot that original Medicare, even though the premiums are higher, that actually might be more advantageous because you’re saving money on a much lower deductible. Right? I think the deductible is $300 per year or something like that?

AP:

You, you got it.

The, the deductible is exceptionally low. The deductible for original Medicare is $233 for 2022.

KL:

Is that per individual or per couple? It’s probably per individual, right?

AP:

There’s no Medicare family plan. It’s individual.

Many advantage plans have a $0 deductible, but as you mentioned, it’s pay as you go insurance similar to work provided coverage. For example, if you go see a specialist you’re going to owe a copay and your doctor needs to be in network. If your doctor’s out of network, then you might have co-insurance or the visit might not be covered at all.

KL:

Okay. So if you’re like my wife that loves to just go to doctors and do a lot of things, you might wanna go with original Medicare. Right? You’re not going to have those copays and things out of pocket along the way, like you would with advantage.

AP:

That’s exactly the type of conversation we’d have with someone in a 15 minute introductory call, we would talk through how often they go to the doctor or the types of doctors they see, because it goes doctor by doctor. And Kevin, it’s even as granular as choosing a doctor based on the location where they practice.

One location might be in network with a plan. But the other location that the doctor practices out of might be out of network.

KL:

So that’s an important thing. You can almost back into it, like if you have doctors that you’re a big fan of, and you’re making this healthcare decision, see if they are in network obviously.

I think with original Medicare, I think I heard this stat that 98% of, of practices actually allow for original Medicare, right? Whereas advantage the percentage is much lower. So, if you’re gonna go that route with the lower premium and things like that, you might just wanna make sure that the doctors that you really are in network, right?

Medicare Open Enrollment Planning Opportunities

AP:

Exactly people who don’t go to the doctor very often tend to be quite happy with a Medicare advantage plan. As long as the doctors that they do see are in network with the plan. Now here’s the rub. This changes every single year. The plans themselves change, the doctors you see change, the care that you need changes, and your prescriptions change too.

And a lot of the reason people like Medicare advantage is because it’s all in one. Many of the plans include prescription drug coverage as well. So it’s really important to shop all your options every year. The time to do that is coming up. That window is October 15th to December 7th, October 15th is when you can shop all options available to you for 2023.

KL:

That’s for advantage, original or both? Do they both have the same open enrollment?

AP:

The, the saying is if, if you go Medigap, you typically marry your Medigap and date your drug plan. You wanna review your prescription drug plan every single year, because there are savings to capture here. Now it’s good to review your Medigap plan every few years, but really it’s set it and forget it.

Keep paying your premiums. You know exactly what you’re paying for. You’re paying for it to cover the other 20% that Medicare otherwise wouldn’t. On the advantage side, it’s really important to review your options and the time to do that is in the fall. So you should, if you go the Medigap route, you should review your prescription drug coverage.

Every fall. If you go the Medicare advantage route, you should review your coverage every fall. If you’re on original Medicare and didn’t get Medigap or Medicare advantage when you first signed up, then the fall is also an opportunity for you to choose a Medicare advantage plan or to change or adjust your prescription drug plan.

KL:

Interesting. So that actually brings up another question I had. At one point, I heard that if you start with a certain type of insurance and then later decide to change that, potentially you might have some medical underwriting or some sort of health questionnaire. And if something changed with your health, that might impact your insurance.

Am I misremembering that?

AP:

You’re bringing up something that’s really important, which is that in the state of Florida, you have a one time open enrollment opportunity, a one time golden ticket to get a Medigap plan with no underwriting. That is no question about your health history.

If you miss that window, unless a Medigap protection applies, you have to answer questions about your health history, and people get dinged all the time. Let’s say they’re on three medications for high blood pressure, for example. A carrier is going to look really closely at that. Same thing with type two diabetes, or an issue with your back or your kidneys or your liver, your heart. Those are all things a carrier would want to know about.

If you miss your open enrollment period, which is the six months after you start Medicare part B. And it’s good to act early here. It’s actually good to do it even before your Medicare begins, because you want to secure that one time opportunity to get a Medigap plan without answering questions about your health history.

KL:

So this is, this is within six months of starting B, right? And the trigger of starting B is turning age 65, or if you’re still working, you can delay that decision for B and just do it when you retire. If you have employer healthcare coverage, right?

So it might even be like age 68 or 67. Like in this case, Jack would be 66, right?

AP:

That’s right. There are three ways to start. The first is by way of turning 65. The second is by way of a special enrollment period. And here that would be Jack. Jack is coming off work provided coverage. His employer is 20 employees or more. Jack has a special enrollment period to sign up for Medicare. The third way is through the general enrollment period, which is January 1st to March 31st, but the general enrollment period is really only if you made a mistake, it means that you should have signed up for Medicare already and you waited too long.

Now, if you have a disability or if you have end stage renal failure, for example, then you get Medicare. But that those are special circumstances. And if that applies to you, happy to be a resource here, you can reach out to me by email [email protected].

Special Enrollment for Medicare and Medical Underwriting

KL:

So this is super important, that special enrollment period without medical underwriting. I think some people, especially clients that I’ve talked to in the past, they say “Hey, you know what, Kevin, I’m healthy now. I’m not going to the doctor very much. I can get away with an advantage plan. Maybe keep my premiums low.”

But then later on, if they decide to switch to original because maybe their health changes, maybe there’s a recent diagnosis that’s not favorable.

That’s a problem. You’re making a bet. Yeah. That your good health will continue. And so, what would happen? I mean let’s say Jack hypothetically started with advantage and then later on wanted to switch to original and something did change with his health.

Could they just exclude him or would his premiums be higher? Or how would that work?

AP:

There’s no underwriting for a Medicare advantage plan.

For context, what Kevin is talking about here is if Jack wanted to go from a Medicare advantage plan to a Medigap. And Jack’s health history declines. In 46 states, Jack unfortunately would have to answer questions about his health history. Now, hopefully his health hasn’t declined that much and a carrier would still accept him.

The carriers ask different questions about your health history, and it varies state by state. And so interesting here, we had to build a database to sort through all the complexity. It would be worth exploring whether Jack qualifies for a Medigap protection, because if he’s moving for example, and let’s say he moves to Maine, Maine is a guaranteed issue state.

What that means is that Jack can get a Medigap plan.

KL:

But that’s why talking to someone like you is helpful because you’ve got to know the rules.

AP:

Exactly. I mean, the rules are changing. The rules vary by state.

KL:

Could one spouse start with original and the other spouse choose advantage? I mean, they’re sort of independent of one another, right?

AP:

Yeah. We see this all the time, especially with couples in Florida where there’s a lot of competition, Florida has a very rich Medicare advantage market.

There’s a lot, especially south Florida, has a lot of competition across carriers. And it’s growing in north Florida too, but that just goes to show you that it’s important to shop all your options every year because the options are changing.

Usually they make the same decision. If one is on a Medigap plan, they both go Medigap. If one, doesn’t go to the doctor at all, then they might do great on a Medicare advantage plan while the spouse might go to the doctor a lot and instead would prefer to be on Medigap, it’s individual coverage.

KL:

Yeah. I could see that being my wife and I, when we’re Medicare eligible, my wife is gonna go original. I might go advantage, but we’ll see what happens at that point.

AP:

I see that with my spouse too.

Avoid penalties!

KL:

Now you mentioned the special enrollment. I wanted to bring this up. I was reading something recently about.

If you’re 65 and you’re still working. You don’t have to enroll in Medicare, right. As long as your company has 20 or more employees. Right? But if your company has fewer than 20, you have to enroll. Is that right?

AP:

Yes. You must. In order to avoid penalty.

KL:

What’s the thought, what’s the thinking there?

What’s the rationale around, requiring that 20.

AP:

The rationale is that for small employers and small employer is defined as 19 or fewer employees, then Medicare is supposed to be your primary insurance.

You can remain on the company plan, but the company plan pays secondary to Medicare. So in effect, what that means is if you work for a small employer, 19 or fewer employees, then what will happen is your work provided insurer can start denying claims for the ones that Medicare should have covered as primary insurer.

So Medicare as primary insurer is supposed to pick up 80% of the coverage. If you didn’t start Medicare, then there’s no one on the hook for the 80%. The small group employer insurance could deny claims.

KL:

I’ve had a few people over the years that turned 65 and they say, “Hey, I don’t need to worry about enrolling in Medicare” because that’s maybe what they’ve read or heard from a friend. But I’ve had a few of those people work for small businesses and they must enroll.

Otherwise you get hit with some penalties when you do go to enroll later on.

AP:

Yes, you get hit with penalties and it’s also dangerous because then your insurance can deny claims where Medicare should have been paying as primary. And of course, since you haven’t started Medicare, you have no one to cover those primary obligations.

What are the total costs for original Medicare vs. Medicare Advantage?

KL:

So before we transition to what to do with Diane’s coverage, all in premiums if you went original Medicare Par A plus Part B plus Part D and the Medigap coverage, what’s a price range?

AP:

First, we have to start with what they owe for Medicare part B. Do Jack and Dianne earn less than $182,000.

KL:

No.

Medicare part B premium with no IRMAA, which is income related monthly adjustment amount. So let’s assume a standard premium. Okay. The standard premium for part B is $170 and 10 cents.

And it’s non-negotiable unless you qualify for Medicaid, which is for the low income. So regardless of whether they go Medigap or Medicare advantage, they owe the $170.10.

Now if Jack starts taking social security, the $170 and 10 cents per month will be deducted from his social security.

If he hasn’t started, then he’ll be invoiced on a quarterly basis.

In terms of Medigap, if Jack lives in Florida will range anywhere from 120 to $185, depending on whether he chooses plan N or plan G. Then Jack would need a standalone prescription drug plan unless he has prescription coverage, at least as good as what Medicare provides. And there are separate late enrollment penalties here.

So it’s really important to not miss the enrollment period to sign up for a drug. Drug plans typically costs anywhere from 10 to $25 per month, depending on the prescriptions one takes. So Jack’s cost picture if he goes Medigap is $170 and 10 cents, plus 120 to $185 per month for Medigap plus 10 to $25 for the standalone prescription drug plan.

KL:

So like $310ish to 370ish. Per month. All in for original Medicare and then out of pocket after that. The only Medicare related expense Jack would see would be the $233 charge for the annual deductible.

How does your income affect Medicare premiums?

You brought up a good point about the 170 or less of adjusted gross income. I’m sorry, 182,000 or less. Your part B premium, for those of you that don’t know, this is based on your income, your adjusted gross income.

And so there is a, a premium range. Okay. So, um, hypothetically, if you were the next premium band up, which is 182,000 to 228,000, your part B premium goes up by about $700 per year. For single filers that premium band would be 91,000 to 114,000, your premiums go up by about $700 per year.

The next band up for singles 114 to 142. And then for married filing joint, it’s 228 to 284. And the premiums are basically double than what they were on that first band. So this is a big part for me as the numbers guy, I like to help try to mitigate as much as possible my client’s taxable income in retirement. There are several ways to do it, but, income tax free withdrawals are the primary way. And so those are Roth distributions, distributions from things like health savings accounts or life insurance, even non-qualified annuities, reverse mortgages could be another option or real estate income.

So by reducing taxable income in retirement, you could also in essence, reduce what you pay in Medicare premiums, which could also help alleviate that pressure on drawing your assets down too quickly during those retirement years. But thanks for breaking down the premiums for original.

What about advantage?

You hear the premiums are much lower, but what are some ballpark ranges of what you can expect for premiums?

AP:

Sure. Jack would owe $170.10 for Medicare part B. And then there are advantage plans as low as $0 premium. These plans would also likely come with prescription drug coverage wrapped in.

We would need to make sure that Jack’s prescriptions are covered affordably. What matters here is the name of the medication. Whether Jack can tolerate a generic or has to go brand name. The dosage and the pharmacy that Jack likes to go to each of these factors influence price. And so it’s actually a really complicated equation.

What’s also important is making sure that the additional benefits appeal to Jack and that they meet his lifestyle needs, but there are great $0 Medicare advantage plans that would be available if Jack decides to go that route. And here Jack would need to, in exchange for that $0 premium, accept the network restriction.

KL:

Got it. So researching those doctors, looking at the prescriptions that he may or may not be taking and backing into the decision that way. But it sounds like your premium could be 50% less, right?

AP:

Yes. It would be 50% less. There are some things to consider. First there’s co-pays when you go to the doctor. Costs if Jack sees specialists. The bill’s going to rack up if he sees those specialists more than once per month. So if he goes to see a specialist twice per month, then the copays will start to add up.

Also importantly, Jack needs to make sure that if one of the doctors is out of network, let’s say Jack would need to accept the consequences, which is that the carrier could deny coverage in that case. Or there might be onerous co-insurance requirements.

Okay. And that’s something I assume you can run some numbers, right?

Some hypotheticals based on how much they’re going to see certain specialists or how many times they anticipate going to see the doctor, and prescriptions. And then you can do a cost benefit analysis.

AP:

It’s important to shop. It’s important for Jack to shop all his options every year because the plans change.

KL:

So let’s talk about Diane a little bit. So she’s got eight years until she gets to 65. So we’ve got some time, what are her options?

One thing we talked about was Cobra for her. I mean, could she get on Cobra to continue on the group plan or does she just have to go straight to the private market, which would be the exchange?

AP:

Diane can Cobra for up to 36 months as a result of Jack’s retirement.

So that’s an option for her. That’s one option. Another option would be to look at the affordable care act exchange. There are generous federal subsidies right now, depending on Jack and Diane’s earnings. Diane might qualify for some of the subsidies and could find a lower cost plan that might be more comprehensive then Jack’s former employers work provided CORBA.

KL:

Okay, so she can use Cobra. He cannot use Cobra because Medicare needs to take over as the primary. So he’s gotta go Medicare.

She has the option of whether it be Cobra or individual insurance through the exchange, healthcare.gov. I think those subsidies just got extended through 2025. Yes, the subsidies were extended under the inflation reduction act, which passed Congress last month. And it’s cool because, you know, on the, um, and I did these calculators too, when I was doing my own coverage for my family.

You could go in there and type in a hypothetical income that you think you’re gonna earn for the year. And they’ll actually quote you what those subsidies might be per month. And so that’s another benefit of having a tax free income in retirement, right? Because if, if you retire before 65 or before your Medicare eligible and you lose group health insurance. If you can keep your income or your taxable income low enough, you can potentially qualify for a lot of subsidies and keep those premiums down until you turn 65. Right?

AP:

That’s right.

We’re Medicare experts. Only Medicare. But yeah, so for Diane, she’s got those two options. She could Cobra, she can look at the exchange. Compare the two and see which one’s more comprehensive and which is more cost effective as well.

KL:

Well, this is great, Ari. I don’t know if there’s anything else we missed that you think the listeners should know about? I think you, you covered a lot of good stuff but any final thoughts.

AP:

Yeah. The fall is coming fast which means only one thing, annual enrollment period. It’s time. If you’re Medicare eligible to shop all of your options. Unfortunately over 70% of people won’t do it, but there’s huge cost savings to capture here. It’s helpful.

If you use an independent advisor to assess all your options, chapter is an example of one, and you can visit us at our website at askchapter.org.

KL:

That’s awesome. I mean, I think that’s a huge benefit. And, and I, as you know, the reason I met you, I have several clients that use chapter and that know you personally and love the service. And you can kind of take over that responsibility because you know, when they think of fall, they’re not thinking of Medicare open enrollment, they’re thinking of, traveling to the mountains to see the foliage. Or kick off for their favorite football team. They’re thinking of spending time with their grandchildren.

Well thank you so much a for joining and helping clarify this complex topic and making it simple. I’m also excited to check out your book in September.

It’s not that complicated, so I love the title. If you guys have questions directly and want to reach out to Ari, his email is [email protected]. Thank you everybody for tuning into today’s episode, I heard hope you learn something valuable and we appreciate all of you and hope that you follow us and give us a subscribe and make sure you continue to tune in.

Until next time, this is Kevin Lao signing off.

Kevin Lao

September 1, 2022

How to divide assets in a blended family

Benjamin Franklin said “the only two certainties in life are death and taxes.”

As a fiduciary financial advisor, one of the most important topics to address is how to divide assets in a blended family.

If something were to happen to you, how do things play out? How do you divide an estate with step children? How do you protect your assets from stepchildren? What about the effects of an unequal inheritance? What about estate planning for a blended family with adult children?

Each situation is unique. Take what applies to you, and make a plan!

How to divide your estate with stepchildren?

The reality is that blended families are almost as common as a traditional family. A blended family is a marriage that involves children from a previous marriage or relationship.

It’s important to consider your own family dynamics when dealing with retirement and estate planning issues.

A remarriage when children are young is very different than becoming a blended family when the children are adults.

You might think if the children are young, it’s more likely you will handle your estate planning and wealth transfer strategies like your “traditional family.” And that may be correct in the sense that you want to divide your assets equally to your biological children and stepchildren.

One potential hurdle to look out for is guardianship issues of your minor children. If something unexpected happened to you and your spouse, it’s possible that an ex-spouse might have guardianship rights over your child or stepchild. Additionally, if your children are minors, the guardian will take custody of their assets until they are age of majority.

You probably want to avoid your ex spouse taking custody over your children’s inheritance. Instead, consider setting up a trust and naming a successor trustee (someone other than your ex of course).

How to protect assets from stepchildren

The most basic form of an estate plan is a will. A will allows you to name specific beneficiaries that will inherit your assets when you die (among other important decisions). You could name your spouse, children from your previous marriage, and even perhaps your stepchildren. You can also exclude anyone you wish within certain limitations.

The issue with having a basic will is that if you do predecease your spouse, all of the assets you leave to your new spouse will be his/her property outright. This means that after his/her death, the remaining estate will be property of their beneficiaries, likely their children (your stepchildren).

This could be problematic if your ultimate goal was to leave your remaining estate to your children, not your stepchildren.

The way to get around this issue is to set up some sort of marital trust, the most common being a Marital Bypass Trust. This can allow you to name the trust as beneficiary of your assets. The trust could be the beneficiary of all, or a portion of your estate.

First and foremost, this type of trust will ensure your spouse is taken care of for their lifetime.

Once your spouse passes away, the remaining trust proceeds will then be left to your children (or other remaining designated beneficiaries). This will prevent any other “unwanted beneficiaries” from receiving your estate.

If you have an existing trust, make sure it’s been reviewed and updated in accordance with the SECURE Act rules. Otherwise, there could be some unfavorable tax consequences for your beneficiaries.

What about adult children in a blended family?

If you are a blended family with adult children, it’s possible one or more of the following might apply:

An age gap with your new spouse
You or your spouse have accumulated substantial assets before your remarriage
You and your new spouse might have children together and separately
Your new spouse might be closer in age to your adult children

If there is an age gap in the remarriage, it’s likely that you will have two separate estate planning and wealth transfer strategies.

Take care of your spouse for their lifetime
Leave a financial legacy to your children

As discussed earlier, the likely solution here is to set up a trust that allows for your spouse to benefit, and then ultimately your children.

However, you may consider leaving some or all of your assets to your adult children if:

your spouse is financially independent
you don’t want your children to wait until your spouse dies to receive their inheritance

If this is appealing, you must be aware of the elective share rules in your state.

Elective Share

For community property states, assets accumulated jointly are assumed to be owned by both parties. However, in non-community property states you can own assets separately despite being married. You can leave those assets to another beneficiary other than your spouse, as long as you leave your spouse a certain % of your total estate (this is known as the Elective Share).

Florida, for example, has an Elective Share rule stating 30% of your assets must be left to your spouse, regardless of what your estate plan says. Additionally, there is no requirement for how long that new marriage lasted!

Even if you set up a trust, certain trusts might fail the elective share test. Therefore, be careful if you have goals to leave a larger portion of your estate to your children instead of your spouse.

If you and your spouse are financially independent, you might consider signing a prenup or a postnup. This will ensure that you have the legal right to “disinherit” your spouse and overrides the elective share rules.

Consider Life Insurance

Life Insurance is a great tool if you have multiple estate planning and wealth transfer goals.

Here’s an example:

Let’s say the bulk of your assets are inside of a 401k or IRA and you get remarried.

Let’s say your adult children are on their own, building their careers and growing their families.

Because of this, you’d like to leave your kids money when you die, but you also want to make sure your new spouse is taken care of during retirement.

First, you may consider setting up a trust for the benefit of your spouse and naming that trust the beneficiary of your 401k or IRA. Your children would be the contingent beneficiary of the new trust. This will protect against any stepchildren or new spouses from inheriting your assets.

If the trust is set up properly, your spouse can maintain favorable life expectancy rules when it comes to required minimum distributions.

Now that your spouse is covered, you buy a new life insurance policy with your children as primary beneficiaries. This way, they aren’t waiting for stepmom/stepdad to pass away to receive their inheritance. If you already have life insurance, you could make sure it’s structured properly and simply name your children as primary beneficiaries.

This also gets around the issue of the elective share. The calculation for the elective share will typically not include death benefits from life insurance. However, it might count cash value, so make sure you structure the policy properly in accordance with your state’s rules.

If the goal is to own the policy throughout retirement, you will want to make sure it’s a permanent policy, not term. Term insurance is more likely to expire before it pays the death claim, and you don’t want to be shopping for permanent insurance when you’re 70.

Effects of an unequal inheritance

If you have multiple sets of beneficiaries, you might be thinking of the effects of an unequal inheritance.

Let’s say you have adult children that are well off financially. However, you also have children with your new spouse that are still 100% dependents.

In this scenario, you might consider leaving a larger percentage of your estate to the side of the family that needs it most.

If you consider this strategy, I highly recommend setting up a trust. This will reduce the likelihood of issues being contested in court, and the terms of the trust remain private. Additionally, it’s likely your dependent children are minors and would need someone to oversee their inheritance (a trustee) until they are responsible adults.

Another consideration for an unequal inheritance is the impact of income sources that will be lost for the surviving spouse. This could include Social Security, pensions, annuities, distributions from IRA’s and investment accounts.

Upon the first spouse passing away, the surviving spouse is entitled to the larger of the two Social Security benefits. However, this still results in a reduction of Social Security income for the survivor.

If you have a pension or annuity that stops at your death, you also need to consider the impact of this lost income.

If your IRAs or 401ks are left to your children instead of your spouse, could your surviving spouse maintain their standard of living for years or even decades to come?

Additionally, would your surviving spouse be able to pay for long-term care if a large portion of your estate was left to your children?

These are all issues you should think through to help divide your assets within your blended family.

One final thought on this topic is that it’s not just about how much you leave, but how you are remembered.

The act of making things easy to manage for your loved ones is a big part of how you will be remembered! Leaving a big mess to clean up won’t help that cause, regardless of how much money you leave behind.

Tax Considerations

The types of assets that are left to children, your spouse or a trust are all important from a tax standpoint.

Qualified Retirement Accounts

Leaving your qualified retirement accounts to your spouse outright will create the optimal tax benefits. These include IRAs, 401ks, 403bs, 457bs, TSPs etc.

On the other hand, leaving qualified assets to your children will likely trigger the new 10-year rule. With the SECURE Act coming into effect in 2019, these accounts can no longer be stretched according to the child’s life expectancy. This will likely result in an acceleration of taxes that could have been minimized had these accounts been left to a spouse.

Naming a trust as beneficiary of a qualified plan also presents some challenges. Tax brackets are significantly higher for trusts versus an individual.

In 2022, a Married Filing Joint taxpayer would have to earn over $647,850 in taxable income to cross the highest tax bracket at 37%.

For trusts, the highest tax bracket threshold is only $13,450!

If you name a trust as beneficiary of a retirement plan, make sure your attorney has revised or drafted the documents to align with the SECURE Act rules. This could mitigate unnecessary tax implications.

Taxable Investments

Investments including stocks, bonds, mutual funds, ETFs, real estate, tangible property and even crypto assets would fall under this category. This assumes these investments are held outside of an IRA, 401k or other qualified retirement plan.

The major tax benefit for these assets is the step up in cost basis after death.

How does the step up in cost basis rule work?

Let’s say you bought $100k of Apple in 2000 and it’s now worth $500k. If you sold $500k worth of Apple, your capital gain would be $400k (500k – 100k).

If you die before selling it, your beneficiary gets a “step up in the cost basis.” Instead of your beneficiary paying taxes on the gain of $400k, their new cost basis is now $500k. If they sold the stock immediately thereafter, they would have little to no capital gains taxes due!

For married couples, there are some additional rules that are based upon the state you live in. For community property states, assets are assumed to be owned jointly, and therefore only ½ of the basis is assumed to be stepped up upon the death of the first owner. Upon the death of the second owner, than the full step up rule is applied.

In non-community property states, you could in fact own assets separately from your spouse so they can take advantage of the FULL step up at your death. This could be accomplished with a revocable living trust in your name only, OR perhaps individual ownership with your spouse as beneficiary (via TOD or POD designations).

Make sure you consider your estate planning and wealth transfer goals before making any changes to your asset titling!

Life Insurance

We’ve already discussed the functionality of leveraging life insurance to take care of one or more of your wealth transfer objectives.

From a tax standpoint, this is one of the most tax efficient assets to leave a beneficiary. It’s 100% income tax free and probate free! Additionally, you can structure this strategy to pass outside of your estate by way of an Irrevocable Life Insurance Trust (ILIT).

If you have a beneficiary with special needs, you could also fund their “Special Needs Trust” with life insurance.

Action Items

Your estate planning and wealth transfer strategies should be personal to you!

Make sure you are taking care of your loved ones the way you intend to.

Make sure you have the proper documents in place that align with your intentions.

Make sure you update and revise all of your beneficiary designations.

Make sure your financial plan is coordinated with your estate plan and wealth transfer goals.

And finally, do your best to make things simple for your loved ones. Communication and clarity are critical to avoid unnecessary conflict. You don’t want your loved ones to question “why” things were set up a certain way.

I hope you found this information valuable!

Make sure to SUBSCRIBE so you don’t miss out on any of our retirement planning insights!

SCHEDULE A ZOOM call if you want to discuss your current situation with a Fiduciary.

And finally, join our “BLENDED FAMILY RETIREMENT AND ESTATE PLANNING” Facebook group for ongoing dialogue and insights from our team of experts!

Kevin Lao

August 19, 2022

Episode 12: Should I pay off my mortgage early?

(transcription) Should I pay off my mortgage early?

Kevin Lao 0:17
Hello, everyone, and welcome to the planning for retirement podcast where we help educate people on how retirement works. I’m Kevin Lao your host, I’m also the lead financial planner at Imagine financial security. Imagine financial security is an independent financial planning and investment management firm based in Florida. However, this information is for educational purposes only and should not be used as investment, legal or tax advice. This is episode number 12. Should I pay off my mortgage early? I hope you enjoy the show. And if you like what you hear, leave us five stars, it really helps and make sure to subscribe or follow to stay up to date on all of our latest episodes.

So this is such an important question and one I get all the time for not just folks that are approaching retirement, but younger folks that just took out their first mortgage and they’re trying to figure out, you know, should they pay it off in 30 years?

Should they pay it off early? And this particular question was was fielded because my client was speaking to a work colleague that’s several years of senior to her. And they recommended that she take $500 a month and apply it towards principle every month, and that would essentially pay down the mortgage after 20 years instead of 30. I mean, that sounds great on paper, I mean, after 20 years, you have no mortgage and free cash flow that you can do whatever you want with. You can invest all of that free cash flow at that point in time. But what is the opportunity cost to not investing that $500 a month, let’s say in a side fund? And so that’s really what we’re going to be addressing today. And really, the concept of paying down your mortgage early or not, comes down to three things. Number one is your personal risk tolerance. And number two is your ability to generate a certain rate of return in that side fund. And then number three is liquidity concerns. Okay, so we’re gonna address all three of these. So the first thing to talk about is risk tolerance. The first challenge of investing that into a side fund versus paying down the mortgage early is that the side fund is generally not going to be a guaranteed rate of return. Even if you look at CDs, or Treasury rates,. Yes, certainly interest rates have come up a little bit, but where are you going to get a four and a half percent, or even a 5% guaranteed rate of return? Nowhere, it doesn’t exist at this point in time. And so paying down the mortgage, just for the simple fact that it’s a guaranteed rate of return of four and a half percent. And that might be aligned with your risk tolerance. In this case, maybe you do pay down that mortgage, over 20 years, because four and a half percent is a pretty damn good rate of return on guaranteed money. Okay? Now, let’s say we take that out of the equation, we understand that the money in the side fund is not going to have a guaranteed rate of return of four and a half or 5%. But let’s say you’re okay with that. You say, Hey, I understand diversification, I understand how investing in stocks work or mutual funds or ETFs. And I am confident I can get a five or six or even 7% rate of return in the side fund over time. What happens to that side fund over 20 years or 30 years or 40 years? Okay, and so that’s what I did for her I crunched the numbers, I just pulled up Excel and I literally just took the the mortgage calculator amortization schedule from bankrate.com. And I plugged everything into Excel. And we calculated after 20 years that mortgage would be fully paid off if she applied that $500 of additional additional principal every single month for that 20 years. Okay, then I ran the second scenario. So let’s call a client a, let’s call client a the one that pays the mortgage down in 20 years, okay, and let’s call client b be the one who pays the mortgage off over 30 years, which is the scheduled amortization. And they invest that $500 a month into let’s call it a side fund. And I ran three different scenarios, let’s say you earn 5% or 6% or 7%, what is the difference over the duration of your life expectancy. So the first thing we found out is that after 20 years, client a has paid off the mortgage but client B has enough in their side fund to pay off the remaining principal if they wanted to, assuming a 5% return! And so this goes back into what I mentioned earlier about liquidity. Your house is not technically liquid. Sure you can tap into it via a cash out refinance which would then reset a new amortization schedule or you could do a HELOC, but that’s also debt against your property. And so it’s not technically a liquid asset whereas the side fund if you set it up properly, it is 100% liquid, you can tap into it at any point in time. Now, of course, if you’re investing that money into a 401 k or a 403 B plan, there’s penalties if you tap it before 59 and a half, but you might not really care about that. On your balance sheet, you have enough saved and invested assuming a 5% rate of return, that equals the remaining principal on your mortgage. In my opinion, client B is winning here, because they have money on their balance sheet that’s 100% liquid. And if they felt like it, they could pay off the mortgage just like client a did. Now, after 20 years, what happens to client A is they have 100% of that principal and interest payment to invest in the side fund. So now they begin their side fund after 20 years as opposed to on day one. So then I tracked after 20 years, what happens to the side fund of client B versus the new side fund of client A. Assuming a 5% rate of return, assuming we stay disciplined, and we’re investing those payments every single month. For client B, it’s that $500 per month of excess principal that they weren’t applying against the mortgage. And now for client A, it’s roughly $31,000 per year that they’re now applying to the side fund. Well, after another 10 years, once the mortgage is fully paid off for client B, client B still has 10% more (just over $40,000) in their side fund, then client A. So if you look at it mathematically a 5% rate of return for someone that’s reasonably aggressive, maybe a balanced investor, they mathematically have more money in their side fund, then did client A even after client a paid off the mortgage, and then reinvested all of those payments into that side fund. Now, what happens when you do 6%, or even 7%? Well, now the multiples go up even higher, instead of having 40,000 more, client B has over $200,000 more in that side fund than client a assuming a 7% rate of return. And if you look at the s&p 500, historically speaking, just over nine and a half percent annually over the course of the last 30 years. I mean, who knows a lot of people think returns are going to be lower over the next decade or two, no one has a crystal ball on this. But I think 7% is a reasonable return for someone who’s fairly aggressive. And so again, it goes back to the first point of risk tolerance. Are you comfortable with taking on some more risk? And are you comfortable with understanding that comparing this to paying down your mortgage is not apples to apples. Paying off your mortgage is a guaranteed rate of return of whatever the interest rate is. Whereas if you invest in the side fund, you might get six, you might get five, you might get seven, but you might not. Maybe we go through a period of time over the next 10 or 20 years, like the lost decade of 2000 to 2010. No one has a crystal ball on this. But if you understand that, you know what your appetite for risk is, and you apply that principle to paying off the mortgage or not, it’ll help make a decision that is best for you. Now, how you invest that side fund, there’s also many factors there. Are you disciplined with the investments? Are you investing in a very well diversified portfolio? Or are you trying to hit homeruns by investing in let’s say, digital assets, or, one or two concentrated positions or stocks that you really, really think you like. Because if those don’t pan out, that negates the entire purpose, because the likelihood of you earning that 7% over the course of the 20 or 30 years, is lower than if you’re well diversified, well disciplined, and well positioned to capture the market returns, as opposed to swinging for the fences. And the last thing is liquidity. All along the way, as you’re investing into that side fund, that money is liquid on your balance sheet, if you had an emergency pop up, let’s say it’s a major medical expense or you lost your job, you could tap into that side fund, whereas during emergencies, you might not be able to tap into the home equity. Maybe you lost your job. How are you going to take out the HELOC or do a cash out refinance? No bank is going to give you a loan. Or what if you have a major medical bill? It might take 30 to 60 days to underwrite your home equity line of credit or do the cash out refinance. So having that side fund that is liquid right away on day one is a huge benefit to that client B who is investing into the side fund versus paying off their mortgage sooner. Personally if you want to know I am client b. I like to leverage the bank’s money, I like to stretch out the debt as long as possible just given how low interest rates ar. The first home I purchased in 2016 had a three and a half percent rate. This home that we just purchased has a 3% mortgage, so I’m confident I can get a five, six or 7%. And that’s a much higher multiple than comparing it to what my interest rate is on my mortgage. But I understand the risk there on the side fund, I understand it’s not guaranteed. And I also understand that I have much more liquidity in that side fund than I do in my home. Now, as interest rates continue to go up the argument to paying off that mortgage early pendulum is beginning to swing in that favor, especially if rates go up to maybe 6%. Then, your appetite for risk needs to be fairly high to to accommodate that higher return in that side fund.

Now, with all of that being said, I talk to clients all the time that are approaching retirement, and they’ve had this goal of being debt free in retirement for many, many years! 15, 20 or even 30 years! Using math to convince them to invest more on their balance sheet versus paying down the mortgage by the time they retire is completely irrelevant to them. Because the qualitative factor of owing nothing to anybody is that much more important than how much they have on their balance sheet. So if that is you, pay off that mortgage by the time you retire, get aggressive, figure out that amortization schedule that lines up with your anticipated retirement date. And don’t feel badly about losing out on those opportunity costs. Because the psychological benefit and that peace of mind you’re going to have by checking that box off of being debt free in retirement is that much more meaningful for you.

Thanks, everybody, for tuning into this episode of the planning for retirement podcast. I hope you learned something valuable. We really appreciate your support and following our podcast journey. If you have any feedback on the show, or even if you have questions that you want answered on the show, send me an email at [email protected]. Just write in the subject line “podcast” and who knows, maybe your question will be answered on the next episode. Until next time, this is Kevin Lao signing off.

Kevin Lao

August 16, 2022