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Author: Kevin Lao

What is a safe withdrawal rate for retirement?

What factors go into retirement withdrawal strategies?

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

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

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

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

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

Replace income without depleting principal

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

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

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

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

Replace Income but maximize legacy

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

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

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

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

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

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

Max spending with no inheritance

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

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

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

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

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

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Episode 4: Maximizing Social Security Benefits for Retirement

 

Maximizing Social Security in Retirement

Maximizing Social Security Benefits for Retirement

Kevin Lao 00:12

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

Is Social Security In Trouble?

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

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

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

What’s the break even for delaying Social Security?

03:41

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

Consider longevity in your family history

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

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

05:51

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

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

 

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

Will you ever rely on Social Security?

08:58

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

Claim Social Security and invest it!

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

Summary

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

 

Episode 3: Four Stress Tests For A Bulletproof Retirement Plan

 

How to stress test your retirement plan

Kevin Lao 00:11

Hello everyone and welcome to the Planning for Retirement Podcast. I am your host, Kevin Lao and today we’re going to be talking about how to stress test your retirement plan.

What is a retirement stress test?

Now most people think about stress tests when they’re going to the doctor, they’re getting hooked up to some monitors, putting a treadmill and doing a little bit of exercise. And you know ultimately, the doctor was monitoring your blood pressure, your heart rate, your fatigue level, all sorts of things. Really, their goal is to see how your heart performs or responds with a little bit of stress. And I like to take that same concept into my financial planning practice to see how my clients’ portfolios or retirement plans or other long term objectives respond with a little bit of stress. And the reason I do this probably is obvious. But really the idea is that we’re planning for a 15, 20, 30 or even a 40 year window, and things are inevitably going to happen. We just don’t know what those things are. And we don’t know when they’re going to happen exactly. So what I like to do because people worry and they are concerned about different things. And I like to flush those things out in the financial planning process to see what’s keeping up keeping them up at night. And ultimately stress test those scenarios to make sure that their long term objectives are still holding up, and still have a high probability of achieving them with a little bit of stress.

The four retirement stress tests that you must consider!

So there are a lot of different stress tests that I’ve run in my career. But what I found is that there are four major stress tests that I put all my clients through. And if they can pass these four stress tests, they are sleeping really, really well at night. They’re enjoying retirement, they’re freed up to spend their own money in retirement, which is an interesting thing. But people that are retired, they have this concern of running out of money. And so there’s always this fear of… you’re spending too much because you don’t know how long you’re going to live or what’s going to happen. So I found that people are enjoying lives more in retirement by stress testing these scenarios up front. So without further ado, the four stress tests has that I run for all of my clients to make sure that they have a bulletproof plan are number 1, Great Recession loss. Number 2, long term care costs. Number 3, prolonged low returns. And number 4, living longer than expected.

 

So we’re going to dive into each of these in a little bit more detail. I hope everyone finds this helpful. I hope you take something away from it. You can all always reach out to me directly you can email me at [email protected]. You can also go to my website and contact me there www.imaginefinancialsecurity.com. You can also subscribe to our podcasts that’s always very helpful. And you can be informed of new episodes that drop etcetera, etcetera. But always love to hear from you to let me know what you think. And if you have any questions as it relates to your situation, always happy to answer and be a resource. So let’s dive in.

Great Recession Stress Test

03:12

Alright, we’re going to start with talking about the Great Recession loss test. Some may call it the bear market tests. And you know a bear market is quantified as a 20% drop in the stock market from its previous high. I like to use the Great Recession loss test because it is the biggest drop in the stock market that I’ve seen in my lifetime. Not bigger than the Great Depression, which was an 86% drop from previous highs and the 1920s, 1929. So that is extreme. But in 2007 or 2009 from its peak, the market dropped about 56%. And it took about 49 months for the market to get back to that previous high that it hit in 2007. A normal bear market will last on average about 22 months. And typically you know they happen every five years. So they’re fairly common. So I want to make sure that if my client goes through one of these types of bear markets and if it’s as extreme or close to the Great Recession… I want to make sure that they’re prepared and we have a plan and we have a high probability of achieving ultimately that retirement income goals or other legacy goals that they might have.

 

So how do we do this? Okay, so the first thing is prioritizing the objectives into needs, wants and wishes. This is important because obviously if we go through a serious recession or a depression you know my clients may not be buying boats or taking their bucket list travel… you know they might be but they’re probably not they can probably make some of those cuts. So we would quantify those as maybe wants or wishes, whereas you know your basics like food, healthcare, water, shelter, those types of things are needs. So we want to make sure that we have three categories of objectives: needs, wants and wishes. And this is all part of the process upfront. Once we have this quantified, we run it through a simulation to see what is the probability of success and achieving those goals if we go through a great recession in their life expectancy.

 

So what’s cool about this is if clients pass the test and great you know there’s not a whole lot of changes we need to make if they fail the tests or if some of their objectives need to be cut out… we can then make decisions on what should be done you know whether that’s changing the investment strategy or saving more before retirement or if they’re already retired, maybe it’s reducing expenses or working you know doing consulting part time. There are a number of different things that we can do. The biggest controllable is obviously the investment strategy.

 

05:58

So with this, what I like to make sure happens is that we have a significant amount of non-correlated assets to stocks in the portfolio. So typically you know clients would refer to this as bonds you know I would call it fixed income or other alternatives. And it’s crazy. I recently saw an article from a major publication that said, bonds are terrible investments, which is insane because you know that’s a very blanket statement, and you’re talking to a audience that is all different ages. So yes… bonds may be terrible for some but they’re amazing for my clients that are approaching or in retirement because they serve as that hedge if the stock market does go through a great recession type of scenario. So let’s say for example, the stock market dips 20% or more or like in 2007, 2009 it dropped 56%. If 100% of our portfolio was in stocks, we would have to liquidate stocks to generate income right… so we’d be selling stocks at a loss.

 

Now, you’ve probably heard the notion you want to be buying low and selling high not selling low. So in order to alleviate this concern, we need to make sure we have a certain dollar amount in the Fixed Income Cash or alternative asset classes to make sure that if we go through a bear market or recession like 2007 2009, where it took 49 months to recover… we have enough in those asset classes so we don’t have to sell stocks low. So if I’m using that benchmark of 49 months of full recovery that’s roughly 4 years of income that we would want to have in fixed income types of investments that we can pull from in those types of bear markets or recessions. What this does is that alleviates the pressure on doing anything within stock… the stock side of the portfolio, let those asset classes recover because historically speaking, stocks do come back and they do perform way better than bonds. I do agree with that. But it allows us to put less pressure on those equity investments, allow them to recover and still generate that income that my clients need to enjoy their lifestyle and have that peace of mind.

 

So again, hopefully the takeaway here is let’s see if the portfolio holds up. And the goals hold up if we go through a bear market scenario like a great recession. And then secondly, let’s make sure we have a well thought out investment strategy to ensure that we have other asset classes in the portfolio that are non-correlated to stocks. So we can weather those storms when we go through them because on average these happen every five years. If we have a 30 year retirement, you’re going to be lucky enough to live through about six of those bear markets.

Long-term Care Stress Test

08:40

Our next we’re going to talk about long term care costs. And this is a topic that has been pretty much at the forefront for my clients since I’ve been in the business and it’s only gotten more prevalent as people are living longer. You know and one thing I saw… a study that was done on life expectancy, which I thought really was staggering to me is that someone who is 65 today has almost a 70% chance of needing some type of long term care services in their lifetime. And what’s even more staggering is that 20% of those aged 65 or older who would need long term care will need it longer than 5 years. And if you think about the cost of long term care, the fact that Medicare does not pay for long term care. It’s concerning for most people and you know, as a practitioner you know doing… we’re specializing in retirement planning. It’s something I need to assume every single person I work with has a long term care plan.

 

I’m not saying they need to own insurance but I need to make sure they have a plan. And what I’ve found is the best way to start that planning discussion is to stress test to see how their retirement goals how their other long term objectives how their investment portfolio holds up. If we put one or even both individuals if they’re married through a long term care stress test. Now how we do this is challenging because you might need care for a year, you might need care for 10 years if it’s something that’s more cognitive like dementia. And it’s obviously impossible to run all of those scenarios. So what I do is I take the average, for women it’s 3.7 years of care for men it’s 2.2 years of care. And I multiply that by the average cost of a private nursing home, which right now is about $105,000 per year in today’s dollars. So someone’s 65 you know that’s today’s dollars, we want to build in a reasonable rate of inflation for 5 maybe 6%, depending on the state and depending on the type of care we’re going to stress test is a prudent inflation rate for this type of service. And so if we’re looking out 15, 20, or even 30 years down the road in doing the stress test… the numbers are going to be quite staggering.

 

And you know personally… I think there’s probably some sort of bubble that’s going to burst with long term care costs going up the way they have been over the last couple of decades. And I think technology and the industry will evolve to help alleviate some of that inflation. But for now, it’s quite staggering. So once we run through the stress test… I will then share with my client if they have a high degree of success and self-insuring and this assumes they don’t have any long term care insurance. And if they have a high degree of success, self-insuring you know they really have one of two options, they could self-insure, meaning use their own assets whether that’s investment portfolios 401ks, IRAs, individual stocks or bonds, mutual funds whatever it might be, they can use their own assets to self-insure or they can decide to buy insurance to hedge their portfolio. And what I mean by that is instead of liquidating investments that are going to generate potentially 5, 6, 7 8% a year in returns, they simply buy insurance so that if they ever need care… they can keep those assets on their balance sheet to essentially work for them and for future generations or maybe their spouse, and essentially allow the insurance to pay the costs of long term care. So or they can do a combination of you know and that’s what I see a lot of people do is they’ll get some insurance but then they’ll self-insure for the rest.

 

12:27

And you know there’s no magic number but I think the stress tests will give us an idea of… Hey, are you successful self-insuring? And if so, we have some options. If you’re not successful then really, there’s one of two things. Number 1, we can change the goals. Meaning you can work longer, you can spend less, you could change your investment strategy, you could do consulting, or work part time, or you can buy some insurance to hedge against this risk. And you know from my experience, you know if you are in your 50s or 60s or even your 40s you know long term care insurance is relatively affordable. But the older you get… you know once you get into your mid to late 60s or 70s, it gets more expensive. So you know in those scenarios… you know you’re going to want to look through many different carriers. And you’re going to want to work with an agent that can look at many different carriers to see what is the best fit for you based on your age and health profile. And there’s a lot of different flavors of insurance. You know there’s hybrid policies, there’s pay as you go, there’s one lump sum payment policy.

 

So there’s a lot of flavors out there. I don’t personally sell insurance you know as a fee only planner… I work with my clients to give advice on these policies. But ultimately what I will do is I will work with my clients with their insurance broker to come up with the best solution. And you know, ultimately, what I found is that having a decision is probably the most important thing because I’ve had people brush it off and not doing it… do anything. And ultimately they leave it to their loved ones whether it’s their spouse or children to make the decision or even find out if they have insurance or not. And so another key takeaway is once you have a plan for paying for your care, is making sure your financial powers of attorney, making sure you’re your healthcare powers of attorney, making sure they are aware of what that plan is. So if God forbid something happened tomorrow, they know where to go. They know what assets to utilize to pay for your medical costs and things of that nature. And they’re not scrambling at the last minute. So again, stress test the plan, see if you’re successful with a long term care event, if you need insurance or if you want insurance, there are a lot of different flavors you can go and making sure you’re consulting with the right individuals, the right advisors is extremely important in my experience, and then obviously let the loved ones know let the people know your friends or family. What your decision is on that front so they can essentially follow suit. When or if something were to happen.

Prolonged Low Returns Stress Test

15:05

Alright, the third stress test we’re going to talk about is prolonged low returns in the stock market. And I’m not going to go into too much detail because I think it’s pretty obvious what it is we’re going to assume lower than expected returns in the portfolio over the next 10, 20 or 30 years, and see how the portfolio reacts. You know, the goals react. But I think why we do this is relevant and I think it’s a few pieces of data that I want the listeners to… to know about is important. If you look over the last 10 years… okay let’s take the S&P 500 [phonetic 15:38], which is a benchmark for U.S large cap stocks. The S&P 500 over the last 10 years from 2011 to 2020 has returned 11.96% per year. So we’ll call it 12% a year. If we look over a longer period of time let’s say 50 years the S&P 500 has returned 6.8% per year.

 

So essentially over the last 10 years the markets outperformed 5% per year. So you know there was there was a lot of factors there. And you know if you think about the Great Recession, 2007 and 2009, we were just coming out of that in 2011. You know, so that’s a factor. You know anytime you come out of recession, the stock market booms… you know we had quantitative easing… we had prolonged low interest rates. So there’s not a lot of places to go for yield naturally, people invest in stocks to get yield and low interest rate environments. But if we believe in the law of averages and looking at the idea that the market is cyclical you know… I’m going to venture that we could experience some lower expected… lower than expected returns over the next 10, 20 or 30 years. So if we believe that it’s prudent to stress test how the portfolio is going to react to those types of scenarios. And you know the way we do this, if a client has a more aggressive appetite, meaning they have a higher exposure in stocks in their portfolio and their strategy… I would argue that we would want a stress test closer to 1.5 or 2% per year less in returns over the duration of the life expectancy. The client’s more balanced if they’re more conservative, they have a higher percentage in fixed income with a portfolio. We could probably lean more towards 1% per year less from a return standpoint.

 

But you’d be surprised at the results you know if you are a… you know on the edge of being successful or if you’re on the verge of being unsuccessful versus successful. You know it’s one of those things that you’d want to know. And if we enter that scenario of being in a lower than expected return type of market for a 10 or 15 year period you know it’s probably good to know like… hey, what can I reasonably expect from an income standpoint? And more importantly, from a goal standpoint, you know what do I need to prioritize as my needs versus wants versus wishes.

 

18:02

So I hope that’s helpful. And again, this is one of those things that I think everybody should do especially not even just the folks approaching retirement especially those folks that are 20 years away from retirement or even 30 years away. Because you know in that scenario, we’re assuming a… let’s say a 20 year or a 30 year savings rate window as well as another 30 or 40 year retirement phase. So the return that you build into the analysis, which will then determine how much you need to save for retirement is extremely important. Because you know if we assume a 7 or 8% return every year but we’re only getting 5 or 6 you know that makes a big difference in terms of how much you to need save. And then much rather those younger clients that are that have the time to be more aggressive on savings as opposed to having that false sense of security. So again, this exercise is not only important for those that are in that retirement age but if you have kids or if you’re listening and you’re in your 30s or in your 40s you know think about using a more conservative targeted return in your model to see what kind of savings rate you need to come up with to get to that targeted… targeted goal that you set forth in your plans.

Longevity Stress Test

19:24

Alright the final stress test we’re going to talk about is longevity risk or living longer than expected. Now obviously nobody has a crystal ball. And as a financial planner, I have to look at statistics when I’m dealing with clients whether it be individuals or couples you know as we approach potentially a 20 or 30 year retirement window or even longer. And one statistic that always jumps out to me is that a 60 year old female, a nonsmoker, has a 30% chance to live until 94 and a 20% chance to live until 96 and actually a 10% chance to live until a 100. So if that 60 year old retires at let’s say 65 and they live until, let’s say 96, which there’s a 20% chance… that’s a 31 year retirement window we’re planning for. So that’s a lot… a lot of variables can change there you know inflation, interest rate changes, tax law changes, other legislation changes, rates of return, etc. Another thing to think about is that males or females live longer than males. And if you look at that same 60 year old and let’s consider this to be a male, also, nonsmoker has a 30% chance to live until 92 instead of 94, a 20% chance to live until 94. And then a 10% chance to live until 96. So if you look at that scenario you know two healthy individuals… you know that are approaching retirement, there’s a pretty good likelihood that the female is going to outlive the male. And you know if you ever go to a nursing home or a long term care facility… you know majority of them are women.

 

And so oftentimes what happens you know, if you’ve ever had personal experience in dealing with a loved one… you know that needs care is that if the male of the household needs care. Oftentimes, their spouse is still living and is able to help with some of the care at home. And if that male were to pre deceased, the female… then the female’s left to their own devices to get care at their end of life. And so oftentimes, the female is relying on some sort of professional help whether that be in home or in a nursing home etc. So the first issue that I deal with when we’re talking about longevity risk is sort of piggybacking off the long term care planning that we talked about a few segments ago is we need to make sure that there is a long term care plan for the surviving spouse in most cases, the female. And so oftentimes, if we’re deciding on who to buy insurance for long term care… I will oftentimes and if there’s a decision you know whether it be budget or other factors or maybe health, oftentimes, I will advocate for the female be the one to buy the insurance because they’re much more likely to rely on professional care. So they’re not a burden on their other loved ones whether it be children or grandchildren. So that’s the first thing.

 

The second thing we always have to address is with longevity risk is providing some kind of guaranteed income that my clients can never outlive. And you know… so the first source of this and the largest source of this type of guaranteed income, and I’m using quote to [unintelligible 22:34] quotes when I’m talking about guarantee is Social Security. And you know the reason I’m using [unintelligible 22:39] on this one is because you know right now, it provides for roughly 40% of all income received by individuals 65 and older. And actually I looked at a report recently, and it said that Social Security represents approximately 20% of the entire federal budget. So it’s a big number. And other estimates… I’ve seen other studies that I’ve seen done for Social Security estimates is that by 2041 if nothing changed, there’s going to be a deficit in funding Social Security, which is not a surprise you know. So for those that are you know 60 to 65, are in their 70s or 80s already collecting Social Security, they’re very close to it… they’re not as much of a concern. But the clients that are maybe in their 40s or 50s definitely more of a concern there of… hey, is Social Security going to be there at the same capacity when I get to retirement than it currently stands? And there’s a there’s obviously a big question mark to that.

 

And so many times you know when we’re dealing with this type of scenario, we’re looking for their privately funded sources to provide that guaranteed income. And you know the natural… the natural answer for guaranteed lifetime income is to purchase some kind of privately sold annuity. And so annuities by design are meant to provide that guaranteed lifetime income that one can never outlive.

 

23:52

So essentially you’re putting that longevity risk on the insurance company. The bet is that you outlive what the insurance company how long they think you’re going to live. So you know they have their actuary tables, and they run all the statistical model you know based on your age and your gender and they figure out… okay you know what… I think this client is going to live until certain age and if you live past that, and then you pass that breakeven point and you’ve made out ahead, if you pass away earlier or prior to that obviously the insurance company, quote-unquote [phonetic 24:29], wins. But there’s definitely something to be said, for that peace of mind where you know a client is entering retirement with no concerns about that income source ever going away… you know unless the insurance company obviously goes belly up, which is a different conversation.

 

So you know the caution I would throw out there is that these are oftentimes sold sort of as a you know… I would call it a fear-mongering type of solution you know where, you know, folks that are entering retirement, they’re obviously concerned about market volatility, they’re concerned about income. And so oftentimes these are pushed by you know… the insurance agents that purchase these annuities. And the question is do you buy one? Do you not buy one? If you want to buy one how much of it do you purchase? And frankly you know my personal experience with this is that these annuity products in these contracts are very complex. And so with that obviously… I’m biased given I am a fee only planner, I don’t sell annuity products. I always recommend clients that are looking at purchasing some type of annuity product to consult with a fee only practitioner to get that second set of eyes when you’re working with your insurance agent to figure out what makes sense, what type of flavor of the annuity makes sense. And then ultimately, how much of your money should be put into that type of product.

 

So just personally within my practice… I like a scenario, if my clients have a certain amount of fixed expenses that they never want you know they never want to be concerned about meeting… okay and let’s say Social Security makes up 50% of those expenses. And then the rest is made up of all of their other investments you know there’ll be a 401k plan or an IRA or other stock portfolio. And that scenario, we might look at back backing into how much they would need to put into that annuity to get that other 50% for their fixed expenses. Okay… so that’s kind of a very simplistic way to say that we want guaranteed income sources to fund most of the guaranteed expenses that my clients have.

 

Now, if my client has a Social Security Plan you know for them or them and their spouse, and they also have a pension you know whether it be through military or federal government or private pension… I may not really even consider an annuity in that case you know because we may have most of the fixed expenses being met by those fiscal fixed income sources. But that’s a real simple way to sort of figure out okay… hey, here’s my fixed expenses, how much do I need to back into putting into this type of annuity to get those the fixed expenses met by fixed income?

 

Now another caution I would throw out there aside from the complexity is that interest rates are historically low. You know the 10 year treasury… I mean was next to nothing you know just within the last few months and frankly, interest rates have been historically low really since [unintelligible 27:16] you know since the Great Recession… you know they had a lot of several series of rate cuts, and they’ve stayed like that for a long period of time. What’s happened is that these insurance companies, the models that they ran, to assume the longevity piece of the pie as well as what they could earn on their general portfolio to pay out the income sources, their way lower than expected. And so the result of that now is that these annuity rates are extremely low. And so it’s very important to look at those types of products and kind of look under the hood to make sure that the annuity is what you think it is because many times it’ll be dressed up you know it’ll say a certain thing. But really, if you look at the fine print, it’s really going to be performing a different way and have liquidity restrictions or substantial upfront costs. So again I get… I’m biased but always consult with a fee only practitioner that understands these types of products but does not actually earning a commission from recommending that particular solution.

Summary

28:14

So we’ve talked about the long term care planning, we’ve talked about that risk there addressing later in life expenses for the surviving spouse, we’ve talked about guaranteed income. What I will say about guaranteed income and the final note here you know before I close out this segment is that we can replicate a very well designed portfolio we can replicate the guaranteed income sources that my clients need to get that fit that extra 50% to get to their fixed expenses with a well-designed investment portfolio. And you know… I say that obviously you know, there’s volatility involved, there’s always risk involved. But for my experience… I am a big fan of using the endowment model. And the endowment model you know essentially being the notion of creating a really well diversified portfolio and creating a targeted withdrawal rate on that portfolio to where you have an extremely low risk of ever dipping into principle or at the very least outliving your assets.

 

And I and I’m definitely more of a fan of that type of strategy really for two reasons: Number 1, you maintain all of that liquidity on your balance sheet. And so whereas the annuity once you give that money out to the insurance company you know that’s a, you know that’s gone… you know that’s an irrevocable decision, the insurance company has your money. And then secondly, it’s very… it’s essentially impossible to leave those assets to the next generation you know so that is important to you and not only to maintain liquidity for those long term care expenses down the road or to leave those assets to let’s say… kids or grandkids you know the annuity oftentimes provides a lot of limitations there. So for that reason… Again, if we’re well discipline, we can design a strategic investment policy statement. Again, consult with a practitioner that understands income when it comes to investing portfolios that’s very different than accumulating assets. You know again… I always lean towards that route because it gives my clients flexibility. It keeps the assets on their balance sheet for the emergencies. And then ultimately, they’re able to leave those assets for legacy whether it’s to their family or to charity.

 

So I hope that’s helpful to get an understanding of how we’re addressing those longevity risks… how our clients are alleviate some of the concerns around social security? How our clients are using the longevity statistics when it comes to planning for things like long term care expenses? And then ultimately how to create that replicate that guaranteed income streams like Social Security have with your own assets?

 

30:54

I hope everyone enjoyed this episode and hope you have some takeaways that you can apply to your own situation. If you would like help stress testing your retirement plan and want to speak to me, you can reach me directly at [email protected]. You can also go to my website at www.imaginefinancialsecurity.com. There’s a book now link that goes directly to my calendar. So you can book a 30 minute free consultation, always happy to have those discussions and see how we can help you directly and I can assure you that if you can pass these four stress tests. You will be sleeping better at night and you will retire with a high degree of confidence and have that financial peace of mind that you will never have to be have to go back to work or be forced to go back to work which is there’s a lot to be said for that. So until next time… signing off. My name is Kevin Lau, your host of Planning for Retirement and hope everyone enjoys the rest of your day.

The “Tax Trap” of Traditional 401ks and IRAs

They say it’s not what you earn, it’s what you keep. I agree with this wholeheartedly as it relates to not spending more than you make (obviously). However, in my line of work, being sensitive to the TAX efficiency of a retirement plan is critical. If I can save my clients $10,000 or even $20,000/year in taxes during retirement, that’s huge!

Episode 2: The Tax Trap of Traditional 401ks and IRAs

The 401k IRA Tax Trap

The Tax Trap of Traditional 401ks and IRAs

 

Kevin Lao 00:12

What’s going on everybody? This is the Planning for Retirement Podcast. My name is Kevin Lao and I am your host.

What is the tax trap?

So today’s topics are twofold. The first thing I wanted to address is; what I like to call the Tax Trap of 401ks and Traditional IRAs. So I don’t think people address this enough prior to them retiring. And this is the notion of being tax efficient prior to getting into retirement and control it on acquisition. So having seen this go down for years and years and years being in business, I thought it’d be beneficial to do an episode specifically relates to falling into that tax trap and how to avoid it well before you turn retirement age. So that would be number one.

The SECURE Act

Number two is the Secure Act. And for those of you that don’t know, the Secure Act was legislation that was passed to reform retirement. And I don’t think many people really understand the ramifications of the Secure Act. It was largely swept under the rug obviously for good reasons because of Coronavirus in 2020 so it did not get much publicity after March of 2020. So, I thought I’d be good to revisit this topic because it is going to drastically change the way retirement [unintelligible 01:32] for future generations. And for those of you that are retirement age that are thinking about leaving your retirement account 401k IRA [unintelligible 01:42] children or grandchildren, you need to hear what I have to say.

 

For those of you that are younger, let’s say you’re in your 30s, 40s and 50s and your parents or grandparents are retirement age, and they plan on leaving a 401k or IRA to you, you should also understand the ramifications because this could absolutely screw up your tax situation.

 

So these are the topics we’re going to address today. And I’m also going to talk about some strategies to offset some of these concerns that my clients are putting into play and hopefully it’s beneficial for everybody. Let’s dive in!!

How does the tax trap occur?

All right so why our traditional 401k’s and traditional IRAs, why do they lead to a tax trap at retirement. So I want to clarify something when I am referring to a traditional 401 K and IRA plan I am referring to those that are flooded with before tax dollars. And what that leads to is tax deferral in those plans and then when you go to make those withdrawals in retirement, then they are taxed at ordinary income rates, whatever they might be in the future and that is the key.

 

When you think about taxation now relative to where they might be in the future. I’m not going to make a bold prediction here because I think a lot of people feel the same way I do. I’m going to suggest that taxes are likely to be higher in the future than they are today.

 

03:09

 

And if you think about, right now, we are at a $27 trillion deficits in the US, and that’s not shrinking. It’s growing. And you think about some of the government liabilities that are not funded like Social Security, Medicare, Medic-aid, you think about in 2008 we had massive bailouts and then in 2020 and likely in 2021, we add more bailouts. And you know, that causes concern for someone who is, let’s say, 15, 20, 30 years out from retirement age because if you are deferring taxes at potentially lower rate today, and you’re enjoying market growth for the next 10, 15, 20, 30 years, you’re growing this massive tax liability that Uncle Sam it’s just licking his chops. So therein lies the tax trap. And, you know, again, I refer to these that are funded by pretax dollars I’m not saying 401ks are bad because frankly 401ks are a great thing. You know they are forced savings plans that employers offer. They oftentimes give you matching contributions, essentially free money. So absolutely take advantage of this programs for your employer, do the max contribution possible.

Diversify your tax buckets!

But what I want you to think about is how can you diversify your tax situation.

 

So if taxes are higher in the future, you’re not stuck with only one pocket drop. And one of the ways to do this and think about this is looking at Roth 401ks and Roth IRAs. So literally the opposite of a traditional 401k or IRA plan these are funded with after tax dollars, and these enjoy tax free growth. So regardless of what tax rates are in the future, it does not matter. You’ve already paid taxes on the contributions and as it stands right now, the IRAs code allows you to withdraw those funds as long as it’s for qualified purposes, i.e. retirement, they can be withdrawn tax free so you know, when I’m planning with clients, I am all about tax diversification, I’m all about being strategic and I understand that, you know, we can’t predict the future. We don’t know exactly what tax rates are going to be in 5, 10, 15, 20 years throughout their retirement years. But if we have diversification we can be strategic based on who is in office essentially. Because one thing is guaranteed regardless of whose administration we’re going to try to change taxes. They might raise taxes and might slash taxes and might raise taxes for some, slash taxes for others. So regardless of what they do if we have some money in tax deferred and some money tax free, then we can be strategic. So for periods of times and very high taxes, and we don’t want to touch your tax deferred programs we can draw from tax rates.

 

 

06:00

 

If we’re appear [phonetic] to have time of very low taxes, you might be more okay with drawing your taxable funds. And so you can’t do that if you don’t have diversification. So I think the takeaway here is when you’re contributing to these retirement plans, be strategic and consultant with advisor, a tax advisor, a fiduciary financial planner, they can point you in the right direction to see what your options are in your plan. And also, hopefully they understand your situation that can give you the best guidance possible for you to make the right decision for yourself.

Required Minimum Distributions (RMDs)

Again, don’t fall into the tax trap because what it leads to is, folks when it gets to retirement is a lot of surprise and I’ll give you an example. Required Minimum Distributions kicked in at age 72 and at age 72 now the rule is you have to take out a certain percentage every single year for the duration of your life expectancy.

 

And right now the IRAs tables they are kind of outdated I would anticipate them updating these at some point in the not so distant future. But every year that percentage that you are forced to withdraw goes up and up and up. And so income from Social Security or let’s say you’re consulting or working part time, or maybe you have some investment income, and maybe even need this income from your 401 K plan or IRA. Well the IRAs as it stated right now at age 72. You’re forced to take those withdrawals whether you need it for income or not. And again, this leads to a tax situation where you know, let’s say you have a $2 million 401k plan and let’s say your percent that you’re forced to withdraw in the given years, let’s say 5%. Well, that’s $100,000 that you have to add to your taxable income if that is a traditional 401k or IRA plan that you may or may not be and the result is it might push you into a higher tax bracket, it might actually put you into a different Medicare [unintelligible 08:02] premium which I should pay more Medicare costs. So there’s a lot of ramifications that people really think about before they get to their retirement age so I urge you to plan early and often, think about taxes. Well before you get to retirement age so you can get smart and strategic when you’re going to make those withdrawals.

SECURE Act, explained

All right, let’s talk about the Secure Act. So the Secure Act, it stands for setting every community up for retirement enhancement act. And in my opinion, this is probably the most substantial overall when it comes to retirement, planning, since I have been in a business 2008. There’s a lot of good to it, it’s made it more cost effective for small businesses to offer retirement plan, it allows lot of these small companies to join together essentially as a union and get discounted rates [phonetic 08:59] because then these providers look at them as one entity as opposed to several sets. So that’s a positive.

 

 

09:05

 

It also increased Required Minimum Distribution age from 70 and a half to 72. So just a little bit more time to deferred Required Minimum Distribution age until they are forced to draw upon them. It allows penalty free withdrawals upto $10,000 for 529 plans to repay student loans. So if you get 529 plan or you have one set up for your children or let’s say someone set up 529 plan for you that you never just use in college you can use those up to $10,000 to repay student loans, so that is nice. It’s a little bit more diversification when it comes to retirement plans, etc., etc. And there are some other things as well. So there’s a lot of positive because in order to pay for it, this is estimated this cost was legislations estimated 10s of billions of dollars and the way they are going to pay for this is by eliminating the stretch IRA essentially allows for a non-spouse [phonetic 10:15]. Let’s say a child, an initial owner of an IRA or 401k plan who passes away that allows for them to withdraw those distributions [unintelligible 10:28].

 

Now that’s a big deal because we talked a little bit about Required Minimum Distributions a moment ago where someone with 2 million dollars maybe force [phonetic 10:36] to take a 5 percent. Well, I’m going to give you another example, who is 90 years old, they are forced to take out roughly 8.27% per year for that year from their retirement account. Let’s say they were to pass away, pre Secure Act and they were to leave those dollars to someone who’s let’s say, 55 year old. Well, for the 55 year old son or daughter instead of having to take out 8.27% of the account they are only required based on their life expectancy to take out 3.38% of the o they got tax savings. I mean that is that is more than 50% of what they would essentially have to pay if their parents unintelligible 11:28] drawn retirement account, so in essence allows that non spouse beneficiary in this case in child to stretch out this tax deferral stretch out that retirement throughout their life expectancy, well, as secure act very fine. They eliminated the stretch IRA and essentially it forces these non-spousal beneficiaries and there are some exceptions so please consult with your tax advisor, your attorney, your financial planner, to understand the Secure Act there are some exceptions, but in general common beneficiary like a child or grandchild, they will be forced to withdraw all of the proceeds of that account within 10 years. It doesn’t matter the schedule, they can take it all out in year one, which would be a really big tax bill. They take it out and they can spread it out over 10 years. The IRS doesn’t really. They just want to make sure that all of the money is out of that retirement account.

The inherited IRA rule changes

12:27

 

So why is this significant? Well, instead of that 55 year old beneficiary taking out 3.38% that year given their life expectancy, and let’s say that account is a million dollars that is roughly 33,000 that would have to take out. Let’s say they were had to have that same [phonetic 12:44] million dollar account inherited and let’s say they want to spread out that tax burden evenly across 10 years. Well, if you look at simple math, they would have to take out $100. So instead of recognizing 33,000 as income, now they’re recognizing 100,000 income. Now obviously, as the account grows, let’s say it’s 2 million, 3 million the tax burden become bigger and bigger. And what I hear from a lot of my clients who have children that are in the 30s and 40s and 50s is that may make way more than my clients ever did during the working years and I think that is just the byproduct of the United States being a great nation, wealthy nation. But many times the children and grandchildren are much better off financially from an income standpoint as they are predecessor and so why that’s so important because they may already be in very high tax. And they may be in a really complex situation, they may live in a state with high taxes i.e. California.

 

So if you are leaving those retirement accounts to one of those types of beneficiaries, it could seriously impact the taxation of those accounts. And I am having this conversation left and right every single with clients that have retirement accounts that they saved into 20, 30, 40 years. They worked in extremely [unintelligible 14:04] And now they are in the situation with 70 or 75 or even 80 years old, and there’s not much you can do, you know, other than some small planning, you know conversions, which we’ll talk about in a second, but there’s not a whole lot you can do to alleviate that tax.

 

So there’s a conversation that you have to be had with your advisors, your financial advisors mistake, you got to make sure that you’re not going to screw over the next generation because I’ve never heard any of my clients say they want to give the IRAs more money than they have to. And you know this is the perfect example and this provision was slipped in and a lot of people don’t understand it. And so please be aware of how this will impact your situation and I am happy to have this conversation with you. If you have questions by your personal situation then you can email me on my website at www.imaginefinancialsecurity.com.

 

I’m happy to dive into the details of your situation to see how this impacts you and your beneficiaries.

 

15:08

 

All right, so with all that being said, why don’t we break down three different strategies that my clients are putting into play in light of some of these tax concerns in the future? And also with the secure act now fully in play as of 2020 and I’m going to categorize them into beginner, intermediate and advanced.

How to avoid the tax trap of 401ks and IRAs?

Beginner I would put into play for someone who is younger, maybe they have at least 5, 10 or 15, better yet 20 more years of working and accumulating retirement accounts. And simply looking at the idea of instead of maximizing all of their contributions before tax, looking at Roth 401ks and Roth 403 B plans or even Roth IRAs, and we’re checking with your HR department and seeing if those plans are available, these after tax plans. And if so deciding whether or not it makes sense for you to put these dollars in on the post-tax basis in [unintelligible 16:05] before tax. Now, you don’t have to go all in one way or the other. You know, I have a lot of clients that split contribution some do pretax, maybe 50% and then the other 50% after taxes into the Roth. You can do whatever you’d like and you know, the scenario where you may want to leverage more on the tax deferred side is a scenario where you live in a high tax state now and you plan to retire in a low or no income state tax… States* That was a lot.

 

So an example would be somebody’s working in New York and they plan to retire Florida, which is where I live now. And we have a lot of those types of clients and in those scenarios if they’re already a high income, and there’s obviously heavy state taxes there and they’re retiring in the next couple of years, maybe 3 or 4 or 5 years down the road. It may be beneficial to do some before tax or leverage a little bit more before tax and therefore once they retire and residents of Florida or Tennessee or any other state income free tax state then take distributions and pay the taxes.

 

Now, other folks who are again concerned about tax rates going up, they may just wanted leverage more on the tax free side of the Roth side. And, you know, obviously there are some restrictions, you know, some folks may not have the ability to use Roth 401 K or 403 B plan some plan don’t offer them for whatever reason, and other folks maybe phase out of Roth IRAs and there is an income limitation. But once you make a certain amount you can longer contribute to a Roth IRA directly.

 

You know, there are some loopholes around that which I’m not going to get into those types of tax planning strategies on this episode. But there are some loopholes, just search backdoor Roth IRA. That’s a way to contribute to a Roth even though you’re above that Roth hiring threshold, but again, you got to be careful with it. You need to make sure you’re aware of the aggregation rule that can really, really mess up on a tax standpoint. So please consult your tax advisers before you make any of those decisions and I’m not getting any tax advice here.

 

18:08

 

All right, so we’ve addressed beginner which is simply contributing more to the Roth side when you are working.

 

Intermediate; someone who has been working for a longer period of time, let’s say they’re in their 40s 50s or 60s they are approaching retirement sooner rather than someone that is in the 20s or 30s, they may have accumulated a decent size, next [unintelligible 18:41] a 401 K’s or IRAs already. Now these folks may benefit from doing what’s called Roth conversions. So a Roth conversion the way that works is you take dollars that are already in an IRA and you convert them pay the taxes now and convert them to a Roth to enjoy that tax free growth going forward.

 

Now, obviously the downside you have to have the cash to pay the taxes, the taxes can’t just come out of the account because you will be charged penalties presumable if you are younger than 59 year and a half. So you got to have some cash on hand to pay the tax but the benefit is you can get those dollars in growing tax free for the next 15, 20, 30 plus years and enjoy all of that tax free growth. And again, avoid those Required Minimum Distributions, that those are the type of plans have in place at age 72. Now this is a great tool that I have utilized a lot of clients in the past. You want to make sure that when you’re doing this that you’re not putting yourself into a tax un-favorable situation. So for example, someone who’s aged 65 and they are in Medicare and you’re doing Roth conversions. You may not want to put them in a threshold or a tax bracket or they are paying more Medicare costs. That’s something you want to be aware of. You may not want to push into different tax brackets so there is definitely a sweet spot for you. So you definitely want to make sure if you consult your advisors in terms of what is best for you and if this strategy makes sense.

 

But again, I’ve reviewed this many, many times with clients and for some it makes sense and for some it’s not. And you know it all depends on situation that is why you want to consult your advisor before making any decision. However, crunching the numbers and looking at the analysis long term for many of those clients where it makes sense, it could save not only them 1000s of dollars in taxes in retirement, but also their beneficiaries, you know, especially because in light of the Secure Act and stretch IRA elimination.

 

All right last category, the advanced. Now this one I would characterize for folks that have accumulated a pretty substantial network, maybe in retirement accounts, or combination of retirement accounts and elsewhere. And you’re looking at the notion of buying a life insurance policy to essentially pay those taxes that will be due upon their passing within those retirement accounts. Let’s say hypothetically someone has a $4 million IRA, and they plan it leaving it to their doctor. But $4 million will have to be liquidated within 10 years assuming they are not an exempt beneficiary.

 

So let’s say hypothetically, they wanted to withdraw those funds in equal installments over 10 years. So for simple math purposes 400 k dollar. So they would have to they would have to pay taxes on that $400,000 annually, you know, which I would have heard that they may do 100,000 or so plus or minus depending on with your tax situation is per year on taxes. So over the course of the next 10 years, they’re going to have to pay about a million dollars in taxes if you take 100,000 times 10 If you follow me. So the idea of buying life insurance is that the individual that wants to maximize these dollars to the beneficiaries versus the IRS, they decided by a permanent life insurance policy for a million dollars. And over the course of their lifetime they may pay a fraction of a million dollars in premiums for the benefit of those dollars, going tax free to that beneficiary and help alleviate that tax burden on there.

 

 

22:26

 

Now, there’s a lot of nuances involved. When it goes into buying permanent life insurance. There’s a lot of flavors, there is universal policy, hybrid policies. There’s joint and survivor policies, traditional whole life. So you want to make sure you’re consulting with some seasoned professionals when it comes to doing this. I always recommend coordinating with your financial planner, your insurance agent and even your estate planner to make sure that this strategy A makes sense and B that you’re designing the policy properly.

 

Given my background, I have an extensive background in insurance. This is a conversation I am very comfortable with having with our tax advisers and with my state attorneys clients. So if you have questions on this, don’t hesitate to reach out to directly on the website, www.imaginefinancialsecurity.com. So I hope that helps.

Summary

So the three areas; again, beginner, intermediate and advanced. I think that many people that are working can take advantage of Roth contributions very, very easily. In terms of the right percentage going where or how much you speak towards Roth, it’s going to depend on your situation personally. So again, please consult someone you trusts on this matter, Roth conversions or IRA conversions into rock.

 

Again, a great tool for some and for some it’s not a great tool. But again, it’s a way that you can add more dollars into that tax free bucket and protect it from that Secure Act tax penalty and also enjoy the tax free growth without the Required Minimum Distributions and advanced life insurance planning which again is a great tool assuming the client is healthy. That’s another nuance as well you have to be healthy and qualify for life insurance and many people that are in their 60s or 70s maybe they have in preexisting condition resistant condition or it’s just cost prohibitive. So again, there’s a lot of you know what if scenarios to see if that type of planning makes sense. But I hope you liked today’s episode. I hope you enjoyed it and I hope you subscribe to our podcast if you like it what will bring it to the table. You can do that by hitting the subscribe button to whatever platform you’re using, whether it’s Spotify, iTunes, etc. You can also just go to our website directly all over the podcast and blog post we are going to listed there on the in sites tab www.imaginefinancialsecurity.com. You can also contact me directly via email if you have specific questions that you want to address or if there is topics that you want me to bring to the table in these podcast. This is what this is for. I do this for fun because I’d like to talk about financial planning strategies and I like to help people regardless if they are client of mine or not. And I hope everybody enjoyed it. Look forward to next go run. Cheers!!

 

Episode 1: Introduction to “The Planning for Retirement” Podcast

I started this podcast as a unique way to deliver informative content to friends, family, clients and prospective clients.  The strategies and concepts are developed based on frequent challenges or questions I come across in my personal practice.  However, this should not be misconstrued as investment or tax advice, and you should consider your own unique circumstances before making any changes. 

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