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Category: Financial Planning

Should I use an HSA for Retirement Planning?

"Should I use an HSA?"

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  If the funds are used to pay for qualified expenses, the funds can also be withdrawn tax free for those purposes.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

Why participate in a Health Savings Account?

 

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

1.  You recognize a tax deduction today. 

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

2.  Tax efficient growth

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

3.  Flexibility

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

4.  Growth opportunities

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

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

 

Who is eligible?

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

What are qualifying medical expenses?

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

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

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

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

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

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

2.  Medicare premiums

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

What happens to your HSA when you die?

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

Final Word

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

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

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

Tax Benefits of Charitable Giving

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

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

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

Let's first talk about Required Minimum Distributions

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


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

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

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

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

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

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

Qualified Charitable Distribution

 

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

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

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

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

Planning Ahead

 

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

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

Donor Advised Funds

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

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

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

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

Conclusion

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

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Stress Test Your Retirement Plan

Have you stress tested your retirement goals?

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

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

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

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

2.  Longevity Risk (living longer than you anticipate)

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

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

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

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

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6 Stress Tests for a Bulletproof Retirement

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

Free Webinar

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

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

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

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

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

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.

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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!

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