Retirement Income Archives

6 Smart Retirement Strategies When You’ve Oversaved

October 9, 2025

If you’re like most high achievers I work with, you probably spend way too much time comparing yourself to others. Maybe you’re scrolling through social media, seeing someone’s luxury vacation photos, or reading anonymous posts about retirement savings that make you question whether you’ve done enough. But what if I told you that many successful people face the opposite problem—they’ve actually saved too much for retirement?

The Gap and the Gain

This reminds me of a powerful concept I discovered in Dan Sullivan’s book “The Gap and the Gain.” Most of us live in “the gap.” We’re constantly measuring where we are against where we want to be in the future. We’re always chasing the next milestone, the next savings target, the next achievement. But there’s another way to think about your progress: measuring backwards from where you started.

When I think about my own business journey, I can either

Focus on how far we still need to go to reach our future goals
Celebrate many of the achievements that seemed impossible when we started in February 2021

The same principle applies to your retirement planning. Instead of worrying about whether you have “enough,” consider how far you’ve come from your starting point.

Many successful professionals find themselves overfunding their retirement accounts without realizing it. You’ve been disciplined savers for decades, making sacrifices and staying focused on your goals. The challenge with overfunding isn’t having too much money. It’s knowing how to optimize it for maximum impact during your lifetime and beyond.

What Does It Mean to Be Overfunded for Retirement?

Being overfunded for retirement means your financial plan shows you have significantly more resources than you need to maintain your desired lifestyle throughout retirement. In technical terms, this typically means having a Monte Carlo simulation success rate of 90% or higher.

What Is A Monte Carlo Simulation?

A Monte Carlo simulation runs 1,000 different hypothetical scenarios with varying market returns to stress-test your retirement plan. If you’re at 90%, that means in 900 out of 1,000 scenarios, you never need to make lifestyle adjustments. The remaining 100 scenarios represent extreme market conditions. For example, the “lost decade” from 2000 to 2010, when U.S. stocks were negative due to the dot-com crash and Great Recession.

Using Monte Carlo simulation results, many retirees and pre-retirees discover they have more capacity than expected. What’s particularly telling is looking at the median trial—scenario number 500—which shows your likely portfolio value at the end of your life. For overfunded retirees, this number is often two to three times their starting portfolio value, even after decades of spending on travel, gifts, and lifestyle expenses.

Here’s what this means in practical terms. If you have $2 million today, and your median ending portfolio value is $4-6 million, you’re leaving substantial wealth on the table during your lifetime. That money could be used to

Make memories with loved ones
Support family members
Make charitable impacts while you’re alive to see them

The reality is that $2 million today doesn’t feel as wealthy as it once did. Inflation has changed the purchasing power dramatically. In many parts of the country, a million dollars barely covers a starter home. But when your financial plan shows you’ll likely end with significantly more than you started with, despite living well, you have options that most retirees don’t.

Strategy 1: Retire Earlier Than You Initially Planned

The most obvious benefit of overfunding is the ability to retire earlier than you originally planned. I recently worked with a client in their 50s who assumed they needed to work until 62 to maximize their pension and start Social Security early. After running their numbers, we discovered they could retire today if they wanted to.

Now, I’m not suggesting you should retire just because you can financially. Retirement creates a lot of free time and mental space that needs to be filled with purpose. When you’re on the treadmill of working life, it’s difficult to step back and really think about what you want to do in your next chapter. Who do you want to spend time with? Where do you want to live? What kind of impact do you want to make?

But knowing you have the financial freedom to retire early opens up possibilities you might not have considered. Maybe you’ve always wanted to start that business venture, write a book, or serve on a nonprofit board. Perhaps you want to pursue a “second act” that’s more about passion than paycheck. When you’re focused on retirement planning over 50, overfunding becomes a real possibility that can fund these dreams.

Early retirement also allows you to gradually dial back your work commitments rather than stopping abruptly. You might

Reduce your hours
Take on consulting projects
Redirect the money you were saving for retirement toward other goals

The key is having a plan for what you’re retiring to, not just what you’re retiring from.

Strategy 2: Spend More Intentionally Without Guilt

You’ve earned the right to spend without guilt. After decades of disciplined saving and careful budgeting, it’s time to upgrade your experiences and lifestyle in meaningful ways.

This might mean flying first class instead of coach, especially on longer trips where comfort makes a real difference. Or staying longer at destinations—turning a week-long vacation into a month-long adventure. Many of my clients discover they can book nicer accommodations, take their entire family on trips, and create experiences they’ll remember forever.

The concept of “giving with a warm hand versus a cold one” also applies to experiences. Instead of just leaving money to your children and grandchildren, create memories together while you’re alive to enjoy them. Things like

Taking your family to Europe
Renting a house for everyone at the beach
Funding educational trips for grandchildren

These experiences often mean more than a future inheritance.

Intentional spending also includes services that free up your time for more important activities. Maybe you hire a housekeeper, landscaping service, or personal assistant. If you love golf but hate yard work, paying someone else to maintain your lawn gives you more time on the course. These services aren’t luxuries when they allow you to focus on what truly matters to you.

The psychological shift from “I can’t afford that” to “Is this worth it to me?” is profound. When your financial plan shows you have more than enough, spending decisions become about value and priorities rather than affordability.

Strategy 3: Take More Investment Risk for Greater Returns

What I’m about to say may seem counterintuitive. Having excess retirement funds actually gives you the capacity to take on more investment risk if you choose. When your Monte Carlo simulation shows you’ll be fine, even in market downturns lasting five or six years, you can potentially earn higher long-term returns.

Higher returns over 10, 15, or 20 years can significantly increase your ability to make an impact during your lifetime and leave a larger legacy. More money means more options for family gifts, charitable giving, and lifestyle enhancement.

This doesn’t mean being reckless with your investments. It means understanding that you have the financial capacity to weather market volatility because your spending needs are well-covered even in worst-case scenarios. You can potentially allocate more to growth investments and less to conservative bonds or cash.

The key is matching your risk capacity (what you can afford to lose) with your risk tolerance (what you’re comfortable losing). Being overfunded gives you more flexibility in this equation.

Strategy 4: Take Less Investment Risk and Sleep Better

On the flip side, being overfunded also gives you the option to reduce investment risk significantly. If you’ve been riding the market roller coaster for 30 years and you’re tired of the volatility, you’ve earned the right to step off.

This is the “if you’ve won the game, stop playing” approach. You can

Dial back your stock allocation
Increase bonds and cash
Focus on preserving what you’ve built rather than growing it aggressively

Sure, your returns might be lower. However, they’ll be more predictable, and you’ll still have more than enough to fund your lifestyle.

Many clients find this approach appealing as they get deeper into retirement. The peace of mind that comes from knowing your portfolio won’t drop 30% in a market crash can be worth more than the potential for higher returns.

Additionally, if you have guaranteed income from pensions or Social Security covering your basic expenses, you have even more flexibility with your investment portfolio.

Strategy 5: Gift More During Your Lifetime

The ability to make a meaningful impact on your family while you’re alive to see it is where overfunded retirement really shines. For 2025, you can gift up to $19,000 per year per recipient without filing any gift tax forms. For married couples, that’s $38,000 per recipient, and if you have multiple children and grandchildren, the numbers add up quickly.

But lifetime gifting isn’t just about the money—it’s about the conversations and lessons that come with it. When you give your adult children or grandchildren money, use it as an opportunity to teach them the financial principles that got you to where you are today. Explain

Why you’re gifting the funds
What you hope they’ll do with the money
How you built the wealth you’re now sharing

These conversations help you understand what kind of stewards your beneficiaries will be with larger inheritances. If you gift money for a down payment but they spend it on luxury items instead, that tells you something important about their financial maturity and decision-making.

Charitable Giving

Charitable giving is another powerful option. If you’re over 70½, you can make qualified charitable distributions directly from your IRA up to $107,000 annually (in 2025) without paying taxes on the withdrawal. This is particularly valuable if you don’t need your required minimum distributions for living expenses but are forced to take them anyway.

Donor-Advised Funds

Donor-advised funds offer another flexible approach. You can bunch several years of charitable gifts into one tax year to

Exceed the standard deduction threshold
Get the immediate tax benefit
Distribute the funds to charities over time

Strategy 6: Leave a Multi-Generational Impact

Some people prefer not to make their children’s lives “too easy” during their lifetime. It’s the belief that a healthy dose of struggle builds character. If this describes your philosophy, being overfunded gives you the opportunity to impact multiple generations with the wealth you’ve created.

Think about the power of compound growth over decades. A $2 million portfolio that grows to $8-10 million by the time you’re 90 could

Fund college educations for great-grandchildren not yet born
Start family businesses
Create charitable foundations that operate in perpetuity

If this is your plan, you need to be extremely thoughtful about the structure.

How will the money be distributed?
At what ages can beneficiaries access funds?
What are the funds intended for?
Should assets be held in trust with professional management?

More importantly, you need to have conversations with your family about how you built this wealth and what it represents. Share the story of your sacrifices, discipline, and decision-making. Help them understand that this money isn’t just a windfall—it’s the result of decades of intentional choices.

I think about my great-grandfather, who built a rice mill business in China and Burma. His multi-generational impact allowed my father to attend prestigious schools in India and eventually immigrate to the United States. That legacy shaped our entire family’s trajectory across multiple generations.

However, be aware of the tax implications of leaving large retirement accounts to the next generation. With the 10-year distribution rule for inherited IRAs, your beneficiaries may face substantial tax bills if they’re successful in their own careers. Strategic Roth conversions during your lifetime can help minimize this tax burden and preserve more wealth for your family.

Making the Most of Your Overfunded Retirement

If you find yourself being someone who has saved diligently and has more than enough for retirement, you have options that most people don’t. The key is shifting from a scarcity mindset to one of abundance and intentionality.

Remember the Gap and the Gain concept. Instead of constantly measuring yourself against others or future goals, take time to appreciate how far you’ve come. You’ve achieved something remarkable through decades of discipline and smart decisions.

You may choose to

Retire early
Spend more intentionally
Adjust your investment risk
Increase your gifting
Plan for multi-generational impact

The most important thing is making conscious choices about your wealth rather than letting it accumulate by default.

Your financial plan isn’t a one-time event. It’s an ongoing process that should evolve as your circumstances and priorities change. What feels right in your first year of retirement might be different after five or ten years of experiencing financial security.

The goal isn’t just to have enough money for retirement. The goal is to use your resources in ways that align with your values and create the kind of impact you want to make during your lifetime and beyond. When you’re overfunding retirement, you have the luxury of choice. Make sure you’re making those choices intentionally.

Ready to discover if you’re overfunded for retirement? A comprehensive financial plan can help you understand your true capacity and explore strategies to optimize your wealth for maximum impact during your lifetime.

How We Can Help

At Imagine Financial Security, we help individuals over 50 with at least a million dollars saved navigate these complex retirement decisions.

If you are looking to

Maximize your retirement spending
Minimize your lifetime tax bill
Worry less about money

You can start with our Retirement Readiness Questionnaire linked on our website at www.imaginefinancialsecurity.com. Click the “Start Now” button to learn more about our process and how we might be able to help you achieve a more confident retirement.

Not quite ready to take the questionnaire, but want helpful tips and resources? Sign up for our monthly newsletter and/or subscribe to our YouTube channel.

This is for general education purposes only and should not be considered as tax, legal or investment advice.

financial planning overfunded for retirement overfunded retirement oversaving for retirement retirement planning strategies for retirement spending

Kevin Lao

October 9, 2025

Sequence of Returns Risk: 7 Strategies to Protect Your Retirement

September 25, 2025

Recently, I talked about the 4% rule and how it’s historically conservative, with average withdrawal rates potentially as high as 7% annually. But here’s the kicker: averages hide the risk of when bad returns happen.

This is what we call sequence of returns risk. Imagine retiring at the end of 2007 with $2 million saved. You’re ready for the good life, ready to enjoy retirement. Then the market drops 51%. Suddenly, that $140,000 withdrawal doesn’t look very safe anymore.

In today’s article, we’ll highlight some major market downturns over the last few decades and discuss seven real strategies to help you protect against this dreaded sequence of returns risk.

What is Sequence of Returns Risk?

Sequence of returns risk is the danger that the timing of withdrawals from your retirement account could negatively impact your portfolio’s overall rate of return. This risk becomes particularly significant when you begin withdrawing funds from your investment portfolio in retirement.

The sequence of returns in the first few years of retirement can determine whether your savings last a lifetime. Unlike pre-retirement years, when you’re accumulating assets, the sequence of returns matters significantly once you start withdrawing money.

For example, two retirees with identical portfolios and withdrawal rates can have dramatically different outcomes based solely on when they retire. If you retire just before a market downturn, your portfolio may never recover, even if the market eventually rebounds.

Historical Market Downturns: A Look at Bear Markets

To understand the real impact of sequence of returns risk, let’s examine some significant market downturns that could have affected retirees.

The Dot-Com Bubble (2000-2002)

This period was particularly painful because there were actually two separate bear markets in a three year span:

In March 2000, there was a total drawdown of 36% over 18 months
After a brief rally from January 2002 through October 2002, prices dropped another 33%

This means you had two 30+ percent drops in basically a three-year period. This is why this time is often called “the lost decade.” The markets were flying in the 90s because of the dot-com boom. Anything with a dot-com at the end of its name was soaring in price, and people were feeling euphoric.

I guarantee some folks tried to retire around 2000 after seeing their 401(k) grow to $2 million. They were feeling confident until they experienced a 36% drop at the beginning of 2000 and then another 33% drop in 2002.

The Great Recession (2008-2009)

From October 2007 through November 2008, prices dropped 51%. Then, after a brief rally at the end of 2008, from January 2009 through March 2009 (ultimately hitting bottom on March 9, 2009), prices dropped another 27%.

I’ve talked to people who retired around this time. Thankfully, many stayed retired, which was great. But I also know people who were planning to retire in 2008, 2009, or 2010 who couldn’t. They wanted to retire but weren’t able to, whether because of fear or their portfolios dropping significantly.

COVID-19 Sell-Off (2020)

Who would have predicted a pandemic at the beginning of 2020 and the markets dropping 30% over just five weeks? For me, this was the most dramatic sell-off because of its speed.

I remember talking to a friend who worked at Google whose coworker’s wife was a doctor. At the beginning of the pandemic, she knew what was happening and moved their 401(k) to cash.

They were right for a period—the 30% drop happened. But the crazy part was that we hit bottom on March 23, 2020, and the markets fully recovered all those losses by May, only 2 months later. The S&P 500 ended that year up 18% after being down 30% in March.

This illustrates why I caution people against trying to time the market. You can’t predict these things, which is why you shouldn’t get too high in the highs or too low in the lows.

The Triple Bear Market (2022)

The 2022 downturn was different from anything I’d experienced in my career. I call it the “triple bear market” because it affected stocks, bonds, and cash:

Stocks were down 25% over about nine months
Bonds were down 15% due to aggressive interest rate hikes
Cash was essentially returning a negative yield because interest rates on cash lagged behind inflation

This triple threat created a challenging environment for retirees, as all three major asset classes were negatively impacted simultaneously.

7 Strategies to Protect Against Sequence of Returns Risk

Retiring into these markets is largely uncontrollable. What you can control is having a plan for your portfolio management and withdrawal strategy to protect against sequence of returns risk. Here are seven effective approaches:

1. Implement Guardrails (Dynamic Withdrawals)

One of my favorite strategies is the concept of guardrails or dynamic withdrawals. Instead of sticking to a fixed percentage rate like the 4% rule, you adjust your withdrawals based on portfolio performance.

Guardrails, made famous by Guyton and Klinger, establish decision rules for when to make adjustments to your withdrawal rate. There are four primary decision rules:

Portfolio Management Rule: Pull funds from overweight asset classes. If stocks are up, trim stocks to get back to your target allocation. If stocks are down and bonds are up, trim from bonds.
Inflation Rule: Give yourself an inflation raise every year, similar to the traditional 4% rule.
Capital Preservation Rule (Portfolio Rescue Rule): If your withdrawal rate increases by 20% because your portfolio value decreased, cut your spending by 10%.
Prosperity Rule: If your withdrawal rate decreases by 20% because your portfolio value increased, give yourself a 10% raise.

By implementing these four rules, you can potentially increase your starting withdrawal percentage by 20-25% while maintaining the same or better probability of success compared to the traditional 4% rule.

This strategy works best for those with flexibility in their spending. If you break down your expenses and find that 50% is discretionary, you could be a great candidate for guardrails because you have the capacity to cut spending during market downturns.

2. Create a Bucket Strategy

The bucketing concept involves having a dedicated pool of assets you tap into for withdrawals. This might include:

Cash reserves
CDs
Short-term bonds
Individual bonds like short-term treasuries
Short-term bond funds or ETFs
Intermediate-term bond funds

There’s no scientific formula for how much to keep in these buckets. Some advisors recommend 1-2 years of expenses based on the average duration of bear markets. Others suggest up to 5 years of expenses, considering that the Great Recession took about five years to fully recover from the bottom in 2009.

The right amount depends on your risk tolerance. Someone with higher risk tolerance might be comfortable with just 1-2 years in cash or cash equivalents. Someone more concerned about market volatility might prefer 5 years in a CD ladder or individual bond ladder.

For our clients, we use a combination of money market funds, individual bonds, short-term bond ETFs, and intermediate-term bond ETFs. This typically provides liquidity for 2-5 years of expenses, depending on risk tolerance and other income sources.

3. Categorize Your Spending (Needs, Wants, Wishes)

Breaking your spending into three distinct categories—needs, wants, and wishes—helps identify what you can potentially cut during market downturns.

This approach helps determine:

How much of your spending is truly discretionary
Whether you have the flexibility to cut spending by 10% if needed
How much to allocate to your bucketing strategy

For example, I recently worked with a couple planning to retire in their 50s with a 7% initial withdrawal rate until they begin Social Security. By analyzing their spending, we determined they had enough discretionary expenses to implement guardrails successfully.

4. Consider Partial Annuitization

Annuitization involves turning some of your assets into a lifetime income stream. While annuities can be a controversial topic, they have a place in retirement income planning when used appropriately.

The benefit of partial annuitization is that it puts less pressure on your volatile assets (stocks and bonds). This allows those investments to potentially grow at a higher rate because you’re withdrawing less from them while maximizing income from the annuity.

I’ve said this before: you will not out-withdraw an annuity in your lifetime. I recently had a client with TIAA who received an annuitization schedule showing a payout rate close to 8% annually. Few advisors would recommend withdrawing 8% from a portfolio due to sequence of returns risk.

To determine if annuitization makes sense for you:

Identify your essential spending needs.
Compare those needs to guaranteed income sources like Social Security or pensions.
If there’s a gap, consider annuitizing enough assets to fill that gap.

5. Earn Additional Income

Similar to annuitization, earning part-time income early in retirement can significantly reduce sequence of returns risk. This strategy can be implemented reactively to a market downturn—if we enter a bear market, you could work part-time and reduce your portfolio withdrawals.

This works best if you:

Enjoyed aspects of your career
Are willing to work a couple of days a week
Would consider consulting or a completely different field

I’m working with a couple who initially planned to retire several years from now, but after seeing friends get sick or pass away, they want to retire sooner. The wife has a side hustle, and they’re considering renting out an ADU (additional dwelling unit) on their property through Airbnb. These two income sources could potentially allow them to retire 4-5 years earlier than planned.

6. Adjust Your Social Security Strategy

You may have plans to delay Social Security as long as possible to maximize lifetime benefits. However, if you’re experiencing a significant market downturn early in retirement, starting Social Security earlier than planned could reduce pressure on your portfolio.

While this might reduce your lifetime Social Security income, it could be worth considering if it helps preserve your portfolio during a critical period. What’s helpful is that if you start Social Security before your full retirement age, you have a one-time option to stop it at your full retirement age and then delay until 70 (or as long as you want) to receive delayed credits.

7. Implement an Asset Allocation Glide Path

Different phases of retirement have different income needs and sources. Your investment strategy should be dynamic, not set-it-and-forget-it.

Early in retirement, during what I call the “bridge period” (from retirement until you start Social Security), you may have no guaranteed income and might be less risk-tolerant. During this phase, you might have more in your cash bucket—perhaps that five years in cash, cash equivalents, or short-term bonds.

Once you start Social Security, you’ll have guaranteed income covering your fixed expenses. At this point, you can potentially take on more risk because your withdrawal rate might drop significantly—from 5% to 1%, for example. This increased risk capacity could allow for a more growth-oriented portfolio allocation.

Preparing for the Next Downturn

I don’t know when the next market downturn will be—I don’t have a crystal ball. If I did, I probably wouldn’t be working at all! But the most important thing is to have a plan in place before the next downturn occurs.

Right now, markets are looking pretty good. This is the perfect time to set your plan. We may be heading into a recession, the Fed may be too late with cutting rates, unemployment might tick up with tariffs and uncertainty—I don’t know. But set up your plan before the next downturn so you can implement it unemotionally rather than reactively.

Be proactive instead of reactive. What are you doing to reduce your sequence of returns risk? If you’re approaching retirement or already retired, now is the time to review your strategy and ensure you’re protected against this significant risk to your retirement security.

Remember, sequence of returns risk can devastate your retirement savings if you don’t have a protection strategy in place. The strategies outlined above—guardrails, bucketing, spending categorization, partial annuitization, part-time income, Social Security timing, and dynamic asset allocation—provide a framework for building that protection.

By implementing these approaches before market volatility strikes, you’ll be better positioned to enjoy a secure retirement regardless of what the markets do in those crucial early years.

At Imagine Financial Security, we help individuals over 50 with at least a million dollars saved navigate these complex retirement decisions.

If you are looking to maximize your retirement spending, minimize your lifetime tax bill, and worry less about money, you can start with our Retirement Readiness Questionnaire linked on our website at www.imaginefinancialsecurity.com. Click the “Start Now” button to learn more about our process and how we might be able to help you achieve a more confident retirement.

Not quite ready to take the questionnaire, but want helpful tips and resources? Sign up for our monthly newsletter and/or subscribe to our YouTube channel.

This is for general education purposes only and should not be considered as tax, legal or investment advice.

down market strategies financialplanning retirement planning retirement strategies sequence of returns risk what is sequence of returns risk

Kevin Lao

September 25, 2025

6 Reasons to Take Advantage of a Roth Conversion

July 31, 2025

While I recently outlined reasons to steer clear of a Roth conversion, today I’m flipping the coin to explore when it can be a smart, strategic move for your financial future.

Why Consider a Roth Conversion During Market Downturns

A Roth conversion can be particularly beneficial during market downturns. When the market is down, you’re essentially exchanging a number of shares based on the dollar amount you want to convert from your tax-deferred account (whether it’s an IRA or a 401k) into a Roth.

You’ll have to pay taxes now in exchange for tax-free growth, which is the advantage Roth accounts offer. When markets are down, you can convert more shares with the same dollar amount.

For example, if you were looking to convert $50,000 worth of Vanguard’s Total Index (VTI) back in 2022 (the last bear market), you’d be able to convert an additional 25% worth of shares because the market was down roughly 25% that year. Just a thought, given we had some rough patches this April with the tariff concerns. We could continue to see more volatility in the months ahead.

While we can’t control market volatility, we can control smart tax planning. Let’s jump into the top six reasons you may consider a Roth Conversion in your financial planning strategy.

1. For Accumulators: Backdoor Roth IRA Strategy

The first reason is actually for people who are pre-retirement, or what I call “accumulators.” There are income thresholds for single and married filing jointly to directly contribute to a Roth IRA. If you fall into that category, the Roth conversion or backdoor Roth IRA strategy comes into play.

Essentially, you’ll make a non-deductible contribution into an IRA and then convert those assets into a Roth IRA. There are some tax traps you might fall into (the aggregation rule), so consult with your tax planner or financial planner before making this move. This strategy is available for IRAs, and sometimes, for 401ks as well. Contribution limits are much higher for 401ks than IRAs. If you have this option within a 401k, this could really boost your retirement savings.

2. Tax-Free Growth Long-Term

Reasons 2 through 6 are for individuals nearing retirement who have accumulated substantial savings in tax-deferred IRAs or 401ks.

The second reason is for long-term tax-free growth. If you believe tax rates probably aren’t going down and are more likely to go up or stay the same, then tax-free growth and compounding interest are much more powerful than tax-deferred growth. This could be for legislative reasons, or even simply projecting out your lifetime tax brackets. We know now that the One Big Beautiful Bill Act has made the current brackets permanent. Still, that doesn’t mean YOUR tax bracket might rise over time based on changes in your income or assets.

3. Eliminate or Reduce Required Minimum Distributions

A Roth conversion can eliminate or reduce your required minimum distributions. Required Minimum Distributions (RMDs) are mandatory withdrawals from traditional retirement accounts (IRAs, 401ks, 403bs, TSPs, 457bs, etc.) that the IRS requires once you reach a certain age. The beginning age is currently 73 if you were born before 1960, or 75 if you were born in 1960 or later. RMDs could potentially push your income into higher tax brackets later in retirement when spending actually might go down. Furthermore, if you don’t need all that income, it forces you to realize it anyway to avoid the 25% penalty for a missed RMD.

4. Save Money on Medicare Premiums

Many people don’t realize that when you sign up for Medicare, you might find yourself paying MORE for Medicare Part B and D. Part A is free, and everyone has the same base premium for B and D. However, the more money you make in retirement, the chances of triggering an “IRMAA” surcharge goes up.

IRMAA stands for Income-Related Monthly Adjustment Amount. There are 5 different premium tiers, and each tier increases your IRMAA surcharge. You can also look at it like an excise tax. The more you’ve saved in tax-deferred vehicles (401ks and IRAs), the higher those RMDs might be. More income from RMDs means your Medicare premiums may go up.

5. Reduce the “Surviving Spouse’s Tax Penalty”

The likelihood that a married couple passes away in the same year is very low. Most of the time, women outlive men, or one spouse outlives the other by many years. This is especially relevant if there is a significant age gap between spouses.

Filing jointly is much more tax-advantaged for most people. The surviving spouse will have to switch to filing single, typically the year following the initial spouse’s passing. This could result in pushing the surviving spouse into a much higher tax bracket than when they could file jointly.

Taking this into consideration to ensure you’re not placing your surviving spouse in an unfair or unfavorable tax situation upon your passing is a compelling reason to convert assets from traditional to Roth.

6. Address Changes from the SECURE Act

With the SECURE Act going into effect at the end of 2019, we’re seeing the largest acceleration of taxes on retirement assets that we’ve ever experienced. Essentially, the stretch IRA is eliminated for most non-spousal beneficiaries. With the stretch IRA, beneficiaries could “stretch” their IRA withdrawals over THEIR life expectancy. However, the SECURE Act now requires most beneficiaries to liquidate the entire retirement account by the end of the 10th year. This could result in pushing your heirs into an unfavorable tax bracket, especially if they are successful in their own right. We hear all the time that our clients’ children are making more than they ever made! Couple this with large IRAs or 401ks as an inheritance in their peak earning years, and you can see the potential tax trap this brings about. We call it “The Death Tax Trap of 401ks.”

This acceleration of taxes is a big reason to convert from tax-deferred accounts to tax-free accounts. When Roth accounts pass to the next generation, the beneficiaries can enjoy tax-free distributions of the assets instead of tax-deferred distributions.

Understanding the Roth IRA Conversion Process

The concept of a Roth Conversion is essentially to pay the tax now as opposed to deferring those taxes in an IRA or 401k. If you follow the appropriate 5-year rules, everything that grows and compounds in that account, along with the withdrawals, should be tax-free in retirement.

Compare that to a traditional IRA or traditional 401k. These plans give you a tax deduction upfront, but all of that compounding interest and distributions in the back end are taxed as ordinary income in retirement.

Many of my clients over 55 have accumulated the majority of their retirement assets in tax-deferred vehicles, such as 401(k)s and/or IRAs. They may be concerned about the future direction of taxes, particularly given the funding levels of Medicare, Medicaid, and Social Security.

The general concept is: does it make sense to pay taxes now at a potentially lower rate and enjoy tax-free compounding as opposed to tax-deferred compounding going forward?

The Tax Trap of Traditional 401(k)s and IRAs

The impact of Required Minimum Distributions are oftentimes one of the biggest tax traps of 401ks and IRAs. Because our clients were diligent savers during their working years, they accumulated substantial assets in 401(k) plans and IRAs. When they turn 73 or 75, they’re forced to take out a certain percentage of those retirement accounts each year.

As your life expectancy shortens, the amount you’re required to take out increases. You start out at a little under 4%, and by the time you get to 90, you’ll be taking out north of 8% of your retirement account, whether you need it or not.

Think about what that can do to your taxable income, Medicare premiums, and ultimately, how those assets are passed on to the next generation. This tax trap is what we’re trying to solve well before clients hit that magic age.

Planning for Longevity in Retirement

More and more people are living longer, often into their 90s. The life expectancy of a 62-year-old female includes a 30% chance of living until 96. When planning with clients over 55 or 60, we may be looking at a retirement of 30 years or more, even longer than their working years.

You must consider this in light of the high inflation we have experienced these past few years. The cost of goods going up over that retirement period on a potentially fixed income is worrisome for many clients. That’s what we try to plan for and mitigate inflation risk coupled with longevity risk.

The Retirement Red Zone

I call the period ten years before you retire and the ten years after you retire the “Retirement Red Zone.” Decisions are magnified, and mistakes are magnified if you make the wrong move.

From an investment perspective, that’s important, especially during volatile times. Certainly, from a tax perspective, which also contributes to the long-term rate of return on your portfolio. This is something I aim to help my clients with as they prepare.

Strategic Planning for Retirement Success

While nobody can predict the future of taxes, you can take the known variables and project out your estimated lifetime tax rates. You will find that throughout retirement, there could be some opportunistic times when your income goes way down. If you’re making strategic moves during that time frame, such as Roth conversions, that planning can help position your retirement assets for better long-term growth and tax efficiency.

Remember, the planning doesn’t stop after retirement, it just changes. Whether you are on the brink of retirement or you’ve been retired for several years, having good guidance at every stage of the process is crucial for achieving financial peace and security in retirement.

Take a deeper dive into this topic by listening to Episode 10 of The Planning for Retirement Podcast. This is for general education purposes only and should not be considered as tax, legal or investment advice. At Imagine Financial Security, we help individuals over 50 with at least a million dollars saved navigate these complex retirement decisions.

If you are looking to maximize your retirement spending, minimize your lifetime tax bill, and worry less about money, you can start with our Retirement Readiness Questionnaire linked on our website at www.imaginefinancialsecurity.com. Click the “Start Now” button to learn more about our process and how we might be able to help you achieve a more confident retirement.

Not quite ready to take the questionnaire, but want helpful tips and resources? Sign up for our monthly newsletter and/or subscribe to our YouTube channel.

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Kevin Lao

July 31, 2025

7 Reasons Not to Do a Roth Conversion

July 17, 2025

I’ve never met anyone who wants to overpay the IRS. As a result, one of the number one topics we discuss with clients is how to reduce their lifetime tax bill. More specifically, whether or not they should consider a Roth Conversion with some of their IRA dollars.

Before we talk about the seven reasons that might cause you to delay, reduce, or reconsider doing a Roth conversion, let’s look at some big news brewing in Washington related to taxes on Social Security.

Social Security has a complicated formula to determine how much of your benefit will be included in your taxable income. On the low end, your entire benefit could be tax-free (0% included in taxable income). On the high end, up to 85% of your Social Security benefit could be taxable.

Senior Citizens Tax Elimination Act

Congressman Thomas Massey from Kentucky, along with 29 Republican co-sponsors, has introduced the Senior Citizens Tax Elimination Act. To provide some context, prior to 1986, Social Security benefits weren’t taxable at all. In 1986, Social Security implemented revisions and created the provisional income formula that determines how much of your benefit is included in taxable income.

Massey’s bill would essentially repeal the inclusion of Social Security benefits in taxable income altogether. This would also include tier one railroad benefits (pensions from working at the railroad). The bill was first introduced last year, but now it’s legitimate. It’s in the House and seems to have a decent chance of passing.

However, there are costs associated with implementing this bill. According to the Committee for Responsible Government, this is estimated to cost taxpayers about $1.8 trillion over the next decade. When we couple this with Social Security’s projected insolvency date of around 2033-2034, it raises questions about funding.

Currently, 80% of Social Security benefits are funded by payroll taxes from current workers. The Social Security trust fund supplements the remaining 20%. If benefits become tax-free, this could accelerate the insolvency date.

So, how will they pay for this bill? My crystal ball says taxes will increase in some way to fund the deficits projected for Social Security and Medicare.

Why is this relevant to our Roth conversion discussion? Because, while we know what taxes look like today, it’s virtually impossible to be 100% certain about future tax rates.

What is a Roth Conversion?

A Roth conversion involves moving or converting funds from a tax-deferred vehicle (like a traditional IRA, 401(k), 403(b), or TSP plan) into a tax-free vehicle. In exchange for doing this, you elect to pay the taxes now.

Why would you do this? At one point, you believed deferring taxes was the way to go, or maybe you didn’t have access to a Roth account. This is pretty common—15-20 years ago, many employers didn’t offer Roth 401(k) plans. But now you have the ability to convert some of those assets to Roth.

The benefit of a Roth account is tax-free growth going forward, as opposed to tax-deferred growth. But there are situations where converting might not be the best strategy.

1. You’re in a Higher Tax Bracket Today Than You Will Be in the Future

The first reason to reconsider a Roth conversion is if you’re currently in a higher tax bracket than you expect to be in the future. There are several scenarios where this might happen:

When you retire, your W-2 income or self-employment income disappears. Your only income might be capital gain distributions, dividends, interest, a small pension, or IRA distributions. If your tax bracket will drop substantially in retirement, it might make sense to wait until you enter what we call the “Roth conversion window.” This window is after retirement, but before you start taking Required Minimum Distributions (RMDs) and/or Social Security.

Your income might be temporarily high due to things like

Selling a business, stock, or rental property
Receiving a large bonus
Inheriting money

Doing a Roth conversion during these high-income years could push you into an unnecessarily higher tax bracket.

You might believe taxes will decrease in the future due to legislative changes, making it beneficial to wait for potential tax cuts before converting.

In short, if you expect your income bracket to drop at some point, it might be worth evaluating conversions at that time instead of now.

2. You’re Leaving a High-Income Tax State for a Low or No-Income Tax State

According to the Tax Foundation, state income taxes significantly influence net migration in the U.S. The top third of states with positive net migration have an average state income tax of about 3.5%. The bottom third average nearly double that at 6.7%.

I don’t believe you should move to a state in retirement solely because of taxes. However, if you’re planning to move from a high-tax state like New Jersey, New York, or California to a low or no-income tax state, you might consider waiting to do Roth conversions until after your move.

You could potentially benefit from both a lower federal bracket at retirement and little to no state income tax, maximizing your tax savings on the conversion.

It will be interesting to see how migration patterns evolve as companies bring employees back to in-person work. For retirees with the flexibility to move anywhere, taxes will likely remain an important consideration.

3. Your Heirs Are in Lower Tax Brackets

The SECURE Act, passed at the end of 2019, eliminated the “stretch IRA” for most beneficiaries. Previously, individuals who inherited an IRA could stretch distributions over their life expectancy. Now, most non-spouse beneficiaries must liquidate the account within 10 years.

This applies to both traditional IRAs and Roth accounts. The key difference is that Roth account distributions during those 10 years are tax-free to beneficiaries, while traditional IRA distributions are fully taxable.

If your beneficiaries are in a very low tax bracket, while you are in a higher tax bracket, there could be an argument for not converting. For example, if you’re in the 24% or 32% bracket due to Social Security, a pension, and investment income, while your children are in the 10% or 12% bracket, it might make more sense to leave those assets to your heirs and let them pay taxes at their lower rate.

The challenge with this approach is that it requires knowing exactly when you’ll pass away and what tax bracket your children will be in at that time. Your 25-year-old child who’s currently in graduate school with no income might eventually have high earning potential or start a successful business, putting them in a higher tax bracket than you.

Additionally, even if your beneficiaries are in a relatively low tax bracket, inheriting a large IRA could push them into a higher bracket during the 10-year distribution period. For example, if your IRA is worth $2 million, your beneficiaries would need to distribute about $200,000 annually over 10 years, potentially pushing them into a much higher tax bracket regardless of their current income.

You should also consider the distribution of your assets between taxable, tax-deferred, and tax-free accounts when making this decision.

4. Hidden Taxes Could Reduce the Benefit of Converting

Any Roth conversion will increase your taxable income in the year you do the conversion, even though it doesn’t put cash in your bank account. This can trigger various “hidden taxes” based on calculations like modified adjusted gross income (MAGI), taxable income, or provisional income.

Here are some examples:

IRMAA Surcharge: The Income-Related Monthly Adjustment Amount applies once you’re Medicare eligible. While Medicare Part A is free, Part B has a premium (about $185 for 2025). Part D depends on your chosen drug plan. If your income exceeds certain thresholds, you’ll pay additional surcharges for both Part B and Part D. These surcharges can range from $1,000 to over $6,000 per year per person.

ACA Premium Tax Credits: If you retire before 65 and use the Affordable Care Act for health insurance, you might be eligible for premium tax credits based on your modified adjusted gross income. Roth conversions could reduce these credits.

Net Investment Income Tax: If your MAGI exceeds $250,000 (married filing jointly) or $200,000 (single), there’s an additional 3.8% tax on investment income like dividends, interest, and rental income.

Capital Gains Taxes: If you’re married filing jointly and your taxable income is below $96,700 for 2025, you don’t pay any tax on long-term capital gains. A Roth conversion could push you above this threshold.

Social Security Taxation: As mentioned earlier, between 0% and 85% of your Social Security benefits could be taxable depending on your provisional income. Roth conversions can increase this percentage.

While these hidden taxes aren’t necessarily reasons to avoid Roth conversions entirely, they should factor into your decision about timing and amount.

5. You’re Planning to Donate to Charity During Your Lifetime or at Death

Traditional IRAs are some of the best accounts to donate to charity. If you convert all your tax-deferred assets to Roth, you lose this potential tax benefit.

One powerful strategy is the Qualified Charitable Distribution (QCD). Once you turn 70½, you can donate up to $107,000 (in 2025) directly from your IRA to charity without recognizing an taxable income. What makes this even more powerful is that once you begin taking Required Minimum Distributions (RMDs), you can reduce your RMD dollar-for-dollar up to that cap.

For example, if your RMD is $50,000 and you typically donate $30,000 to charity, you could do a $30,000 QCD directly from your IRA. This would reduce your RMD to $20,000, essentially making that $30,000 completely tax-exempt—even better than a tax deduction.

Similarly, if you’re planning to leave money to charity at death, your traditional IRA is a great asset to use. While your non-spousal beneficiaries (typically children or nieces/nephews) will have to pay taxes as they withdraw from the inherited IRA over the 10-year period, charities don’t pay any taxes on these distributions.

This doesn’t mean you shouldn’t convert at all, but you might consider not converting as much or as aggressively if charitable giving is part of your plan.

6. You’re Planning to Self-Fund for Long-Term Care Costs

Long-term care is one of the most significant risks retirees face today. The uncertainty lies in whether you’ll need care, and if so, for how long—six months or ten years? The costs can be substantial, often exceeding six figures annually.

Some people buy long-term care insurance, while others plan to use their own assets. If you’re in the latter group, there’s an interesting tax angle to consider. While IRA distributions are taxable, there’s a deduction if your medical costs exceed 7.5% of your adjusted gross income. These expenses can be added to your itemized deductions.

If you need long-term care later in life, it’s almost certain your expenses will exceed that 7.5% threshold, given the high costs involved. If you have an IRA you can tap into to pay for care, you might be able to deduct some of those distributions because of the medical expense deduction.

While this deduction may not offset the entire tax on the distribution, it can be significant enough to argue against converting all of your IRA to Roth.

7. You Don’t Have the Cash to Pay the Taxes

The traditional approach to paying for Roth conversion taxes is to use cash on hand from a savings or checking account, or to increase withholding from sources like Social Security or a pension to offset the additional taxes.

If these aren’t options—if you don’t have the cash or need your income from other sources—you may have to use funds from your IRA to pay the tax. If you’re younger than 59½, this isn’t advisable because you’ll face a 10% early withdrawal penalty.

Even if you’re over 59½, using money from your IRA to pay the taxes leaves less money invested that could otherwise grow tax-deferred. This may not be ideal depending on your time horizon and the breakeven point of the Roth conversion.

Your plan should strongly favor Roth conversions for it to make sense to pay the tax out of the IRA. While there are cases where this works (I have a client for whom we’re doing exactly this), if you don’t have the cash and the case for Roth conversion isn’t compelling, you might want to pause or avoid the conversion altogether.

Final Thoughts on Roth Conversion Decisions

Understanding when a Roth conversion makes sense requires careful analysis of your current situation, future expectations, and overall financial goals. While Roth conversions can be powerful tools for retirement planning, they aren’t right for everyone in every situation.

Remember that tax laws and personal circumstances change over time, so regularly reviewing your retirement and tax planning strategy is essential for long-term success.

If you’re approaching retirement and wondering if you should do a Roth Conversion, check out Episode 66 of The Planning for Retirement Podcast. Consider working with a financial advisor who specializes in retirement income planning. They can help you analyze your specific situation and develop a claiming strategy that aligns with your overall financial goals.

At Imagine Financial Security, we help individuals over 50 with at least a million dollars saved navigate these complex retirement decisions.

If you are looking to maximize your retirement spending, minimize your lifetime tax bill, and worry less about money, you can start with our Retirement Readiness Questionnaire linked on our website at www.imaginefinancialsecurity.com. Click the “Start Now” button to learn more about our process and how we might be able to help you achieve a more confident retirement.

Not quite ready to take the questionnaire, but want helpful tips and resources? Sign up for our monthly newsletter and/or subscribe to our YouTube channel.

This is for general education purposes only and should not be considered as tax, legal or investment advice.

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Kevin Lao

July 17, 2025

How to self insure for long term care

The numbers don't add up...

These three statistics don’t add up to me!

1. 70% of Americans over 65 will need long-term care during their lives.

2. Fewer than half of you over the age of 65 own insurance to pay for long-term care. Essentially, you are planning to self-insure for long term care.

3. This is the crazy part. 70% of the care being provided is done by unpaid caregivers! Aka. family members…🤔

I wrote about long-term care planning before, but my convictions on this have only increased over the years.

In my previous article, I talked about considerations on whether or not you should purchase insurance.

We also just finished recording a three-part series on The Planning for Retirement Podcast (PFR) about how to fund long-term care costs. Episodes 22 and 23 were about using long-term care insurance and episode 24 was about how to self fund long-term care.

So why do these statistics bother me?

If the majority of retirees will need care, and they are intentionally not buying insurance, that means they plan to self fund for long term care (by default). However, why are family members providing the majority of long term care and not hired help!?

The answer: because there was no real plan to begin with. In reality, it was a decision that was never addressed, or perhaps in their mind they decided to “self fund.” However, that decision was never communicated to their loved ones.

Let me ask you. If you are in the majority that plans to self fund, what conversations have you had with your spouse? Your power(s) of attorney? Your trustee(s)? Do they know how much you’ve set aside if long term care was ever needed? Do they know which accounts they should “tap into” to pay for long-term care?

The chances are “no,” because I’ve never met a client who did this proactively on their own. Ever. And I’ve been doing this for 15 years.

So, this article is for you if you are planning to bypass the insurance route and use your own assets to “self fund long-term care.” I believe this is one of the most important decisions you can make when planning for retirement because it can save how you are remembered.

How much should I set aside to self insure long term care?

It is impossible to pinpoint the exact number YOU will need for care. But let’s pretend your long-term care need will fall within the range of averages.

On average, men need care 2.2 years and women 3.7 years.

The 2021 cost of care study by Genworth found that private room nursing homes cost $108,405/year. Assisted living facilities cost $54,000/year. These are national averages, and the cost of care varies drastically based on where you live.

So let’s use this ballpark figure of $118,800 – $238,491 for men, and $199,800 – $401,098 for women (2.2x the averages for men and 3.7x the averages for women).

The major flaw in using this math is that most people have some sort of guaranteed income flowing into their bank accounts.

Social Security Income
Pensions
Required Minimum Distributions

Of course, not all of that income could be repurposed, especially if you are married. However, perhaps 25%, 50% or 75% of that income could be repurposed for caregivers.

Let’s say you are bringing in $100k/year between Social Security, Pension, and Required Minimum Distributions. Let’s say you are married, and all of a sudden need long term care. For simplicity’s sake, your spouse needs $50k for the household expenses. The other $50k could be repositioned to pay for long-term care. After all, if you need care, you probably are not traveling any longer, or golfing 5 days/week. This unused cash flow can now be dedicated to hiring professional help and protecting your spouse from mental and physical exhaustion.

If we assume the high-end range for men of $238,491, but we assume that $110,000 could come from cash flow (2.2 years x $50k of income), then only $128,491 of your assets need to be earmarked to self fund long term care.

Hopefully, that’s a helpful framework and reassurance that trying to come up with the perfect number is virtually impossible. After all, you may never need care. Or, perhaps you will need care for 5+ years because of Alzheimer’s.

My key point in this article is to address this challenge early (before you turn 60), and communicate your plan to your loved ones.

What accounts are the best to self insure long term care?

My personal favorite is the Health Savings Account, or HSA. I wrote in detail about HSA’s in another blog post that you can read here.

Here’s a brief summary:

You can qualify to contribute to an HSA if you have a high-deductible health plan.
The contributions are “pre-tax.”
Earnings and growth are tax-free (you can invest the unused HSA funds like a 401k or other retirement plan).
Distributions can also be tax-free if they are used for “qualified healthcare costs.”

What is a qualified healthcare cost?

Look up IRS publication 502 here, which is updated annually.

One of the categories for qualified healthcare costs is in fact long-term care! This means you can essentially have a triple tax-advantaged account that can be used to self insure long-term care in retirement.

However, you need to build this account up before you retire and go on Medicare. Medicare is not a high-deductible health plan!

But, if you have 5+ years to open and fund an HSA, it can be a great bucket to use in your retirement years, particularly long-term care costs.

The 2023 contribution limits are $7,750 if you are on a family plan and $3,850 if you are on a single plan. There is also a $1k/year catch-up for those over 55.

So, if you’re 55, you could add up to $43,750 in contributions for the next 5 years. If you add growth/compounding interest on top of this, you are looking at 6 figures + by the time you need the funds for care in your 80s. Not bad, right?

Taxable brokerage accounts or "cash"

This bucket is another great option. Mostly because of the flexibility and the tax advantages of taking distributions. Unlike a 401k or IRA, these accounts have capital gains tax treatment. For most taxpayers that would be 15%, which could be lower than your ordinary income tax rate (it could also be as low as 0% and as high as 20%+).

If you are earmarking some of these dollars for care, I would highly recommend two things:

Separate the dollars you intend to spend for care and give this new account a name (“long-term care account”)
Invest the account assuming a time horizon for your 80s instead of your 60s. In essence, you can make this account more aggressive in order to keep pace with the inflation rate for long term care expenses.

What’s nice about this bucket is that it’s not a “use it or lose it.” Just because you segregated some assets to pay for care, doesn’t mean those dollars have to be used for care. When these dollars pass on to the next generation, they should receive a step up in cost basis for your beneficiaries. If the dollars are in fact needed for care, you will only pay taxes on the realized gains in the portfolio.

🤔 Remember when we talked about tax loss harvesting in episode 19? Well, this strategy could also apply to help reduce the tax impact if this account is used to self-insure long-term care.

Of course, cash is cash. No taxes are due when you withdraw money from a savings account or a CD. Now, I wouldn’t suggest using a CD or cash to self-insure care, simply because it’s very likely that account won’t keep pace with inflation. However, if there is some excess cash in the bank when you need care, this could be a good first line of defense before the more tax-advantaged accounts are tapped into.

Traditional 401ks and IRAs

This bucket is often the largest account on the balance sheet when you are 55+. However, many advisors and financial talking heads recommend against tapping these accounts to self insure long term care because of the tax burden.

Well of course, it may not be ideal as a first line of defense to pay for care, but if it’s your only option, “it is what it is.”

But here’s the thing. If you are needing long term care, you’re most likely over the age of 80. This means you are already taking Required Minimum Distributions or RMDs. If you have a $1mm IRA, your RMD would be $62,500 at age 85. Let’s say you also have Social Security paying you $24,000/year. That’s a total income of $86,500 that is coming into the household to pay the bills. This was my point earlier in that you likely have income coming in that can be repurposed from discretionary expenses to hiring some professional help for care.

This means that you may not need to increase portfolio withdrawals by a huge number if RMDs are already coming out automatically.

But yes, you’ll have taxes due on these accounts based on your ordinary income rates. And yes, if you increase withdrawals from this bucket, this could put you in a position where your tax brackets go up, or your Social Security income is taxed at a higher rate, or perhaps will have Medicare surcharges.

On the flip side, this could also trigger the ability to itemize your deductions due to increased healthcare costs. In fact, any healthcare costs (including long term care) that exceed 7.5% of your adjusted gross income could be counted as a tax deduction (as of 2023).

The net effect essentially could be quite negligible as those additional portfolio withdrawals could be offset with tax deductions, where applicable.

Life Insurance and Annuities

Maybe you bought a life insurance policy back in the day that you held onto. Or you purchased an annuity to provide a guaranteed return or guaranteed income. However, you may find that your goals and circumstances change throughout retirement. Perhaps your kids are making a heck of a lot more money than you ever did, so they don’t have a big need for an inheritance. Or, that annuity you purchased wasn’t really what you thought it was. You could look at these accounts as potential vehicles to self-insure for long term care.

Life Insurance could have two components – a living benefit (cash value) and a death benefit. In this case, you could use either or as the funding mechanism for long term care.

Let’s say you have $150k in cash value and a $500k death benefit. Instead of tapping into your retirement accounts or brokerage accounts, you could look at borrowing or surrendering your life insurance cash value to pay for care. Or, you could look at the death benefit as a way to “replenish” assets that were used to pay for care.

Annuities could be tapped into by turning the account into a life income, an income for a set period of time, or as a lump sum. All of those options could be considered when it comes to raising cash for this type of emergency.

Roth Accounts

This is the second most tax-efficient retirement vehicle behind the HSA. It’s not only a great retirement income tool, but it’s also a great tool to use for financial legacy given the tax-free nature from an estate planning perspective. However, this account could be used to self insure long term care without triggering tax consequences.

Let’s say you need another $30k for the year to pay for care. But an additional $30k withdrawal from your traditional 401k would bump you into the next tax bracket. Instead, you could look to tap into the Roth accounts in order to keep your tax bracket level.

Home equity

The largest asset for most people in the US is their home equity. However, people rarely think of this as a way to self insure long term care. In fact, this is why many caregivers are family members! They want their loved ones to stay at home instead of moving into a nursing home. But perhaps there isn’t a huge nest egg to pay for care. If you have home equity, you could tap into that asset via a reverse mortgage, a cash-out refinance, or a HELOC. There are pros and cons of each of these, but the reverse mortgage (or HECM) is a great tool if you are over the age of 62 and need access to your equity.

The payments come out tax-free, the loan doesn’t need to be repaid (unless the occupant moves, sells, or dies), and there are protections if the value of the home is underwater.

Inform your key decision makers

Now that you have a decent understanding of how much to set aside and which accounts might be viable for you, it’s time to have a family meeting.

If you’re married, have a conversation with your spouse.

If you have children, bring them into the discussion, especially those that will have a key decision-making role (powers of attorney, trustee etc).

You know your family dynamic best. The point you need to get across is that you do have a plan to self insure long term care despite not owning long term care insurance. Your loved ones need to know how much they could tap into (especially the spouse) in the event you need care. This is very important, give your spouse permission to spend! Being a caregiver, especially a senior woman, will very likely result in burnout, stress, physical deterioration, mental exhaustion, and resentment. If you simply leave it to your spouse to “figure out,” they will always resort to doing it themselves in fear of overspending on care.

❌ Don’t do this to them!

I hope you found this helpful! Make sure to subscribe to our newsletter below so you don’t miss any of our retirement planning content! Until next time, thanks for reading!

#fiduciary #staugustine fiduciary financialplanning flat fee financial advisor long term care retirement retirementplanning

Kevin Lao

September 8, 2023

How to Reduce Taxes on Your Social Security Retirement Benefits

If you have already begun drawing Social Security, you might be surprised to learn taxes are owed on some of your benefits! After all, you’ve been paying into the system via payroll taxes, so why is your benefit also taxable? If you have yet to begin drawing Social Security yet, you can never say you weren’t told! As a result, I’m often asked if there is a way to reduce taxes on your Social Security benefits. This blog post will unpack how Social Security taxes work and how to reduce taxes on your benefits. Make sure to join our newsletter so you don’t miss out on any of our retirement planning content (click here to subscribe!). I hope you find this article helpful!

A brief history of Social Security

The Social Security Act was signed into law by President Roosevelt in 1935! It was designed to pay retired workers over the age of 65. However, life expectancy at birth was 58 for men and 62 for women! Needless to say, there weren’t a huge number of retirees collecting benefits for very long. As people began to live longer, several key provisions were added later. One was increasing the benefits paid by inflation, also known as Cost of Living Adjustments (COLA). Another was changing the benefits from a lump sum to monthly payments. Ida Fuller was the first to receive a monthly benefit, and her first check was $22.54! If you adjust this for inflation, that payment would be worth $420.15 today! If you compare this to the average Social Security benefit paid to retirees of $1,782/month, those early payments were chump change!

The Aging Population has Led to Challenges

According to data from 2021, life expectancy at birth is 73.5 years for men and 79.3 years for women! In 2008, there were 39 million Americans over age 65. By 2031, that number is projected to reach 75 million people! We’ve all heard of the notion that older (more expensive) workers are being replaced by younger (less expensive) workers. While taxable wages are going down and retirees collecting benefits are increasing, the result is a strain on the system.

Social Security benefits are actually funded by taxpayer dollars (of course). If you look at a paystub, you will see FICA taxes withheld automatically. FICA stands for Federal Insurance Contributions Act and is the tax revenue to pay for Social Security and Medicare Part A. The Social Security portion is 6.2% for the employee and 6.2% for the employer, up to a maximum wage base of $160,200. So, once you earn above $160,200 you likely will notice a “pay raise” by way of not paying into Social Security any longer. Medicare is 1.45% up to $200,000, and then an additional 0.9% for wages above $200k (single filer) or $250k (married filing jointly).

Up until 2021, FICA taxes have fully covered Social Security and Medicare benefits. However, because of the challenges mentioned earlier, FICA taxes no longer cover the benefits paid out. The good news is there is a Trust Fund for both Social Security and Medicare for this exact reason. If there is a shortfall, the trust fund covers the gap. The big challenge is if nothing changes, Social Security’s trust fund will be exhausted in 2034 and Medicare’s in 2031.

How are the taxes on Social Security calculated?

The first concept to understand is that the % of your Social Security that will be taxable is based on your “combined income,” also known as provisional income. If your combined income is below a certain threshold, your entire Social Security check will be tax-free! If your combined income is between a certain threshold, up to 50% of your Social Security benefit will be taxable. And finally, if your income is above the final threshold, up to 85% of your Social Security benefit will be taxable. Here are the thresholds below.

How is “Combined Income” calculated?

The basic formula is to take your Adjusted Gross Income (NOT including Social Security), add any tax-exempt interest income, and then add in 50% of your Social Security benefits.

If you are retired, you likely will have little to no earned income, unless you are working part-time. Your adjusted gross income will be any interest income, capital gains (or losses), retirement account distributions, pensions, etc. This is important to note because not all retirement account distributions are treated the same! Additionally, capital gains can be offset by capital losses. So even though your cash flow might exceed these numbers significantly, you still might be able to reduce or even eliminate how much tax you pay on your Social Security Income.

Let’s look at two examples (both are Married Filing Jointly)

Client A has the following cash flows:

$40,000 of Social Security benefits
$50,000 Traditional IRA distribution (all taxable)
$10,000 of tax-free municipal interest income

The combined income in this scenario is $80,000.

Half of Social Security ($20,000) + $50,000 IRA distribution + $10,000 municipal bond income = $80k.

Notice how the municipal bond income is added back into the calculation! Many clients try to reduce taxes on their bond interest payments by investing in municipal bonds. However, it’s important to note how this interest income might impact other areas of tax planning.

In this scenario, 85% of their Social Security benefit will be taxable.

The first $32,000 of income doesn’t trigger any Social Security taxes.

The next $12,000 will include 50% ($6,000)

And finally, the amount over $44,000 ($36,000) includes 85% (85% * $36,000 = $30,600).

$6,000 + $30,600 = $36,600

If you divide $36,600 by the $40,000 Social Security benefit, it gives you 91.5%. However, a maximum of up to 85% of the Social Security benefit is taxable, so in this case, they are capped at 85% and $34,000 will be their “taxable Social Security” amount.

Client B has the following cash flows:

$40,000 Social Security Income
$50,000 Roth IRA distribution
$4,000 Interest Income

Client B’s provisional income is only $24,000!

Half of Social Security ($20k) + $0 retirement account distributions + $4,000 interest income = $24,000

As you can see, the Social Security benefits are identical to client A. However, the $50,000 retirement account distribution is from a Roth account, and in this case, it was a tax-free distribution. And finally, the interest income was way down because the client elected to reduce their bond allocations in their taxable account and instead owned them inside of their IRAs (which is not taxable).

So despite having essentially identical cash flows, Client B enjoys 100% of their Social Security check being tax-free! In other words, they have reduced their taxable income by $34,000 compared to client A!

A huge challenge arises for clients who are under the max 85% threshold. Each dollar that is added to their retirement income will increase how much Social Security is taxed! If someone is in the 50% range and they take an additional $1,000 from a Traditional IRA, they will technically increase their adjusted gross income by $1,500! $1,000 for the IRA distribution and $500 for taxable Social Security income!

What can you do about reducing taxes on Social Security?

So while you shouldn’t let the tail wag the dog, you should absolutely begin mapping out how you can make your retirement income plan as tax efficient as possible! Here are a few ways to reduce your “combined income” and thus reduce your taxes on Social Security payments.

Roth Conversions

Simply put, a Roth conversion allows you to “convert” all or a portion of your traditional IRA/401k/403b to a Roth account. Of course, you will have to pay taxes on the amount converted, but all of the growth and earnings can now be tax-free!

This is perhaps one of the most impactful strategies you can incorporate! However, you must start this strategy at the right time! If you are still employed and perhaps at the peak of your earnings, you may not benefit from Roth conversions…yet. However, if you recently retired and have yet to begin the Required Minimum Distributions (RMDs), you might find it to be a valuable strategy if you execute it properly.

One of our most recent podcast episodes is about this topic; you can listen to it here.

Avoid the RMD Trap!

The RMD trap is simply the tax trap that most people with Traditional IRAs or 401ks run into. In the early years of retirement, your RMD starts out quite low because it’s based on your life expectancy according to the IRS. However, each year the amount you are required to withdraw increases. By the time you are in your 80s and even 90s, the amount you are taking out could exceed what you need for cash flows! But despite needing it for income or not, you have to withdraw it to avoid the dreaded penalties, and this could push you into higher tax brackets later in retirement. And of course, this could also increase the taxation of your Social Security check!

Roth conversions help with this, but it could also help to try to even out the distributions! Instead of just waiting for the RMDs to balloon, perhaps you devise a better withdrawal strategy to target a certain tax bracket threshold throughout your retirement.

Asset Location strategies

You may have heard of the term “Asset Allocation,” which involves careful selection of asset classes that align with a portfolio’s objectives. In essence, what % of stocks, bonds, real estate, and cash does the portfolio hold? Asset Location involves selecting which accounts will own those asset classes in order to maximize tax efficiency and time horizon.

When we looked at the Social Security examples earlier, you probably noticed Client B had less taxable interest income. This is because they elected to reduce the amount of fixed income in their “taxable” account, and moved those assets into their IRAs.

Alternatively, you might have a longer time horizon with some of your accounts, like a Roth IRA. Given Roth’s tax-free nature and the NO RMDs, this account is a great “long-term” bucket for retirement income planning. As a result, you might elect to have this account ultra-aggressive and not worry much about capital gains exposure, etc.

You should take advantage of the tax characteristics of different “buckets” for retirement income planning. Not all of your investment accounts should look identical in that sense.

Tax Loss Harvesting

Perhaps one of the most UNDERRATED strategies is tax loss harvesting. Oftentimes when the market is down, people bury their heads in the sand hoping that things will improve one day. And this is certainly better than selling out and moving to cash! However, there is one step many people miss: realizing losses when the markets are down. These losses can then be used to offset capital gains, and even reduce your ordinary income!

I oftentimes hear pushback that people don’t want to offload investments at a loss because they were trained to “buy low and sell high.” This is a great point, but with tax loss harvesting, after the loss is realized, you then turn around and replace the investment you sold with something similar, but not “substantially identical.” That way, you avoid the Wash-Sale rule so you can recognize the tax loss, but you stay invested by reallocating funds into the market.

Episode 19 of The Planning for Retirement Podcast is all about this topic and you can listen to it here!

Qualified Charitable Distributions

Okay, so you missed the boat on Roth conversions, and you are already taking RMDs from your accounts. Qualified Charitable Distributions, or QCDs, allow for up to $100,000/year to be donated to charity (qualified 501c3) without recognizing any taxable income to the owner! Of course, the charity also receives the donation tax-free, so it’s a win-win! I oftentimes hear of clients donating to charity, but they are itemizing their deductions. Almost 90% of taxpayers are itemizing because of the Tax Cuts and Jobs Act of 2017. QCDs can be utilized regardless if you are taking the standard deduction or not! And the most powerful aspect of the QCD is that it will reduce your RMD dollar for dollar up to $100k.

Let’s say your RMD for 2023 is $50k. You typically donate $10k/year to your church but you write a check or donate cash. At the end of most tax years, you end up taking the standard deduction anyways, so donating to charity doesn’t hurt or help you.

Now that you’ve learned what a QCD is, you go to the custodian of your IRA and tell them you want to set up a QCD for your church. You fill out a QCD form, and $10k will come out of your IRA directly to your Church (or whatever charities you donate to). Now, your RMD is only $40k for 2023 instead of $50k! In essence, it’s better than a tax deduction because it was never recognized as income in the first place!

Two important footnotes are the QCD has to come from an IRA and the owner must be at least 70.5 years old! It cannot come out of a 401k or any other qualified plan!

We wrote an entire article on QCDs (and DAFs) that you can read here.

Final Thoughts

Retirement Planning is so much more than simply what is your investment asset allocation. Each account you own has different tax characteristics, and the movement of money within or between those accounts also has tax consequences. Instead of winging it, you could save tens or even hundreds of thousands of dollars in taxes in retirement if you are proactive. However, the tax code is constantly changing! In fact, the Tax Cuts and Jobs Act of 2017 is expiring after 2025, so unless something changes, tax rates are going up for most taxpayers. Additionally, the markets are beginning to recover, so strategies like tax loss harvesting or Roth conversions become less impactful. But, there is still plenty of time and opportunity!

Thanks for reading and I hope you learned something valuable. Make sure to SUBSCRIBE to our newsletter to receive updates on me personally, professionally, and of course, content to help you achieve financial independence! CLICK on the “keep me up to speed” button below.

-Kevin

Kevin Lao

June 16, 2023

What can Retirees learn from Silicon Valley Bank’s failure?

Easy money policy beginning in 2009 led to a historical run in tech companies. Companies that rely on leverage to aggressively grow were borrowing money for next to nothing! Investors weren’t even concerned with cash flows, or healthy balance sheets. If the idea seemed like it could stick, they would take their bets. Some paid off, and some flopped. But the overall sentiment was “risk-on.”
These policies led to the success of Silicon Valley Bank, or SVB. Out of all of the start-ups in the US, SVB provides banking services to nearly half of them. Whether it was providing them loans or deposits, they were the go-to Bank for start-ups.

But what happens to these tech companies (with no positive cash flows) when rates go up?

Instead of borrowing “free money,” they begin to use their own cash (really their investor’s cash) for operations. Why would they borrow for 8% or 9% when their cash is only earning 1% or 2%? At some point, the interest on debt isn’t sustainable.

So, they go to their bank and pull funds for their operations. After all, they still have payroll and other overhead to keep the business going.

Remember the run-on banks in “It’s a Wonderful Life?” No, they don’t keep your money in the bank! It’s invested somewhere!

In SVB’s case, over half of their assets were invested in bonds! What’s more is that the majority of these bonds had long-term maturities, over 10 years, instead of shorter-term maturities.

We talked about interest rate risk in several of our market commentaries over the last couple of years, and SVB completely missed the mark on hedging interest rate risk. Maybe they should’ve been reading our blog!

So how did they raise cash to give to their depositors?
They had to sell their bonds…

What happens to bond prices when interest rates rise?

They go down, simple as that. Think about it. If you bought a 10-year treasury 3 years ago, it was yielding less than 1%. Today, new issues of 10-year Treasuries are yielding 3.7%! So, for anybody to want to buy your bond, you would need to discount it significantly. Otherwise, they will just buy a new issue for almost 4x the interest!

So, instead of SVB holding their bonds to maturity, as they intended to, they needed to sell (at a significant loss) to meet their obligations. The loss realized was $15b, which was equivalent to nearly all of its tangible capital. This led to their ultimate collapse and is the second-largest bank failure in US history (second to Washington Mutual in 2008).

Why didn’t SVB hedge interest rate risk?

I’m not putting the blame on one individual, but it’s no coincidence that the CFO of Lehman Brothers (who left Lehman right before their bankruptcy in 08) is now an executive at SVB. Additionally, the Chief Risk Officer of SVB worked for Deutsche Bank during the subprime-mortgage crisis in 2008.

Some banks are more conservative. They lend to small businesses or individuals. SVB, on the other hand, catered to start-ups in Silicon Valley. These tech start-ups have significantly more risk than the bakery shop next door. Additionally, their deposits were padded over the last two years because of the easy money policy over the last decade coupled with record amounts of stimulus.

The bottom line is that SVB got greedy. Instead of looking at the interest rate environment as a risk, they ignored it. They sought higher yields in longer-term bonds without hedging the need for short-term cash flows. They never expected a “run on the bank.”

So what does this mean for SVB’s deposit holders?

The Federal Deposit Insurance Commission, or FDIC, officially announced on Friday that SVB was closed. This led to a selloff in stocks and of course, those holding SVB stock will lose their investment.

But what about the deposit holders and borrowers? The FDIC typically protects balances up to $250k per entity/bank. In SVB’s case, most of their customers had significantly more than the FDIC limit. After all, these are big wigs out in Silicon Valley. Not surprisingly, here comes the Government to “bail them out.” But they aren’t calling it a bailout, as we saw in 2008/2009, because they say that stock and bondholders in SVB are not protected. However, they are using “emergency-lending authorities” to make funds available to meet bank withdrawals, even those that exceed FDIC limits! In fact, 85% of the bank’s deposits were uninsured! And you can’t argue their customers don’t understand FDIC. These are some of the supposed best and brightest innovators in our country. This is absolutely a bailout; they just aren’t calling it one.

What are the lessons we can learn from SVB’s failure?

After all, SVB is an investor, just like you and me. The principles they failed to adhere to can also lead to an investor running out of money during retirement. The only difference is the Government has no interest in bailing YOU out. So, it’s important to have a plan and process while you are navigating a potential 30+ year retirement!

Lesson #1: Diversification

This is a basic principle of “Investments 101” – Don’t put all of your eggs in one basket! Diversify! In SVB’s case, they put all of their eggs in the tech start-up basket, and they had quite a run-up until 2022.

Coincidently, when I review prospective client portfolios, technology is by far the most concentrated sector. I’m not going to argue the merits of tech companies, but most banks tend to diversify their clientele. This provides less risk of one industry going through hard times.

Oftentimes people bury their heads in the sand in hopes that “things work out.” Well, if you haven’t done anything with your portfolio in a while, there is a good chance you’re overexposed to assets that are overpriced.

SVB chose not to diversify. They decided to stick with their niche, and ultimately the Fed’s aggressive rate hikes put pressure on their customers leading to the run on their bank.

Lesson #2: Match retirement cash flows with YOUR time horizon!

When you are planning for retirement, there are two types of expenses:

Known expenses
Unknown expenses

For your “Known expenses,” wouldn’t it make sense to match those up with “known cash flows” and not “unknown cash flows”? Well, SVB decided to keep their bond portfolio LONG term. The longer the term of the bond, the more interest rate risk it has. It’s important to not chase rates. Just because a bond is paying a higher coupon, doesn’t mean it aligns with YOUR portfolio goals.

This is why I am a big fan of individual bonds for the “core” bond portfolio. With individual bonds, you can hold them to maturity for the “known expenses.” Sure, there is a time and place for bond mutual funds or bond etfs, but those funds have redemption risk, similar to what SVB experienced. In their minds, they wanted to hold their bonds to maturity to match up with later cash flow needs, but their customers wanted cash now.

With bond funds, what if OTHER investors who own that fund want their cash before you do? Well, these are known as redemptions and ultimately the fund may have to sell at an inopportune time, just like SVB! In essence, you lose one of the most important characteristics of a bond, the maturity date!

So, if you have a bond portfolio and are planning for retirement, you must absolutely match your bond portfolio up with YOUR time horizon and YOUR cash flow needs! This eliminates interest rate risk as much as possible. And for retirees, risk management is the name of the game.

Lesson #3: Have a contingency plan

Ok, that’s a great plan for the “known expenses,” but what about the “unknown expenses?” In retirement, things ALWAYS come up. We just don’t know what they will be, and how much they will set us back.

This is why I advocate for an emergency fund OUTSIDE of the retirement portfolio. With high-yield savings accounts offering north of 3% interest, cash can at least earn something while sitting idle. Of course, stick within FDIC limits, but anywhere from 1-2 years worth of FIXED expenses is appropriate for a retiree’s emergency fund. Unlike an investor who is still working and has time to get a new job or allow the portfolio to recover, retirees don’t have those luxuries. Sure, you could beg for your old job back, but that might not be what you WANT to do. Instead, if you have 1-2 years of fixed expenses, this will help preserve your investment portfolio from a larger-than-anticipated withdrawal.

For some, you may not want so much cash sitting around for that “what-if” scenarios, so here are a couple of compliments to a cash reserve fund:

Home Equity Line of Credit
Life Insurance Cash Values

Home Equity Lines of Credit, or HELOCs, are a great way to limit how much you keep in cash. Most people use these for home improvements, but having a HELOC can also help with your emergency fund. Let’s say 1 year of fixed expenses is $100,000. Instead of having $100k-$200k in high-yield savings, you might keep $50,000 in cash, and have a $150k HELOC for the JUST-in-case scenario. That way, your savings account can be your first line of defense. And only if needed, the HELOC can come in as a backup.

Cash Value Life Insurance is probably my favorite emergency fund vehicle in retirement. Unlike term insurance, it can act as a pool of funds available when you really need it.

And unlike a bond which can decline in value based on interest rates, cash values have a minimum guaranteed rate, so the cash can never go down. Think about the power of this tool in the market we are in now where bond prices are down over 15%!

And I’m not talking about Indexed Universal Life policies or Variable Life Policies, I’m talking about a traditional fixed product. If you build up enough cash value over time, you may only need 3-6 months of fixed expenses in cash given the rest of your cash buffer is inside of your life insurance policy. I’m going to write another article on Cash Value Life Insurance later, but it’s a great tool for the right person. But for the wrong person, it’s one of the worst products you can buy!

For what it’s worth, our firm does not sell any insurance products and we have no skin in the game. These products should also be gone over with a fine-tooth comb as they can be extremely complex.

Bonus Lesson #4: Don’t chase the shiny new toy

As I began writing this piece, Signature Bank became the next casualty of the run on banks Sunday, March 12^th. Their Bank was also focused on a niche, commercial real estate. However, in 2018, they decided to chase the shiny new toy, cryptocurrency, or digital assets. As concerns arose from the failure of FTX as well as SVB, customers started to pull their funds from Signature, leading to what is now the 3^rd largest Bank to fail in US History.

I repeat, don’t chase the shiny new toy!

What does this mean for the markets?

It was interesting because the stock market rallied on Monday after both SVB and Signature closed their operations. WHY??

Well, it seems that investors feel the Fed might slow their rate increases in light of the casualties it caused. Slower rate hikes mean potentially less pressure on profits and ultimately earnings. However, I don’t think we’ve seen the end of this narrative. Starting with FTX’s collapse last fall, and now these two large banks failing, other companies that are overweight in speculative investments will continue to unravel. The magnitude of these rate hikes cannot be overstated and this type of carnage has been what we’ve been concerned about since the beginning of 2022.

The story we are very interested in is the impact on small “moms-and-pops” businesses. After all, many of the customers SVB serves provides service to everyday businesses. Whether it’s payroll, cloud services, or other technology, small businesses across the US rely on tech. And if these tech companies are beginning to falter, what does that do to the economic system as a whole? Also, is this going to lead customers of other regional banks to panic? Will they take their money and put it at a larger bank or under the mattress or in cryptocurrency? This could put significant pressure on banks all over the US, which would have a trickle effect on the economy.

In the end, the Fed may not get the soft landing it wanted, but a recession may not be fully priced into the market at this point.

The one silver lining is that inflation does continue to ease, and that’s good news when it comes to what the Fed does next.

For those of you who are close to, or already retired, I have 5 major takeaways for you.

1. Are you overweight in speculative investments?

Tech, consumer discretionary, digital assets, or even speculative real estate. These assets have certainly appreciated significantly over the last decade, but things tend to fall in and out of favor. Therefore, it’s important to review and re-balance your portfolio on an ongoing basis to reduce risk. Even if your portfolio consists of several mutual funds or ETFs, it’s also very possible they are concentrated in certain sectors with higher risk.

2. What does your bond portfolio consist of?

Are the time horizons of your bond portfolio consistent with your personal retirement goals and objectives? If you need help reviewing this, consult a professional (we can help you!).

3. What major unexpected expenses might you run into during retirement?

Sure, we may not have a “run-on-your-retirement” as we had with SVB. However, I can guarantee there will be significant unknown expenses during a multiple-decade retirement. One, in particular, I can think of is the need for long-term care. This is perhaps the largest unknown expense for retirees, and the cost can drain a retirement portfolio much sooner than desired. It’s important to have a contingency plan to protect and preserve the retirement portfolio if the need for care arises.

4. Where do you bank?

The notion of FDIC has come back into play with the collapse of SVB. Are you over the $250k FDIC limit with your bank? While the Fed announced it’s going to make customers of SVB and Signature whole, that may not be the case with smaller regional banks, so it’s important to keep your safe money safe.

5. Don’t be reactive, be proactive.

News like this is never good for the markets. We have been talking about the Fed’s rate hikes for over a year and how certain sectors are going to take a hit. Now, the impact is beginning to rear its ugly head, and we might have a few more quarters of continued bad news. However, you are investing for retirement. Retirement is not just a few quarters, it’s a few decades! As long as your portfolio is aligned with your retirement goals, there is no need to make a knee-jerk reaction to the bad news. After all, if you’ve learned from the lessons SVB’s failure taught us, you can implement a successful retirement plan for “all seasons.”

If you have questions about how these lessons can be implemented into your retirement plan, we would love to meet you and learn more about you.

And finally, make sure to subscribe to our newsletter to stay up to date with all of our latest retirement planning content.

Until next time, thanks for reading.

Sources

https://www.wsj.com/articles/the-silicon-valley-bank-bailout-chorus-yellen-treasury-fed-fdic-deposit-limit-dodd-frank-run-cc80761e?mod=hp_opin_pos_1

https://www.wsj.com/articles/federal-reserve-rolls-out-emergency-measures-to-prevent-banking-crisis-ba4d7f98?mod=economy_lead_pos1

https://www.wsj.com/articles/companies-with-deposits-trapped-in-silicon-valley-bank-9034f33b?mod=article_inline

https://finance.yahoo.com/news/silicon-valley-bank-exec-lehman-000556735.html

https://www.barrons.com/articles/svb-silicon-valley-bank-rates-securities-693c931c

Kevin Lao

March 14, 2023

What are the rules for Required Minimum Distributions?

Congratulations! Lots of blood, sweat, and tears went into a successful career, and you have saved enough to start thinking about when to retire. If you’ve been saving into a 401k, 403b, or another retirement plan through work, you’ve probably heard of Required Minimum Distributions or “RMDs.” You might be wondering;
“What are the rules for required minimum distributions?”
“How do RMDs impact my taxes?
Or, “What can I do now to prepare for RMDs?”

This article is for you! We’ll unpack all of this and provide REAL-LIFE action items to help you plan for RMDs and save in taxes!

What are RMDs and when do they start?

Simply put, RMDs are the IRS’s way of saying, “the party is over.” Or in this case, the tax party is over!

When you contributed to your 401k, IRA, or 403b, you likely took advantage of a generous tax deduction up front and have never paid taxes year over year on earnings. Pretty powerful, right?

The IRS has been patiently waiting for you to start withdrawals, and RMDs are their way of starting to collect their tax revenue.

Starting in 2023, the RMD age, or “beginning date,” is the year in which you turn 73 (for individuals born before 1960). For those born in 1960 or later, the beginning date is the year you turn 75.

Just a few short years ago, the beginning date was the year you turned 70 ½. The SECURE Act of 2019 pushed the RMD age back to 72, and the SECURE Act 2.0 (just passed in December 2022) pushed it back even further. With many retirees living well into their 90s, that’s potentially 20+ years of RMDs!

These qualified plans have such powerful tax advantages because the growth year over year is not taxable! This allows for compounding interest to avoid tax drags altogether, which is unique in the investment world. However, there is a reason why our clients’ largest expense during retirement is TAXES! Our job is to minimize taxes, legally, as much as possible. Part of that job is to minimize the tax impact of RMDs in retirement.+

How are RMDs calculated?

The IRS has life expectancy tables that are updated (not so frequently), and each age has an assigned “life expectancy factor.” Once you reach your beginning date, the account balance at the previous year’s close (December 31^st) is divided by the life expectancy factor in the IRS tables.

Example:

You have a $1,000,000 IRA balance as of December 31^st of 2022.

Assuming you turn 75 in 2023 and you use the Uniform Lifetime Table (more on this in a moment), your life expectancy factor would be 24.6.

To calculate the RMD for 2023, you would divide $1,000,000 by 24.6, which would equate to $40,650.40.

There are three types of life expectancy tables. The Uniform Life Expectancy table (used above) is for single or married account owners. However, if you are married, your spouse is the sole beneficiary of your account, AND is more than 10 years younger than you, you can use the Joint Life and Last Survivor Life Expectancy Table.

The “Single Life” expectancy is for beneficiaries of IRAs that were not the spouse and inherited the account before January 1^st of 2020. For account owners who have inherited IRAs or other retirement accounts beginning in 2020, the new 10-year rule applies, which we will discuss shortly.

The older you get the higher the rate of withdrawal gets. By the time you reach 80, the distribution percentage is close to 5%/year! At 85, it’s 6.25%!

An RMD for a $1,000,000 IRA at age 85 is $62,500!

If you add in Social Security income, perhaps a pension, and other investment income, you can see how this could create a tax burden during the RMD phase. The IRS does not care if you need the income, they just want their tax revenue. And not only will your taxable income in retirement go up, but could impact how much Social Security is taxed and how much you are paying for Medicare premiums!

If you miss an RMD, there are penalties. The SECURE Act 2.0 changed the penalty to 25% from 50%, and that applies to the amount you failed to withdraw. Using our example above with a $40,650.40 RMD, a 25% penalty would equate to $10,162.60 assuming you withdrew nothing!

Needless to say, make sure you satisfy this important rule for required minimum distributions or pay the price.

The first RMD can be delayed until April 1st of the following year!

RMDs need to be satisfied by December 31^st each year. Some of our clients elect to take the RMD monthly in 12 equal payments; others elect quarterly. And some take it as a lump sum. The decision is cash flow driven and how much you need the RMD for income (or not). There is one exception that applies to your FIRST RMD. The first required minimum distribution can be delayed until April 1^st of the following year.

Let’s say you turn 73 in the year 2024, which would make 2024 your beginning date. However, you also plan to retire in 2024 and might still have high wages to report for that tax year. In 2025, you will be fully retired and will have ZERO wages, so you decide you want to take advantage of delaying the first RMD until 2025. In this scenario, you would take the 2024 distribution by April 1^st (of 2025) and of course the 2025 distribution by December 31^st! In this scenario, you have two RMDs on your 2025 tax return, but your overall income perhaps is still lower because of no W2!

Are there RMDs on my current employer plan?

If you are still actively employed and have a qualified plan you are participating in, you can avoid RMDs from those plans only. Let’s say you plan to work until 75, and you have a large 401k with your current employer and an IRA from previous retirement plans. You will still be required to make an RMD from your IRA, but you can avoid the RMD on your 401k altogether. Once you are officially separated from service, that will trigger the “beginning date” for that 401k plan.

It’s also important to note that separation from service triggers the “beginning date” for that 401k. So, assuming you deferred RMDs in your current 401k plan, and retire at 75, you can still take advantage of deferring the first RMD until April 1st following the year you separated from service.

Finally, this rule does NOT apply to Solo 401ks or SEP IRAs. These plans are for self-employed individuals, and RMDs can’t be delayed simply because they are still working.

Can I aggregate my RMDs into one plan?

You might be wondering if you have multiple retirement plans, can you just pull the RMDs from one account?

My favorite answer is, “it depends.”

If the multiple retirement plans have identical plan types (perhaps they are all 401ks or all 403bs), then “yes, you can aggregate the RMDs.” If there are different plan types, like one IRA and one 401k, those plans each have their own RMD and must be satisfied separately. Let’s look at two examples:

Scenario 1: Joe has two IRAs, each with RMDs:

IRA RMD #1: $10,000

IRA RMD #2: $25,000

Total IRA RMD = $35,000

He can satisfy the entire $35,000 from either or both accounts.

Scenario 2: Joe has one IRA and one 401k each with RMDs:

IRA RMD #1: $10,000

401k RMD #2: $20,000

Each RMD would need to be satisfied separately because they are not identical account types.

SECURE Act’s elimination of the Stretch IRA for (MOST) beneficiaries

In January 2020, the SECURE Act of 2019 went into law. Part of the plan to pay for the bill was to accelerate distributions for beneficiaries of IRAs and 401k plans.

Under the previous law, a beneficiary other than the spouse could “stretch” the IRA based on THEIR life expectancy. Assuming the non-spouse beneficiary was much younger (like an adult child), the RMD would be reduced significantly after the original owner’s death. This is when the Single Life Expectancy table is used, as we alluded to earlier.

Let’s look at an example:

An original account holder has a $1mm IRA and is 80 years old. Their RMD would be $1,000,000 / 20.2 = $44,504.96. Before 2020, if that account owner passed away and their 55-year-old daughter inherited the account, her RMD would be $31,645.57. That’s a reduction of almost $13,000 of taxable income! In essence, it allowed the new owner to “stretch out” the distributions over a much longer period of time and thus preserving the tax-deferred status for longer.

The SECURE Act of 2019 eliminated the stretch IRA for MOST beneficiaries. I wrote about this in a previous post, “The Tax Trap of Traditional 401ks and IRAs,” but most beneficiaries other than the spouse will follow the “10-year rule.”

What is the 10-year rule?

The 10-year rule states that a retirement account must be fully liquidated by the end of the 10^th year following the owner’s death. The exception to the 10-year rule is for those who are “eligible designated beneficiaries.” These individuals are essentially a spouse, a beneficiary who is disabled or chronically ill, or a beneficiary who is fewer than 10 years younger than the IRA owner.

Everyone else will follow the 10-year rule.

If the IRA owner passed away on or after the beginning date, RMDs must continue during years 1-9, and then the full balance must be liquidated in year 10. If the IRA owner passed away before their beginning date, there are no RMDs until year 10, when the account needs to be fully liquidated.

It might be tempting to stretch the 10-year rule until the 10^th year, but this would result in significant taxes owed that year. Instead, you might consider taking somewhat equal distributions in years 1-9 and distributing the remaining account balance in year 10 to avoid a huge tax bill.

As you can see by the (overly simplified) chart below, this has significantly increased the size of distributions required after the account owner’s death and ultimately results in higher taxes.

What can you do to minimize the tax impact of RMDs?

If you are like many of our clients, the bulk of your retirement savings might be in tax-deferred 401ks or IRAs. However, newer plans like Roth IRAs and other Roth retirement plans have NO RMDs! Therefore, one way to minimize the RMD impact is to increase the proportion of Roth accounts on your balance sheet. There are two ways to do this:

If you are still working, change the contribution allocation to Roth vs. Traditional (401ks, 403bs, TSPs, etc). If your employer does not have a Roth option, you might consider a Roth IRA.
If you are retired or perhaps not contributing to a retirement plan, you could consider Roth conversions. This allows for money to be moved from tax-deferred accounts to tax-free accounts by paying taxes on the amount converted.

Why would I want to pay more taxes now?

Perhaps you believe your tax bracket will go up due to RMDs. Maybe you saved diligently into 401ks and IRAs and your RMD will be high enough to push you into the next tax bracket.

Also, healthcare is a big expense in retirement! Many people don’t realize that your Modified Adjusted Gross Income (“MAGI”) will impact how much you pay in Medicare Part B and D premiums (known as “IRMAA”)! The base premium for Medicare Part B is $164.90, but this can increase as high as $560.50 depending on your MAGI! Multiply this by 2 for Married Couples and we are talking over $12k/year in premiums alone!

Therefore, you might consider taking small bites at the apple now (pay some additional taxes now), so you don’t have a huge tax drag when RMDs kick in.

Consider taking advantage of "Qualified Charitable Distributions" or QCDs

This is perhaps my favorite tax strategy for retirees. QCDs allow for up to $100,000 to be donated to a qualified charity from your IRA. You have to be at least 70.5 years old, and it has to come from YOUR IRA (not an inherited IRA). This also means you cannot use 401ks or 403bs for QCDs!

While you can start this strategy at 70.5, this has the most impact on those already taking RMDs.

Because of the increase in the standard deduction, the majority of taxpayers are NOT itemizing deductions. If you’re not itemizing deductions, the gift you made to your favorite charity is NOT deductible! Instead of donating cash, a QCD will allow you to use some (or all) of your RMD to contribute to your favorite charity (or charities). The best part; is there is NO impact on itemizing or using the standard deduction! The amount donated via QCD reduces your RMD dollar for dollar (up to $100,000), which is in essence BETTER than a tax deduction! Let’s look at how this works.

Bill’s RMD for 2023 is $50,000.

Bill loves donating to his local animal shelter which is a qualified 501(c)(3). He typically sends a check for $5,000, but he does not have enough deductions to itemize on his tax return. Instead of sending a check, Bill fills out a QCD form with Charles Schwab (where his IRA is) and tells them to send $5k from his IRA directly to the shelter. The QCD is processed, and now Bill’s remaining RMD is only $45,000 for 2023! See, better than a tax deduction!

It’s important to note that the charity has to be a US 501(c)(3) to be eligible for a QCD, and this excludes Donor Advised Funds and certain charities.

Action Items

RMDs will likely always be a part of our tax code. As you can see, however, the rules are changing frequently! Instead of being reactive, begin planning for how to deal with your RMDs well before you start them!

Here are some action items and questions to consider:

1. Run a projection for what your RMD will be at your beginning date

2. Does your RMD provide a surplus of income? Or, do you need your RMD to maintain your retirement lifestyle?

3. If your RMD provides a surplus of income, consider increasing Roth contributions and reducing Pre-tax contributions. Or, consider converting some of your pre-tax balance to Roth when the timing is right. Typically a great time to look at this is when you retire and have a window of time (let’s say 4-5 years) before starting RMDs!

4. If you are already taking RMDs, determine if QCDs are a viable option for you to consider

5. If leaving a financial legacy is important, consider the tax implications of leaving retirement accounts to the next generation. Are your children in higher tax brackets? If so, you might want to consider the impact the 10-year rule will have on their tax bill.

6. Do you believe your tax rate (or perhaps tax rates in general) will be higher or lower in the future?

It’s important to have a plan and consult with a financial professional who understands taxes in retirement! If you have questions about how to address your RMD strategy, reach out to us and schedule an initial “Zoom” meeting! We would love to get to know you and learn how we can help with your retirement journey.

And as always, make sure to subscribe to our newsletter to stay up to date with all of our latest retirement planning content!

Until next time, thanks for reading!

Kevin Lao

February 27, 2023

Using the Guardrail Withdrawal Strategy to Increase Retirement Income

What is a safe withdrawal rate for retirement?

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

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

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

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

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

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

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

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

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

Let’s dive in!

The 4% rule

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

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

The Findings

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

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

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

The downsides of using the 4% rule in practice

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

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

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

What about the mix of stocks and bonds?

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

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

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

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

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

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

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

What about the impact of tax planning?

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

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

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

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

Do retirees' expenses increase with inflation?

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

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

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

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

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

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

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

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

Social Security and other income sources aren't counted

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

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

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

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

What is the Guardrail Withdrawal Strategy?

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

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

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

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

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

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

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

Key factors to consider when implementing the guardrail withdrawal strategy

Risk tolerance

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

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

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

What is the desire to leave a financial legacy?

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

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

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

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

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

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

Key takeaways and final word

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

Here are some key takeaways:

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

We hope you enjoyed this article!

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

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

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

Thanks for reading!

Kevin Lao

February 7, 2023

4 Bear Market Retirement Income Strategies

The 2022 bear market hits retirees the hardest

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

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

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

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

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

Let’s dive in.

#1: Asset Dedication

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

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

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

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

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

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

BONUS Strategy

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

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

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

#2: “Income Flooring”

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

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

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

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

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

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

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

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

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

Caution

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

#3: Cash Value Life Insurance

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

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

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

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

Here are the basics:

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

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

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

You have two options.

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

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

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

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

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

Here’s the challenge.

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

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

Caution

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

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

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

#4: Tap into Home Equity

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

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

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

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

In Summary

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

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

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

Retirement planning = reduce stress and worry less!

Kevin Lao

December 2, 2022