Creating Your Retirement Plan
Everyone has heard the old adage, “Failing to plan is planning to fail,” and when it comes to retirement, this statement couldn’t be truer. Without having a properly formulated and well thought out plan in place, you can lose thousands of dollars by selecting the wrong social security strategy, paying unnecessary taxes or having the wrong investment strategy as common examples. When assessing your needs in retirement and your current action plan to get you there, you will quickly realize that all of these financial areas are interrelated and that one decision affects another. For example, if you decide to take your social security while working or before your full retirement age, your benefit can be reduced or be subject to taxation. If you don’t address large balances in retirement accounts, you will be forced to take large Required Minimum Distributions at age 70 1/2. When coupled with Social Security or pension benefits, many retirees today are experiencing paying the same or even higher taxes in retirement. These are just some examples of why you need to look at all these areas of your financial picture together. Your ultimate goal when planning your retirement is to control taxes and unnecessary fees while maximizing your income to ensure you can spend as much as you would like during your lifetime and/or maximize your wealth transfer to your heirs. In this article, we discuss the first steps of our analysis – determining the proper cash flow and tax planning strategies to maximize your retirement income.
Cash Flow Planning
The first step towards analyzing your financial picture will be a review of your personal balance sheet and income statement to start determining the best way to begin creating income. Starting with your personal income statement, you are going to add up your total annual inflows, which would be all your current sources of income. You will then subtract your total inflows from your outflows, which includes your living expenses, liabilities and taxes. If the difference is a positive number, then that means you have a surplus for the year. If you have a shortfall, you’ll want to take that number and divide it by your investable assets (cash + investment assets) to arrive at your withdrawal rate, expressed as a percentage. A generally accepted rule of thumb amongst financial planners is that this rate shouldn’t exceed 4%, but the truth is that looking at shorter time frames isn’t quite enough analysis. For example, your withdrawal rate could be higher earlier in retirement if it’s a lower percentage later in retirement. This leads to the next step of our planning, using cash flow projections from the current year through the end of retirement to determine strategies that will improve the overall picture.
By running multi-year cash flow projections like the example pictured above, you gain a much better understanding of what your income needs are throughout retirement. One fixed income source that is relied upon by most Americans is Social Security. When reviewing your Social Security Benefit Statement, you’ll see your monthly benefit next to your full retirement age (FRA), which is age 67 for most retirees today. The earliest age you can take social security is age 62 and the latest you can delay it is age 70. It’s important to know that for every year you take it prior to your full retirement age, it gets permanently reduced after a grace period of one year. Conversely, your benefit increases by roughly 7-8% for every year you delay it to age 70, so if your FRA is 66, delaying your benefit will increase it by roughly 25% during your lifetime! Another Social Security strategy called the spousal benefit, entitles one to 50% of their spouse’s benefit upon their full retirement age. In addition to knowing the different types of social security withdrawal strategies, it’s also important to understand that Social Security income can also be subject to income taxation.
In addition to Social Security, pensions are still available to some retirees today and are more common in the public sector amongst federal and state employees, but are still used today by some employers in the private sector. In 1978, a group of high-earning income employees from Kodak approached Congress to allow part of their salaries to be invested in the stock market and be exempt from taxes. From that point on, the employer-sponsored retirement landscape changed with employers favoring defined contribution plans like 401k’s over defined benefit plans like pensions, which place more accountability and risk on the employer. For those employees that have paid into both social security and a federal or state pension, you will need to determine whether your social security benefit will be reduced by the social security pension offset. One often-overlooked factor regarding pensions is whether they provide a Cost of Living Adjustment (COLA). Most federal and state pension programs such as FERS or PERS typically offer a COLA, which means that your pension benefit is indexed to inflation and your income stream will continue to increase over time. In the absence of a COLA benefit, your pension payments will lose purchasing power over time to inflation. This means that you better plan to compensate for the reduced purchasing power down the road. For example, the US Dollar has lost more than 50% of its purchasing power based on inflation rates over the last 20 years!
One of the most important factors to consider when making pension decisions is selecting the proper payout option. There are 3 primary income payout options with defined benefit plans:
A life only option means that your pension will provide you with an income stream on your life only. If you pass away one month after initiating this option, your income will cease and nothing will go to your heirs. If you live to age 120, the pension will continue to pay income until that age. This option will typically pay out the highest monthly benefit vs. your other options.
2. Joint Survivor
If you are married, it’s important to consider income needs for your spouse should something happen to you. For example, if you select a 50% Joint Survivor Option, that means that half of the monthly benefit you will receive during your lifetime will go to your spouse in the event you were to pass away. The tradeoff is that your benefit during your lifetime will be lower than the Life Only option. The reason, of course, is that the insurer is taking on the increased risk of paying out income on two lives instead of one…Thus, the benefit during your lifetime is reduced to offset the risk to the insurer. Many pension plans will offer survivorship options of 50%, 75%, and 100%, however, these options will vary considerably from one employer to another.
Not all pension plans will offer a lump sum benefit, but when it is offered, it pays to determine whether taking a lump sum and rolling it over into an IRA is better than the income options offered. The reason for this is that a dollar you receive 10 years from now is not worth the same as a dollar today. You must factor in the opportunity cost that you pay by not having the money in your hand today to spend or invest. Additionally, inflation is constantly reducing our purchasing power over time, so you must run some present value calculations of the income payouts options to compare apples to apples.
In addition to Social Security and pension benefits, other sources of retirement income can be rental real estate income, part-time employment or income gifting from family members. As with your fixed-income streams in retirement, it’s important to understand the nature and characteristics of these other types of income streams. There are a myriad of factors to consider with rental real estate (too many to list for the length of this article), but understanding how employment income can impact the taxation of social security benefits or that gifts of cash from family members are not considered taxable income are just some examples that will help you as you continue to construct your retirement plan.
Maybe the most neglected aspect of maximizing retirement income for retirees is incorporating a proper tax planning strategy in retirement. As I’ve mentioned before, since income fluctuates so much in retirement, your tax circumstances will constantly change. By running multi-year tax projections, you can see which years you’ll be paying higher taxes and start pursuing strategies to reduce income in those years. As we’ve just covered, a big part of this is to determine how your income in retirement will be structured, and one key variable to account for is your Federal Marginal Tax Bracket (FMTB). We have a progressive federal tax system, which taxes your first range of income at 10%, then 12%, then 22% all the way up to the highest federal rate of 37% as you can see in our table below.
|2019 Federal Tax Brackets|
|Tax Bracket/Rate||Single||Married Filing Jointly||Head of Household|
|10%||$0 – $9,700||$0 – $19,400||$0 – $13,850|
|12%||$9,701 – $39,475||$19,401 – $78,950||$13,851 – $52,850|
|22%||$39,476 – $84,200||$78,951 – $168,400||$52,851 – $84,200|
|24%||$84,201 – $160,725||$168,401 – $321,450||$84,201 – $160,700|
|32%||$160,726 – $204,100||$321,451 – $408,200||$160,701 – $204,100|
|35%||$204,101 – $510,300||$408,201 – $612,350||$204,101 – $510,300|
Your FMTB is the tax rate you pay on each additional dollar of income, so when you are in a 22% marginal tax rate, 22 cents of every extra dollar you earn will go to federal taxes. Also, depending on what state you live in, you will also be on the hook for additional state taxes – in California, state taxes can be as high as 13.3%! So when looking at cash flow and tax projections, your goal is to identify opportunities to begin equalizing your income throughout retirement in an attempt to pay the least amount of taxes possible throughout retirement.
In the context of tax planning, one big factor in maximizing your income is the sequence of withdrawals from your investment accounts. What truly differentiates your investment accounts from one another is how they are taxed upon distribution (tax-free, ordinary income, capital gains rates), which means that you need to evaluate your income and tax situation each year to determine the best strategy for you. Now you can see the importance of creating financial statements and running cash flow and tax projections. Although there isn’t a cookie-cutter solution to the correct sequence of withdrawals because an investor’s investment strategy will be primarily determined by age and tax circumstances, generally speaking, your retirement assets will be maximized by following this order:
Your taxable accounts are subject to capital gain tax rates. What this essentially means is that you have to be careful when liquidating positions because you can trigger tax liability from any positions that have a gain. If you hold a position for less than a year, then the gain will be taxed at your Federal Marginal Tax Rate. If held for longer than 1 year, the gain gets special tax treatment – 15% for most investors, but this is contingent upon the total of all your income. So what happens when there is a loss in a position? Well in a taxable account, you get to use this loss to offset any other capital gains in the current tax year. If you don’t have gains to offset losses, then you get to use up to $3,000 of that loss as a deduction against ordinary income and the IRS allows you to carry forward any unused loss into future years to be used against gains at a later point in time. Every year you are able to use up to $3,000 of your capital loss to offset ordinary income. The ability to use losses to offset gains makes a taxable account very favorable since investors can use strategies such as tax-loss harvesting to control taxes.
Most of us have tax-deferred accounts through our employers where all the contributions made were pre-tax. Since you never paid any tax on those contributions, the IRS assesses ordinary income tax on those contributions along with any growth that occurred in the account over time. So EVERYTHING that is distributed from a tax-deferred account is going to be taxed to you as ordinary income, whether you take a distribution or your heirs withdraw funds from these accounts. At age 70 ½, you have to start taking Required Minimum Distributions (RMD’s) from these accounts starting at a rate of just under 4%, which increases every year you grow older. While retirees may not like paying taxes on these withdrawals, keep in mind that the entire purpose of these accounts is to fund your retirement needs, much like you were receiving a pension.
When you make a contribution to a Roth IRA or Roth 401k, you don’t receive a deduction, so you are contributing after-tax money. The IRS rewards you by allowing all of your growth within the account to be tax-free upon withdrawal, provided certain guidelines are met. Having a tax-free pool to draw from in retirement provides a lot of flexibility with tax-efficient income creation. With a Roth, there is no RMD’s and they are also great assets to pass down to heirs, providing them a tax-free pool that can continue to grow throughout their lifetimes as well. A Roth is great for tax planning purposes when you need income, but are trying to avoid jumping into a higher tax bracket.
Another valuable tool available today for retirees are Roth conversions. A Roth conversion is a strategy to convert an IRA to a Roth IRA or even a 401k to a Roth 401k (employer plan permitting). When this strategy is implemented, the amount that is converted is added to ordinary income, increasing tax liability. So this strategy can make a lot of sense for years where income is low and the account owner anticipates being in a higher tax bracket in the future. By paying some taxes now at lower rates, you are effectively equalizing your tax liability throughout retirement, allowing for more tax-free growth and reducing your future RMD’s.
Hopefully, you are starting to gain some clarity on what putting a financial plan together looks like. As you can see, there are many pieces to the puzzle when it comes to coordinating your cash flow and tax planning strategy, since a decision in one area directly impacts the other. For example, one strategy that incorporates many of these concepts would be to live off of taxable income, delay Social Security and pursue Roth conversions at low tax rates in lower-income years. Unfortunately, many retirees are more focused on their investment performance and neglect these other areas, missing out on valuable opportunities to maximize their income in retirement. Once our cash flow and tax planning strategy are in place, the next step in formulating your retirement plan is to select the right investment strategy that is aligned with your cash flow needs and address your wealth protection needs. Follow along by downloading our Free Retirement Checklist to ensure you don’t forget anything.