How to Pay Zero Taxes on Interest, Dividends, and Capital Gains

How would you like to pay zero taxes on your investment income, including interest, dividends, and capital gains? The only downside is that you have to live in a beautiful warm beach town, where the high is usually 82 degrees and the low in the winter is around 65.

If this sounds appealing to you, you should learn more about the unique tax laws of Puerto Rico. As a US territory, any US citizen can relocate to Puerto Rico, and if you make that your home, you will be subject to Puerto Rico taxes and may no longer have to pay US Federal Income Taxes. You can still collect your Social Security, use Medicare, and retain your US citizenship. (But not vote for President or be represented in Congress!) 

Citizens of Puerto Rico generally do not have to pay US Federal Income Taxes, unless they are a Federal Employee, or have earned income from the mainland US. This means that if you move to PR, your PR-sourced income would be subject to PR tax laws. In 2012, PR passed Act 22, to encourage Individual Investors to relocate to PR. Here are a few highlights:

  • Once you establish as a “bona fide resident”, you will pay zero percent tax on interest and dividends going forward.
  • You will pay zero percent on capital gains that accrue after you establish residency.
  • For capital gains that occurred before you move to PR, that portion of the gain would be taxed at 10%, (reduced to 5% after you have been in PR for 10 years). So if you had enormous long-term capital gains and were facing US taxes of 20% plus the 3.8% medicare surtax, you could move to PR and sell those items later this year and pay only 10% rather than 23.8%.
  • The application for Act 22 benefits costs $750 and if approved, the certificate has a filing fee of $5,000. The program sunsets after 2036. This program is to attract high net worth individuals to Puerto Rico, those who have hundreds of thousands or millions in investment income and gains. If your goal is to retire on $1,500 a month from Social Security, you aren’t going to need these tax breaks.

To establish yourself as a “bona fide resident”, you would need to spend a majority of each calendar year in Puerto Rico, meaning at least 183 days. The IRS is cracking down on fraudulent PR residency, so be prepared to document this and retain proof of travel. Additionally, PR now also requires you to purchase a home in PR and to open a local bank account to prove residency. (Don’t worry, PR banks are covered by FDIC insurance just like mainland banks). Details here on the Act 22 Requirements.

Note that Social Security and distributions from a Traditional IRA or Pension are considered ordinary income and subject to Puerto Rico personal income taxes, which reach a 33% maximum at an even lower level than US Federal Income tax rates. So, Act 22 is a huge incentive if you have a lot of investment income or unrealized capital gains, but otherwise, PR is not offering much tax incentives if your retirement income is ordinary income. 

If you are a business owner, however, and want to relocate your eligible business to Puerto Rico, there are also great tax breaks under Act 20. These include: a 4% corporate tax rate, 100% exemption for five years on property taxes, and then a 90% exemption after 5 years. If your business is a pass-through entity, like an LLC, you may be eligible to pay only 4% taxes on your earnings. If you are in the US, you could be paying as much as 37% income tax on your LLC earnings. Some requirements for Act 20 include being based in PR, opening a local bank account, and hiring local employees.

For self-employed people in a service industry, PR is creating (new for 2019) very low tax rates based on your gross income, of just 6% on the first $100,000, and a maximum of 20% on the income over $500,000. Click here for a chart of the PR personal tax rates and the new Service Tax.
A comparison of Act 20 and Act 22 Benefits are available at  Puerto Rico Business Link

When most people talk about tax havens, they would have to renounce their US citizenship (and pay 23.8% in capital gains to leave), or they’re thinking of an illegal scheme of trying hide assets offshore. If you have really large investment tax liabilities or have a business that you could locate anywhere, take a look at Puerto Rico. Besides the tax benefits, you’ve got great weather, year round golfing, US stores like Home Depot, Starbucks, and Walgreens, and direct daily flights to most US hubs, including DFW, Houston, Miami, Atlanta, New York, and other cities. 

Puerto Rico is still looking to rebuild after the hurricane and it’s probably not the best place to be a middle class worker, but for a wealthy retiree, it might be worth a look. Christopher Columbus arrived in Puerto Rico in 1493 and the cities have Spanish architecture from the seventeenth century. I’ve never been to Puerto Rico, but would love to visit sometime in 2019 or 2020. If you’d care to join me for a research trip, let me know!

(Please consult your tax expert for details and to discuss your eligibility. This article should not be construed as individual tax advice.)

Roth Conversions Under the New Tax Law

Everybody loves free stuff, and investing, we love the tax-free growth offered by a Roth IRA. 2018 may be a good year to convert part of your Traditional IRA to Roth IRA, using a Roth Conversion. In a Roth Conversion, you move money from your Traditional IRA to a Roth IRA by paying income taxes on this amount. After it’s in the Roth, it grows tax-free.

Why do this in 2018? The new tax cuts this year have a sunset and will expire after 2025. While I’d love for Washington to extend these tax cuts, with our annual deficits exploding and total debt growing at an unprecedented rate, it seems unavoidable that we will have to raise taxes in the future. I have no idea when this might happen, but as the law stands today, the new tax rates will go back up in 2026.

That gives us a window of 8 years to do Roth conversions at a lower tax rate. In 2018, you may have a number of funds which are down, such as Value, or International stocks, or Emerging Markets. Perhaps you want to keep those positions as part of your diversified portfolio in the hope that they will recover in the future.

Having a combination of both lower tax rates for 2018 and some positions being down, means that converting your shares of a mutual fund or ETF will cost less today than it might in the future. You do not have to convert your entire Traditional IRA, you can choose how much you want to move to your Roth.

Who is a good candidate for a Roth Conversion?

1. You have enough cash available to pay the taxes this year on the amount you want to convert. If you are in the 22% tax bracket and want to convert $15,000, that will cost you $3,300 in additional taxes. That’s painful, but it saves your from having to pay taxes later, when the account has perhaps grown to $30,000 or $45,000. Think of a conversion as the opportunity to pre-pay your taxes today rather than defer for later.

2. You will be in the same or higher tax bracket in retirement. Consider what income level you will have in retirement. If you are planning to work after age 70 1/2 or have a lot of passive income that will continue, it is entirely possible you will stay in the same tax bracket. If you are going to be in a lower tax bracket, you would probably be better off not doing the conversion and waiting to take withdrawals after you are retired.

3. You don’t want or need to take Required Minimum Distributions and/or you plan to leave your IRA to your kids who are in the same or higher tax bracket as you. In other words, if you don’t even need your IRA for retirement income, doing a Roth Conversion will allow this account will grow tax-free. There are no RMDs for a Roth IRA. A Roth passes tax-free to your heirs.

One exception: if you plan to leave your IRA to a charity, do NOT do a Roth Conversion. A charity would not pay any taxes on receiving your Traditional IRA, so you are wasting your money if you do a conversion and then leave the Roth to a charity.

The smartest way to do a Roth Conversion is to make sure you stay within your current tax bracket. If you are in the 24% bracket and have another $13,000 that you could earn without going into the next bracket, then make sure your conversion stays under this amount. That’s why we want to talk about conversions in 2018, so you can use the 8 year window of lower taxes to make smaller conversions.

2018 Marginal Tax Brackets (this is based on your taxable income, in other words, after your standard or itemized deductions.)

Single Married filing Jointly
10% $0-$9,525 $0-$19,050
12% $9,526-$38,700 $19,501-$77,400
22% $38,701-$82,500 $77,401-$165,000
24% $82,501-$157,500 $165,001-$315,000
32% $157,501-$200,000 $315,001-$400,000
35% $200,001-$500,000 $400,001-$600,000
37% $500,001 or more $600,001 or more

On top of these taxes, remember that there is an additional 3.8% Medicare Surtax on investment income over $200,000 single, or $250,000 married. While the conversion is treated as ordinary income, not investment income, a conversion could cause other investment income to become subject to the 3.8% tax if the conversion pushes your total income above the $200,000 or $250,000 thresholds.

You used to be able to undo a Roth Conversion if you changed your mind, or if the fund went down. This was called a Recharacterization. This is no longer allowed as of 2018 under the new tax law. Now, when you make a Roth Conversion, it is permanent. So make sure you do your homework first!

Thinking about a Conversion? Want to reduce your future taxes and give yourself a pool of tax-free funds? Let’s look at your anticipated tax liability under the new tax brackets and see what makes sense your your situation. Email or call for a free consultation.

How to Create Your Own Pension

With 401(k)s replacing pension plans at most employers, the risk of outliving your money has been shifted from the pension plan to the individual. We’ve been fortunate to see many advances in heath care in our lifetime so it is becoming quite common for a couple who retire in their sixties to spend thirty years in retirement. Today, longevity risk is a real concern for retirees.

With an investment-oriented retirement plan, we typically recommend a 4% withdrawal rate. We can then run a Monte Carlo simulation to estimate the possibility that you will deplete your portfolio and run out of money. And while that possibility is generally small, even a 20% chance of failure seems like an unacceptable gamble. Certainly if one out of five of my clients run out of money, I would not consider that a successful outcome.

Social Security has become more important than ever because many Baby Boomers don’t have a Pension. While Social Security does provide income for life, it is usually not enough to fund the lifestyle most people would like in retirement.

What can you do if you are worried about outliving your money? Consider a Single Premium Immediate Annuity, or SPIA. A SPIA is an insurance contract that will provide you with a monthly payment for life, in exchange for an upfront payment (the “single premium”). These are different from “deferred” annuities which are used for accumulation. Deferred annuities come in many flavors, including, fixed, indexed, and variable.

Deferred annuities have gotten a bad rap, in part due to inappropriate and unethical sales practices by some insurance professionals. For SPIAs, however, there is an increasing body of academic work that finds significant benefits.

Here’s a quote on a SPIA from one insurer:
For a 65-year old male, in exchange for $100,000, you would receive $529 a month for life. That’s $6,348 a year, or a 6.348% annual payout. (You can invest any amount in a SPIA, at the same payout rate.)

You can probably already guess the biggest reason people haven’t embraced SPIAs: if you purchase a SPIA and die after two months, you would have only gotten back $1,000 from your $100,000 investment. The rest, in a “Life only” contract is gone.

But that’s how insurance works; it’s a pooling of risks, based on the Law of Large Numbers. The insurance company will issue 1,000 contracts to 65 year olds and some will pass away soon and some will live to be 100. They can guarantee you a payment for life, because the large number of contracts gives them an average life span over the whole group. You transfer your longevity risk to the insurance company, and when they pool that risk with 999 other people, it is smoothed out and more predictable.

There are some other payment options, other than “Life Only”. For married couples, a Joint Life policy may be more appropriate. For someone wanting to leave money to their children, you could select a guaranteed period such as 10 years. Then, if you passed away after 3 years, your heirs would continue to receive payouts for another 7 years.

Obviously, these additional features would decrease the monthly payout compared to a Life Only policy. For example, in a 100% Joint Policy, the payout would drop to $417 a month, but that amount would be guaranteed as long as either the husband or wife were alive.

There are some situations where a SPIA could make sense. If you have an expectation of a long life span, longevity risk might be a big concern. I have clients whose parents lived well into their nineties and who have other relatives who passed 100 years old. For those in excellent health, longevity is a valid concern.

There are a number of different life expectancy calculators online which will try to estimate your longevity based on a variety of factors, including weight, stress, medical history, and family history. The life expectancy calculator at Time estimates a 75% chance I live to age 91.

Who is a good candidate for a SPIA?

  • Concerned with longevity risk and has both family history and personal factors suggesting a long life span,
  • Need income and want a payment guaranteed for life,
  • Not focused on leaving these assets to their heirs,
  • Have sufficient liquid funds elsewhere to not need this principal.

What are the negatives of the SPIA? While we’ve already discussed the possibility of receiving only a few payments, there are other considerations:

  • Inflation. Unlike Social Security, or our 4% withdrawal strategy, there are no cost of living increases in a SPIA. If your payout is $1,000 a month, it stays at that amount forever. With 3% inflation, that $1,000 will only have $500 in purchasing power after 24 years.
  • Low Interest Rates. SPIAs are invested by the insurance company in conservative funds, frequently in Treasury Bonds. They match a 30-year liability with a 30-year bond. Today’s SPIA rates are very low. I can’t help but think that the rates will be higher in a year or two as the Fed raises interest rates. Buying a SPIA now is like locking in today’s 30-year Treasury yield.
  • Loss of control of those assets. You can’t change your mind once after you have purchased a SPIA. (There may be an initial 30-day free look period to return a SPIA.)

While there are definitely some negatives, I think there should be greater use of SPIAs by retirees. They bring back many of the positive qualities that previous generations enjoyed with their corporate pension plans. When you ask people if they wish they had a pension that was guaranteed for life, they say yes. But if you ask them if they want an annuity, they say no. We need to do a better job explaining what a SPIA is.

The key is to think of it as a tool for part of the portfolio rather than an all-encompassing solution to your retirement needs. Consider, for example, using a SPIA plus Social Security to cover your non-discretionary expenses. Then you can use your remaining investments for discretionary expenses where you have more flexibility with those withdrawals. At the same time, your basic expenses have been met by guaranteed sources which you cannot outlive.

Since SPIAs are bond-like, you could consider a SPIA as part of your bond allocation in a 60/40 or 50/50 portfolio. A SPIA returns both interest and principal in each payment, so you would be spending down your bonds. This approach, called the “rising equity glidepath“, has been gaining increased acceptance by the financial planning community, as it appears to increase the success rate versus annual rebalancing.

There’s a lot more we could write about SPIAs, including how taxes work and about state Guaranty Associations coverage of them. Our goal of finding the optimal solution for each client’s retirement needs begins with an objective analysis of all the possible tools available to us.

If you’re wondering if a SPIA would help you meet your retirement goals, let’s talk. I don’t look at a question like this assuming I already know the answer. Rather, I’m here to educate you on all your options, so we can evaluate the pros and cons together and help you make the right decision for your situation.

How The Tax Act Impacts Retirement Planning

With all of the new changes in the Tax Cuts and Jobs Act (TCJA), we’re looking very thoroughly at how this will impact retirement planning. Some of the impacts are direct and immediate, but we are also considering what might be secondary consequences of the new rules in the years ahead.

Although taxes will be slightly lower and more simple for many middle class retirees, the tax changes may mean that some old strategies are no longer effective or that new methods can help reduce taxes or improve retirement readiness. Here are seven things to consider if you are now retired or looking to possibly retire in the next decade.

1. Plan ahead for RMDs. The new lower tax rates will sunset after 2026 and the higher 2017 rates will return. Once you are past age 70 1/2, retirees must take Required Minimum Distributions and must have started Social Security. There are many retirees in their seventies who actually have more income, and therefore way more taxes, than they require to meet their needs. I think we should be doing much more planning in our fifties and sixties to try to reduce retirement taxes, because once you are 70 1/2, you have no control.

See 5 Tax Saving Strategies for RMDs

If you want to reduce your future RMDs, consider doing partial Roth Conversions before age 70 1/2 – converting a small part of your IRA each year, within the limits of your current tax bracket. This is valuable if you now are in a lower tax bracket, 10% to 24%, which is scheduled to rise after 2026.

If you are retiring soon, consider delaying Social Security and starting first with withdrawals from your retirement accounts. Withdrawing cash for several years can help reduce future RMDs, and delaying Social Security benefits past Full Retirement Age provides an 8% annual increase in benefits. That’s a rate of return that is higher than our projected returns on a Balanced (50/50) portfolio. If you delay from age 66 to 70, you’ll see a 32% increase in your Social Security benefit, which reduces longevity risk. Social Security is guaranteed for life, but withdrawals from your portfolio are not!

When higher rates tax return, your (delayed) Social Security benefits are taxable at a maximum of 85% of your benefit, whereas, 100% of your IRA distributions are taxable as ordinary income.

2. Roth 401(k). If you are in a moderate tax bracket today because of the TCJA, you might prefer to contribute to a Roth 401(k) rather than a Traditional 401(k). You don’t get a tax deduction today, but the Roth will grow tax-free and there are no RMDs on a Roth. Therefore, having $24,000 in a Roth is worth more than having $24,000 in a Traditional IRA. In retirement, if you’re in the 25% tax bracket, a $24,000 Traditional account will net you only $18,000 after tax.

Rather than looking to convert your IRA to a Roth after it has grown, the most cost effective time to fund a Roth is likely at the beginning. If you currently have substantial assets in a traditional 401(k) or IRA, consider the Roth option for your new contributions.

3. Second Homes less appealing. The new tax law has placed a cap of $10,000 on the deductibility of state and local taxes. If you own a second home, or are considering purchasing one, this cap may make it more expensive.

Many retirees have paid off their primary residence and then use a home equity loan to purchase a second property. Starting in 2018, you are no longer able to deduct home equity loans. This makes it less attractive to use a home equity loan (or line of credit), and it also makes paying off your mortgage less appealing. If you have a mortgage, it can still be deductible, but if you pay it off, you cannot then borrow from your equity in a tax beneficial way.

If you were previously paying more than $10,000 in state and local taxes, you will either be capped to $10,000, or more likely, be unable to deduct ANY of those taxes, because you are under the standard deduction of $24,000 for a married couple. Going forward, I think more retirees will find it financially appealing to downsize and minimize their housing expenses since they are effectively getting zero tax benefit for their property taxes and mortgage interest.

4. Charitable Strategies. Another casualty of the increased $12,000 / $24,000 standard deduction: Charitable Giving. Most retirees will no longer receive any tax deduction for their donations. Two planning solutions: establish a Donor Advised Fund, or if over age 70 1/2, make use of the Qualified Charitable Distributions from your IRA. We have begun several QCDs this month for our clients!

5. In-State Municipal Bonds. For high income retirees in states with an income tax, it is not difficult to exceed the $10,000 cap on the SALT taxes. In the past, many of these high earners invested in National municipal bonds to get better diversification, even if it meant that they paid  some state income tax on their municipal bonds. “At least you are getting a Federal Tax Deduction for paying the State Income Tax”, they were told. Going forward, they won’t receive that benefit. As a result, I expect that more high earning retirees will want to restrict their municipal bond purchases to those in their home state, where they will not owe any State or Federal tax on this income (especially New York, California, Illinois, etc.). Here in Texas, with no state income tax, we will continue to buy municipal bonds from any and all states.

6. Estate Tax. The TCJA doubled the Estate Tax Exemption from $5.5 million to $11 million per person, or $22 million for a married couple. Now there are only a very small number of people who really need to worry about Estate Taxes. Most retirees will not need a Trust today. (If you might still be subject to the Estate Tax, we can definitely help you.)

7. Health Insurance Costs Will Rise. The repeal of the Individual Mandate of the Affordable Care Act will allow many healthy young people to skip having health insurance. I think that’s a mistake – no one plans to get sick or injured. But what it means for society is a loss of healthier individuals from the insurance risk pool. Adults between age 55 and 65 should expect to see large increases in their individual insurance premiums. More people will be unable to retire until age 65, when they become eligible for Medicare, because they cannot afford the rising individual health insurance premiums. Just this week, a client informed me that they are delaying their retirement for one year because their health insurance bill is increasing from $575 a month to nearly $800.

Wondering how the new tax law will impact your retirement plan? Let’s get together and take a look. Even if your retirement is years away, there are steps we can take today so you can feel confident and prepared that your finances will all be in place when you need them.

Can You Contribute to an HSA After 65?

[For a primer on HSAs, start here: Health Savings Accounts, 220,000 Reasons Why You Need One.]

If you are working past age 65 and covered by an employer-sponsored health plan that is HSA compatible (a high deductible health plan or HDHP), you could in theory continue to fund a Health Savings Account with employee or employer contributions. However, an HSA contribution is only allowable if you do not have any other type of insurance. So, if you sign up for Medicare Part A (or any other Part), you would be disallowed from continuing to make new HSA contributions. Many health plans require coordination with Medicare at age 65, so be sure to check with your insurer.

If you choose to not sign up for Medicare at age 65, it is very important to maintain records that you were covered by an employer sponsored health plan. Otherwise you will pay permanently higher premiums for Part B when you do eventually enroll.

Luckily, if you have an existing HSA, there are lots of uses for your account. Just like before you started Medicare, you can use funds in an HSA to pay your out-of-pocket expenses like your doctor or hospital co-pays and prescription drug costs. You can use your HSA to pay for dental, vision, or other medical expenses not covered by Medicare.

Additionally, Medicare participants can use an HSA to pay for their premiums for Part B, Part D, or for a private Medicare Advantage plan. If your Medicare premiums are deducted from your Social Security check, just reimburse yourself from your HSA and keep detailed records as proof. Retirees may also use their HSA to pay a portion of their premiums towards a Long-Term Care policy, if they have one.

You can use an HSA to reimburse yourself for medical bills for past years, again providing you can document and prove these were qualified expenses. When you pass away, if you have listed your spouse as beneficiary, your spouse can inherit your HSA, and treat it as their own. Then they can also access the money tax-free for qualified medical expenses. However, if your HSA beneficiary is not a spouse (or one is not named), then the account will be distributed and that distribution will be taxable.

For Medicare participants interested in an HSA-like option, there is the Medicare MSA. This is a Medicare Advantage Plan which provides a cash account for expenses, but not fewer tax benefits than an HSA. Details from Medicare here.

How Much Should You Contribute to Your 401(k)?

Answer: $18,000. If you are over age 50, $24,000.

Those are the maximum allowable contributions and it should be everyone’s goal to contribute the maximum, whenever possible. The more you save, the sooner you will reach your goals. The earlier you do this saving, the more likely you will reach or exceed your goals.

At a 4% withdrawal rate in retirement, a $1 million 401(k) account would provide only $40,000 a year or $3,333 a month in income. And since that income is taxable, you will probably need to withhold 10%, 15%, or maybe even 25% of that amount for income taxes. At 15% taxes, you’d be left with $2,833 a month in net income. That amount doesn’t strike me as especially extravagant, and that’s why we should all be trying to figure out how to get $1 million or more into our 401(k) before we do retire.

I’ve found that most people fall into four camps:
1) They don’t participate in the 401(k) at all.
2) They put in just enough to get the company match, maybe 4% or 5% of their income.
3) They contribute 10% because they heard it was a good rule of thumb to save 10%.
4) They put in the maximum every year.

How does that work over the duration of a career? If you could invest $18,000 a year for 30 years, and earn 8%, you’d end with $2,039,000 in your account. Drop that to $8,000 a year, and you’d only have $906,000 after 30 years. That seems pretty good, but what if you are getting a late start – or end up retiring early – and only put in 20 years of contributions to the 401(k)? At $8,000 a year in contributions, you’d only accumulate $366,000 after 20 years. Contribute the maximum of $18,000 and you’d finish with $823,000 at an 8% return.

I have yet to meet anyone who felt that they had accumulated too much money in their 401(k), but I certainly know many who wish they had more, had started earlier, or had made bigger contributions. Some people will ignore their 401(k) or just do the bare minimum. If their employer doesn’t match, many won’t participate at all.

Accumulators recognize the benefits of maximizing their contributions and find a way to make it happen.

  • Become financially independent sooner.
  • Bigger tax deduction today, pay less tax.
  • Have their investments growing tax deferred.
  • Enjoy a better lifestyle when they do retire. Or retire early!
  • Live within their means today.
  • 401(k)’s have higher contribution limits than IRAs and no income limits or restrictions.

Saving is the road to wealth. The investing part ends up being pretty straightforward once you have made the commitment to saving enough money. Make your goal to contribute as much as you can to your 401(k). Your future self will thank you for it!

When Can I Retire?

There are a couple of approaches to determine retirement readiness, and while there is no one right answer to this question, that doesn’t mean we cannot make an intelligent examination of the issues facing retirement and create a thorough framework for examining the question.

1) The 4% approach. Figure out how much you need in annual pre-tax income. Subtract Social Security, Pensions, and Annuity payments from this amount to determine your required withdrawal. Multiply this annual amount by 25 (the reciprocal of 4%), and that’s your finish line.

For example, if you need $3,000 a month, or $36,000 a year, on top of Social Security, you would need a nest egg of $900,000. (A 4% withdrawal from $900,000 = $36,000 a year, to reverse it.) That’s a back of an envelope method to answer when you can retire.

2) Monte Carlo analysis. We can do better than the 4% approach above and give you an answer which more closely meets your individual situation. Using our planning software, we can create a future cash flow profile that will consider your financial needs each year.

Spouses retiring in different years? Wondering if starting Social Security early increases your odds of success? Have spending goals, such as travel, buying a second home, or a wedding to pay for? We can consider all of those questions, not to mention adjust for today’s (lower) expected returns.

The Monte Carlo analysis is a computer simulation which runs 1000 trials of randomly generated return paths. Markets may have an “average” return, but volatility means that some years or decades can have vastly different results. A Monte Carlo analysis can show us how a more aggressive approach might lead to a wider dispersion of outcomes, good and bad. Or how a too-conservative approach might actually increase the possibility that you run out of money.

It tells us your percentage chance of success as well as giving us an idea of the range of possible results. It’s a data set which provides a richer picture than just a binary, yes or no answer to whether or not you have enough money to retire.

Even with the elegance of the Monte Carlo results, the underlying assumptions that go into the equation are vital to the outcome. The answer to not outliving your money may depend more on unknowns like the future rate of return, your longevity, the rate of inflation, or government policy than on your age at retirement. Change one or two of these assumptions and what might seem like a minor adjustment can really swamp a plan when multiplied over a 30 year horizon.

Luckily, we don’t have to have a crystal ball to be able to answer the question of retirement age, nor is it an exercise in futility. That’s because managing your money doesn’t stop at retirement . There is still a crucial role to play in investing wisely, rebalancing, managing withdrawals, and revisiting your plan on an ongoing basis.

While all the attention seems to be paid to risks which might derail your retirement, there is a greater possibility that you will actually be able to withdraw more than 4%. After all, 4% was the lowest successful withdrawal rate for almost every 30 year period in history. It’s the worst case scenario of the past century. In most past retirement periods, you could have withdrawn more – sometimes significantly more – than 4% from a diversified portfolio.

If you are asking “When can I retire?”, we need to meet. And if you aren’t asking that question, even if you are 25, you should still be wondering “How much do I need to be financially independent?” Otherwise, you risk being on the treadmill of work forever, and there may just come a day in the distant future, or maybe not so distant future, when you wake up one morning and realize you’d like to do something else.

Reducing Sequence of Returns Risk

The possibility of outliving your money can depend not only on the average return of the stock market, but on the order of those returns. It doesn’t matter if the long-term return is 8%, if your first three years of retirement have a 50% drop like we had going into March of 2009, your original income strategy probably isn’t going to work. Taking an annual withdrawal of $40,000 is feasible on a $1 million portfolio, but not if your principal quickly plummets to $500,000.

We evaluate these scenarios in our financial planning software and can estimate how long your money may last, using Monte Carlo analysis that calculates the probability of success. For most people retiring in their 60’s, we plan for a 30 year horizon, or maybe a little longer. And while this analysis can give us a rough idea of how sound a retirement plan is, no one knows how the market will actually perform in the next 30 years.

What we do know from this process is that the vast majority of the “failures” occur when there are large drops in the market in the early years of retirement. When these losses occur later on, the portfolio has typically grown significantly and the losses are more manageable. This problem of early losses is called Sequence of Returns Risk, and often identifies a critical decade around the retirement date, where losses may have the biggest impact on your ability to fund your retirement.

There are ways to mitigate or even eliminate Sequence of Returns Risk, although, ultimately I think most people will want to embrace some of this risk when they consider the following alternatives. Sequence of Returns risk is unique to investing in Stocks; if you are funding your retirement through a Pension, Social Security, Annuity, or even Bonds, you have none of this risk.

1) Annuitize your principal. By purchasing an Immediate Annuity, you are receiving an income stream that is guaranteed for life. However, you are generally giving up access to your principal, forgoing any remainder for your heirs, and most annuities do not increase payouts for inflation. While there is some possibility that the 4% rule could fail, it is important to remember that the rule applies inflation adjustments to withdrawals, which double your annual withdrawals over the 30 year period. And even with these annual increases, in 90% of past 30-year periods, a retiree would have finished with more money than they started. The potential for further growth and even increased income is what you give up with an annuity.

2) Flexible withdrawals. The practical way to address Sequence of Returns Risk is to recognize upfront that you may need to adjust your withdrawals if the market drops in the first decade. You aren’t going to just increase your spending every year until the portfolio goes to zero, but that’s the assumption of Monte Carlo Analysis. We can do this many ways:

  • Not automatically increase spending for inflation each year.
  • Use a fixed percentage withdrawal (say 4%) so that spending adjusts on market returns (instead of a fixed dollar withdrawal).
  • Reduce withdrawals when the withdrawal rate exceeds a pre-determined ceiling.

It is easier to have flexibility if withdrawals are used for discretionary expenses like travel or entertainment and your primary living expenses are covered by guaranteed sources of income like Social Security.

3) Asset Allocation. If we enter retirement with a conservative allocation, with a higher percentage in bonds, we could spend down bonds first until we reach our target long-term allocation. Although this might hamper growth in the early years, it could significantly reduce the possibility of failure if the first years have poor performance. This is called a Rising Equity Glidepath.

Other allocation methods include not withdrawing from stocks following a down year or keeping 1-3 years of cash available and then replenishing cash during “up” years.

4) Don’t touch your principal. This is old way of conservative investing. You invest in a Balanced Portfolio, maybe 50% stocks and 50% bonds, and only withdraw your interest and dividends, never selling shares of stocks or bonds. In the old days, we could get 5% tax-free munis, and 3% in stock dividends and end up with 4% income, plus rising equity prices. Since you never sell your stocks, there is no sequence of returns risk. This strategy is a little tougher to implement today with such low bond yields.

Investing for income can create added risks, especially if you are reaching for yield into lower quality stocks and bonds. That’s why most professionals and academics favor a total return process over a high income approach.

5) Laddered TIPS. Buy TIPS that mature each year for the next 30 years. Each year, you will get interest from the bonds (fairly small) and your principal from the bonds that mature that year. Since TIPS adjust for inflation, your income and principal will rise with CPI. It is an elegant and secure solution, with a 3 1/3% withdrawal rate that adjusts for inflation.

The only problem is that if you live past 30 years, you will no money left for year 31 and beyond! So I would never recommend that someone put all their money into this strategy. But if you could live by putting 80% of your money into TIPS and put the other 20% into stocks that you wouldn’t touch for 30 years, that may be feasible.

Except you’d still likely have more income and more terminal wealth by investing in a Balanced Allocation and applying the 4% rule. However, that is a perhaps 90% likelihood of success, whereas TIPS being guaranteed by the US Government, TIPS have a 100% chance of success. (Note that 30 year TIPS have not been issued in all years, so there are gaps in years that available TIPS mature.)

If the market fell 30% next year, would your retirement be okay? How would you respond? What can you do today about that possibility? If you worry about these types of questions, we can help address your concerns about risk, market volatility, and Sequence of Returns.

What we want to do for each investor is to thoroughly consider your situation and look at your risk tolerance, risk capacity, other sources of retirement income, and find the right balance of growth and safety. Although the ideal risk would be zero, you may need substantially more assets to fund a safety-first approach compared to having some assets invested. And that means that for how much money you do have, the highest standard of living may come from accepting some of the Sequence of Returns Risk that accompanies stock investing.

When a 2% COLA Equals $0

Social Security provides Cost of Living Adjustments (COLAs) annually to recipients, based on changes to the Consumer Price Index. According to an article in Reuters this week, the Social Security COLA for 2018 should be around 2%. Social Security participants may be feeling like breaking out the Champagne and party hats, following a 0.3% raise for 2017 and a 0% COLA for 2016.

Unfortunately, and I hate to rain on your parade, the average Social Security participant will not see any of the 2% COLA in 2018. Why not? Because of increases in premiums for Medicare Part B. Most Social Security recipients begin Part B at age 65, and those premiums are automatically withheld from your Social Security payments.

Social Security has a nice benefit, called the “Hold Harmless” rule, which says that your Social Security payment can not drop because of an increase in Medicare costs. In 2016 and 2017 when Medicare costs went up, but Social Security payments did not, recipients did not see a decrease in their benefit amounts. Now, that’s going to catch up with them in 2018.

In 2015, Medicare Part B was $105/month and today premiums are $134. For a typical Social Security benefit of $1,300 a month, a 2% COLA (an increase of $26 a month) will be less than the increase for Part B, so recipients at this level and below will likely see no increase their net payments in 2018. While many didn’t have to pay the increases in Part B over the past two years, their 2018 COLA will be applied first to the changes in Medicare premiums.

I should add that the “Hold Harmless” rule does not apply if you are subject to Medicare’s Income Related Monthly Adjustment Amount. If your income was above $85,000 single, or $170,000 married (two years ago), you would already pay higher premiums for Medicare and would be ineligible for the “Hold Harmless” provision. And if you had worked outside of Social Security, as a Teacher in Texas, for example, you were also ineligible for “Hold Harmless”.

The cost, length, and complexity of retirement has gone up considerably in the past generation. Not sure where to begin? Give me a call, we can help. Preparation begins with planning.

Can You Reduce Required Minimum Distributions?

After age 70 1/2, owners of a retirement account like an IRA or 401(k) are required to withdraw a minimum percentage of their account every year. These Required Minimum Distributions (RMDs) are taxable as ordinary income, and we meet many investors who do not need to take these withdrawals and would prefer to leave their money in their account.

The questions many investors ask is Can I avoid having to take RMDs? And while the short answer is “no, they are required”, we do have several ways for reducing or delaying taxes from your retirement accounts.

1. Longevity Annuity. In 2014, the IRS created a new rule allowing investors to invest a portion of their IRA into a Qualified Longevity Annuity Contract (QLAC) and not have to pay any RMDs on that money. What the heck is a QLAC, you ask? A QLAC is a deferred annuity where you invest money today and later, you switch it over to a monthly income stream that is guaranteed for life. Previously, these types of deferred annuities didn’t work with IRAs, because you had to take RMDs. Luckily, the IRS saw that many retirees would benefit from this strategy and provided relief from RMDs.

Investors are now permitted to place up to 25% of their retirement portfolio, or $125,000 (whichever is less), into a QLAC and not have to pay any RMDs during the deferral period. Once you do start the income stream, the distributions will be taxable, of course.

For example, a 70 year old male could invest $125,000 into a QLAC and then at age 84, begin receiving $31,033 a year for life. If the owner passes away, any remaining principal will go to their heirs. (Source of quote: Barrons, June 26, 2017)

In retirement planning, we refer to possibility of outliving your money as “longevity risk”, and a QLAC is designed to address that risk by providing an additional income stream once you reach a target age. Payouts must begin by age 85. A QLAC is a great bet if you have high longevity factors: excellent health, family history of long lifespans, etc. If you are wondering if your money will still be around at age 92, then you’re a good candidate for a QLAC.

2. Put Bonds in your IRA. By placing your bond allocation into your IRA, you will save taxes several ways:

  • You won’t have to pay taxes annually on interest received from bonds.
  • Stocks, which can receive long-term capital gains rate of 15% in a taxable account, would be treated as ordinary income if in an IRA. Bonds pay the same tax rate in or out of an IRA, but stocks lose their lower tax rate inside an IRA. You have lower overall total taxes by allocating bonds to IRAs and long-term stocks to taxable accounts.
  • Your IRA will likely grow more slowly with bonds than stocks, meaning your principal and RMDs will be lower than if your IRA is invested for growth.

3. Roth Conversion. Converting your IRA to a Roth means paying the taxes in full today, which is the opposite of trying to defer taking RMDs. However, it may still make sense to do so in certain situations. Once in a Roth, your money will grow tax-free. There are no RMDs on a Roth account; the money grows tax-free for you or your heirs.

  • If you are already in the top tax bracket and will always be in the top tax bracket, doing a Roth Conversion allows you to “pre-pay” taxes today and then not pay any additional taxes on the future growth of those assets.
  • If not in the top bracket (39.6%), do a partial conversion that will keep you in your current tax bracket.
  • If there is another bear market like 2008-2009, and your IRA drops 30%, that would be a good time to convert your IRA and pay taxes on the smaller principal amount. Then any snap back in the market, or future growth, will be yours tax-free. And no more RMDs.
  • Trump had proposed simplifying the individual tax code to four tax brackets with a much lower top rate of 25%, plus eliminating the Medicare surtaxes. We are holding off on any Roth conversions to see what happens; if these low rates become a reality, that would be an opportune time to look at a Roth Conversion, especially if you believe that tax rates will go back up in the future.

4. Qualified Charitable Distribution. You may be able to use your RMD to fund a charitable donation, which generally eliminates the tax on the distribution. I wrote about this strategy in detail here.

5. Still Working. If you are over age 70 1/2 and still working, you may still be able to participate in your 401(k) at work and not have to take RMDs. The “still working exception” applies if you work the entire year, do not own 5% or more of the company, and the company plan allows you to delay RMDs. If you meet those criteria, you might want to roll old 401(k)s into your current, active 401(k) and not into an IRA. That’s because the “still working exception” only applies to your current employer and 401(k) plan; you still have to pay RMDs on any IRAs or old 401(k) accounts, even if you are still working.

We can help you manage your RMDs and optimize your tax situation. Remember that even if you do have to take an RMD, that doesn’t mean you are required to spend the money. You can always reinvest the proceeds back into an individual or joint account. If you’d like more information on the QLAC or other strategies mentioned here, please send me an email or give us a call.