Much has been studied, analyzed, and written about the “safe withdrawal rate” from a retirement portfolio, but unfortunately, there is no withdrawal rate that is guaranteed to work in all circumstances. The interest rates on bonds remains so low today that a portfolio of 60% equities and 40% bonds is almost certainly going to lag its historical return over the next decade. That’s a real danger to anyone who is basing their retirement withdrawals on past performance.
The SEP-IRA is a terrific accumulation tool for workers who are self-employed, have a family business, or who have earnings as a 1099 Independent Contractor. SEP stands for Simplified Employee Pension, but the account functions similar to a Traditional IRA. Money is contributed on a pre-tax basis, and then withdrawals in retirement are taxable. Distributions taken before age 59 1/2 may be subject to a 10% penalty.
Social Security is a cornerstone of retirement planning. Although financial planners spend considerable time thinking about portfolio construction and sustainable withdrawal strategies, nothing beats Social Security in terms of its lifetime guaranteed income and automatic inflation adjustments. Given the significance of Social Security in retirement, it’s remarkable how many people don’t do any numerical analysis about when to start benefits. There is a strong behavioral bias to start benefits early. In fact, 74% of beneficiaries begin benefits before their Full Retirement Age (66 for those born between 1943 and 1954).
A 2013 study from Prudential considered whether a hypothetical 65-year old female retiree would have enough retirement income to last her lifetime. In their scenario, they calculated a 21% possibility of failure, given market volatility and longevity risk. When they added in a third factor of “an extended period of low interest rates”, the failure rate rose to 54%.
For several years, taxpayers have had an opportunity to make Qualified Charitable Distributions, or QCDs, from their IRA. This was originally offered for just one year and then subsequently was renewed each December, an uncertainty which made it difficult and frustrating for planners like myself to advise clients. Luckily, this year Congress made the QCD permanent. Here is what it is, who it may benefit, and how to use it.
A QCD is a better way to give money to charity by allowing IRA owners to fulfill their Required Minimum Distribution with a charitable donation. To do a QCD, you must be over age 70 1/2 at the time of the distribution, and have the distribution made payable directly to the charity.
If you are over 70 1/2, you must take out a Required Minimum Distribution from your IRA each year, and this distribution is reported as taxable income. When you make a qualified charitable contribution, you can deduct that amount from your taxes, through an itemized deduction. The QCD takes those two steps – an IRA distribution and a charitable contribution – and combines them into one transaction which can fulfill your RMD requirement while not adding to your Adjusted Gross Income (AGI) for the year.
The maximum amount of a QCD is $100,000 per person. A married couple can do $100,000 each, but cannot combine or share these amounts. For most IRA owners, they will likely keep their QCD under the amount of their RMD. However, it is possible to donate more than your RMD, up to the $100,000 limit. So if your goal is to leave your IRA to charity, you can now transfer $100,000 to that charity, tax-free, every year.
The confusing thing about the QCD is that for some taxpayers, there may be no additional tax benefit. That is to say, taking their RMD and then making a deductible charitable contribution may lower their taxes by exactly the same amount as doing a QCD. Who will benefit from a QCD, then? Here are five situations where doing a QCD would produce lower taxes than taking your RMD and making a separate charitable contribution:
1) To deduct a charitable contribution, you have to itemize your deductions. If you take the standard deduction (or would take the standard deduction without charitable giving), you would benefit from doing a QCD instead. That’s because under the QCD, the transaction is never reported on your AGI. Then you can take your standard deduction ($6,300 single, or $12,600 married, for 2016) and not have to itemize.
2) If you have a high income and your itemized deductions are reduced or phased out under the Pease Restrictions, you would benefit from doing a QCD. The Pease Restriction reduces your deductions by 3% for every $1 of income over $259,400 single, or $311,300 married (2016), up to a maximum reduction of 80% of your itemized deductions.
3) If you are subject to the Alternative Minimum Tax (AMT). The AMT frequently hits those who have high itemized deductions. With the QCD, we move the charitable contributions from being an itemized deduction to a direct reduction of your AGI.
4) If you are subject to the 3.8% Medicare Surtax on investment income. While IRA distributions are not part of Net Investment Income, they are part of your AGI, which can push other income above the $200,000 threshold ($250,000, married) subject to this tax.
5) If your premiums for Medicare Parts B and D are increased due to your income, a QCD can reduce your AGI.
You can make a QCD from a SEP or SIMPLE IRA, provided you are no longer making contributions to the account. You can also make a QCD from a Roth IRA, but since this money could be withdrawn tax-free, it would be preferable to make the QCD from a Traditional IRA. 401(k), 403(b), and other employer sponsored plans are not eligible for the QCD. If you want to do the QCD, you would need to rollover the account to an IRA first.
Charitable giving is close to our heart here at Good Life Wealth Management. We believe that true wealth is having the ability to fearlessly help others and to use our blessings to make the world a better place. If that’s your goal too, we can help you do this in the most efficient manner possible.
Inflation was almost non-existent in 2015 due to falling commodity prices. This means that for 2016, most of the IRS contribution limits to retirement accounts are unchanged. Zero inflation creates some unique problems for Social Security and Medicare beneficiaries, which we will explain.
If you are automatically contributing the maximum to your retirement plan, good for you! You need not make any changes for 2016. If your contributions are less than the amounts below, consider increasing your deposits in the new year.
2016 Contribution Limits
Roth and/or Traditional IRA: $5,500 ($6,500 if age 50 or over)
401(k), 403(b), 457: $18,000 ($24,000 if age 50 or over)
SIMPLE IRA: $12,500 ($15,500 if age 50 or over)
SEP IRA: 25% of eligible compensation, up to $53,000
Gift tax annual exclusion: $14,000 per person
Tax brackets and income phaseouts increase slightly for 2016, but there are no material changes. People are still getting used to the new Medicare surtaxes, which include a 3.8% tax on net investment income (unearned income), and a 0.9% tax on wages (earned income). The surtax is applied on income above $200,000 (single), or $250,000 (married filing jointly).
Capital gains tax remains at 15%, with two exceptions. Taxpayers in the 10% and 15% tax brackets pay 0% capital gains, and taxpayers in the 39.6% bracket pay a higher capital gains rate of 20%. For 2016, you will be in the 0% capital gains rate if your taxable income is below $37,650 (single) or $75,330 (married).
For Social Security recipients, the Cost of Living Adjustment (COLA) for 2016 is 0%. We previously had a 0% COLA in 2010 and 2011, and it creates an interesting situation for Medicare participants. Medicare Part A is offered free to beneficiaries over age 65. Medicare Part B requires a monthly premium.
Part B premiums should be going up in 2016, but about 75% of Part B participants will see no change, thanks to Social Security’s “Hold Harmless” provisions. The “Hold Harmless” rule stipulates that if Medicare Part B costs increase faster than Social Security COLAs, beneficiaries will not have their SS benefits decline from the previous year. And since there is no COLA for 2016, any Medicare Part B premium increase would cause SS benefits to negative.
For the past three years, Part B premiums have remained at $104.90 per month. You are eligible for no increase under the “Hold Harmless” rule, if you are having your Part B payments deducted from your Social Security benefit AND you are not subject to increased Medicare premiums under the Income Related Monthly Adjustment Amount (IRMAA).
For most Part B recipients, Medicare premiums are fixed. For higher income participants, IRMAA increases your premium, as follows for 2016:
MAGI $85,000 (single), $170,000 (married): $170.50
MAGI $107,000 (single), $214,000 (married): $243.60
MAGI $160,000 (single), $320,000 (married): $316.70
MAGI $214,000 (single), $428,000 (married): $389.80
If you fall into one of these income categories, above $85,000 (single) or $170,000 (married), you are ineligible for the “Hold Harmless” rule and will have to pay the premiums above, even if this causes your Social Security benefit to decline from 2015.
If you are delaying your Social Security benefits and pay your Part B premiums directly, you are also ineligible for the “Hold Harmless” rule. Finally, if you did not participate in Social Security, for example, teachers in Texas, you would also not be eligible for the “Hold Harmless” rule.
The big surprise this week was that the new budget approved by Congress and signed by President Obama on Monday abolishes two popular Social Security strategies for married couples. The two strategies that are going away are:
1) File and Suspend. A spouse could file his or her application but immediately suspend receiving any benefits. This would enable the other spouse to be eligible for a spousal benefit, while the first spouse could continue to delay benefits to receive deferred retirement credits until age 70.
2) Restricted Application. Also called the “claim now, claim more later” strategy, this would allow a spouse to restrict their application to just their spousal benefit at age 66, while continuing to defer and grow their own benefit until age 70.
Both of these strategies were ways for married couples to access a smaller spousal benefit, while still deferring their primary benefits until age 70 for maximum growth. And now, these strategies will be gone in 6 months from today. It was estimated that these strategies could provide as much as $50,000 in additional benefits for married couples. Needless to say, people close to retirement who were planning on implementing these strategies feel disappointed and upset.
Some Baby Boomers have done a lousy job of saving for retirement and are going to be heavily reliant on Social Security. According to Fidelity Investments, the average 401(k) balance as of June 30 was $91,100 and their average IRA balance is $96,300. If an investor had both an average IRA and 401(k), they’d still have only $187,400. But those figures don’t tell the true depth of the problem facing our nation, because those “average balances” don’t count the 34% of all employees who have zero saved for retirement. For many retirees, savings or investments are not going to be a significant source of retirement income.
Looking at current beneficiaries, the Social Security Administration notes that 53% of married couples and 74% of single individuals receive at least 50% of their income from Social Security. For 47% of single beneficiaries, Social Security is at least 90% of their retirement income! As of June 2015, the average monthly benefit is only $1,335, so that should give you some idea of how little income many retirees have today.
Our country simply cannot afford to let Social Security fail, and yet the current approach is unsustainable. People think that Social Security is a pension or savings program, but it is not. It is an entitlement program where current taxes go to current beneficiaries. Back in the years when the ratio of contributors to retirees was 5 to 1, there was a surplus of taxes which was saved in the Social Security Trust Fund. Currently, there are only 2.8 workers per beneficiary and since 2010 Social Security benefits paid out have exceeded annual revenue into the program. By 2035, there will be only 2.1 workers per beneficiary, and this demographic change is the primary reason the system cannot work in its current form.
Today’s estimate is that the Trust Fund will be depleted by 2034. The Disability Trust Fund will be depleted next year, in 2016, at which time funds will have to shifted within Social Security to pay for Disability benefits not covered by payroll taxes.
The 2015 Trustees Report calculates that to fix Social Security for the next 75 years, the actuarial deficit is 2.68% of taxable payroll. This represents an unfunded obligation with a present value of $10.7 Trillion. Every year, the Trustee’s Report tells Congress the size of the shortfall, so Congress can take steps to either reduce benefits or raise taxes to correct the problem.
Unfortunately, changing Social Security has become a “hot potato” which no politician wants to touch. For those who have been brave enough to propose a solution, they are attacked with one-liner sound bites, accusing them of “trying to take away your Social Security benefits.” It is so disappointing that our elected officials cannot come together on a solution to ensure the solvency of our primary source of national retirement income.
It was surprising that the two Social Security claiming strategies were abolished so quickly and with such little opposition or discussion. This will save Social Security a small amount, but it’s doubtful this will make any material improvement in the program’s long-term viability.
For workers close to retirement, it seems unlikely that there will be any significant changes to the Social Security system as we know it today. The best thing you can do is to delay benefits from age 62 to age 70, which will result in a 76% increase in benefits. If you live a long time (to your late 80’s or longer), you will end up receiving greater lifetime benefits for having waited, and the guaranteed income from Social Security will decrease the “longevity risk” that you will deplete your portfolio over time.
For younger workers, I think it is highly probable that we will see the Full Retirement Age increase or a change in how the Cost of Living Adjustments are calculated. For high earners, I believe that you will see the current income cap of $118,500 increase significantly or be removed altogether. Another proposal is to apply a Social Security tax to unearned income, such as dividends and capital gains, to prevent business owners from shifting income away from wages in order to avoid taxes.
I think the strongest approach for investors will be to save aggressively so that your nest egg can be the primary source of your retirement income. Then you can consider any Social Security benefits as a bonus.
Nearly every day, I talk with someone who is a member of the “sandwich” generation. No, this isn’t a group of people who like peanut butter and jelly. The sandwich generation refers to people, primarily Baby Boomers, who are caring and providing for both their own children and older family members, most often their aging parents.
This can create quite a strain, emotionally and financially, as adults have to prioritize their time and money to care for their own children as well as their aging relatives who may be dealing with health issues, financial problems, and sometimes declining mental faculties and decision making abilities. Needless to say, given these competing demands, their own retirement planning is often the casualty. Some become full-time caregivers and may be out of the workforce for years while they care for an ailing family member.
In recent months, I’ve heard many sad and difficult situations, including:
We are living longer today, which is a great blessing. However, it also means that many of us will live to an age where we may eventually need some assistance. This is a good problem to have. If everyone only lived into their 50’s, like we did in the 1800’s, we wouldn’t need to address these issues! We should be thankful that medical advances have so greatly extended our longevity over the past century.
While there are many difficult emotional aspects to these conversations, there are many financial considerations as well. If you are part of the sandwich generation, we can help you navigate the difficult decisions you face with your aging parents while making sure that you are also managing your own financial goals.
People who have these conversations with their financial planner in their 60’s may save a great deal of stress and burden on their children in 15 or 20 years. We can help you plan better to make sure that your future doesn’t depend on your children’s finances and generosity. Here are some thoughts about how you can remain healthy and happy as you age:
If you are already retired, we can make sure you have a retirement income plan, health care funding, and an estate plan to carry out your wishes. Don’t wait. Our cognitive abilities decline slightly each year, so it’s best to make these decisions in your 60’s or early 70’s and not wait until your 80’s or 90’s.
Men, especially, seem to be in denial about the importance of this planning. Typically, the husband does die first and most retirement homes I have visited are 60% to 90% women. So gentlemen, if you don’t want to plan for yourself, plan for your wife. If you fail to plan for her, sorry, that’s just plain irresponsible. And hopefully you agree she deserves better.
Whether you are in the sandwich generation or just want to make sure you aren’t going to make your children part of the sandwich generation in the future, financial planning can help.
Retirement planning today has largely shifted from guaranteed income from pensions to withdrawal strategies from 401(k) accounts and IRAs. Most financial planners recommend retirees start with an initial withdrawal rate of 4%. This approach was developed because historically, a 4% withdrawal rate, adjusted for inflation each year, would allow a retirement portfolio to last for 30 years under almost all circumstances.
The market was up in each of the past six years, which can give retirees a false sense of security about increasing their spending. In recent years, investors could take out 5%, 6%, or more from their portfolio and still end the year with more money than they started with. Markets go up and down, and if you withdraw all of your gains when the market is up, you can run into trouble when the market drops by 20 or 30 percent.
I find the challenge many retirees face with the 4% rule is forgetting to budget for unexpected expenses. If they have $1,000,000, a 4% withdrawal would be only $40,000 a year (before taxes). They can get by on this amount, but when their car needs replacing, they want us to send another $25,000. Suddenly, their annual withdrawal is up to $65,000. The next year, they need $10,000 for a new roof, and the next year, it’s something else. The issue is rarely reckless spending, but failing to set aside money for these unanticipated expenses.
The danger is that if a retiree takes too much, too soon, there won’t be enough remaining principal in their account to last for 30 years. Diminishing your account early in retirement means that future dividends and capital gains will be smaller in dollar terms, and cannot adequately replenish the annual withdrawals. Then the retiree may have to make drastic changes in their spending and lifestyle to avoid depleting their account. If there is a multi-year correction (like 2000-2002), combined with several years of large withdrawals, it is possible a retiree could see their portfolio drop to one-half their starting value in just five years.
I write this because the first challenge with the 4% rule is that many retirees don’t follow it and take out much more when the market is up. The good news, however, is that for the great majority of history, a 4% withdrawal rate was actually extremely conservative.
In a recent article by Michael Kitces, he examined the 4% rule, looking at 115 rolling 30-year periods, invested in a 60/40 portfolio. He found that in more than 90% of the periods, after 30 years of inflation-adjusted 4% withdrawals, a retiree would have finished with more money than they had at the beginning of retirement. In fact, the median wealth after 30 years, was 2.8 times the initial principal. The 4% rule was not an average withdrawal rate, but based on surviving a steep and prolonged downturn like The Great Depression.
Looking at all 115 30-year periods, Kitces found that retirees could have withdrawn a range of 4-10% of their initial principal, with a median of 6.5%. The 4% rule is the lowest withdrawal rate that worked, and since we don’t know future returns, the safest assumption. While that’s no guarantee that the 4% rule will work in the future, investors should feel very confident with this approach.
Now for some even better news: looking at all 115 periods, Kitces found that whenever the portfolio had grown to 50% above the starting value, withdrawals could be increased by 10%. This “ratchet” approach could be done every three years, and is on top of annual increases for inflation.
For example, let’s consider a retiree who started with a $1 million portfolio and experienced 3% inflation for 5 years. The annual withdrawal amount would have started at $40,000 (4%) and grown to $46,371 with inflation. If the portfolio were now to exceed $1.5 million, we could ratchet up their spending by an additional 10%, to $51,008 and that would become the new annual withdrawal amount.
Here’s a summary of how to make the 4% rule work for you:
1) Make sure you stick to a 4% withdrawal and don’t forget to set money aside for unexpected expenses.
2) Remember that the 4% rule is based on the worst case scenario of terrible market performance.
3) You can plan to increase your withdrawals each year for inflation.
4) If your portfolio grows to 50% above your initial starting value, you can ratchet up your annual withdrawal by an additional 10%.
5) Finally, recall that the 4% rule worked for a portfolio comprised of 60% stocks, 40% bonds. Don’t think that you can apply the 4% rule to a portfolio that is 80% invested in cash or CDs. It’s stocks that fuel the growth which enables the withdrawals to be increased.
Roth IRAs are incredibly popular and for good reason: the ability to invest into an account for tax-free growth is a remarkable benefit. Unlike a Traditional IRA or Rollover IRA, there are no Required Minimum Distributions, and you can even leave a Roth IRA to your heirs without their owing any income tax. For retirement income planning, $100,000 in a Roth IRA is worth $100,000, whereas $100,000 in a Traditional IRA may only net $60,000 to $75,000 after you pay federal and state income taxes.
The only problem with the Roth IRA is that many investors make too much to be able to contribute and even those who can contribute are limited to only $5,500 this year. If you’re a regular reader of my blog, you may recall a number of posts about the “Back-Door Roth IRA”, which is funded by making a non-deductible Traditional IRA contribution and immediately making a Roth Conversion.
But there is another way to make much bigger Roth contributions that is brand new for 2015. Here it is: many 401(k) plans offer participants the ability to make after-tax contributions. Typically, you wouldn’t want to do this. You’d be better off making a tax-deductible contribution.
When you separate from service (retire, quit, or leave) and request a rollover, many 401(k) plans have the ability to send you two checks. One check will consist of your pre-tax contributions and all earnings, and the second check will consist of your after-tax contributions.
What can you do with these two checks? This was a gray area following a 2009 IRS rule. If the distributions were from an IRA, you would have to treat all distributions as pro-rata from all sources; i.e. each check would have the same percentage of pre-tax and after-tax money in it.
Remarkably, the IRS ruled in 2014 that when a 401(k) plan makes a full distribution, it can send two checks and each check will retain its unique character as a pre-tax or after-tax contribution. No pro-rata treatment is required. This will allow you to rollover the pre-tax money into a Traditional IRA and the after-tax money into a Roth IRA. This rule applies only when you make a full distribution with a trustee to trustee transfer.
Since this is a new rule for 2015, it is likely that your HR department, 401(k) provider, and CPA will have no idea what you are talking about, if you ask. Refer them to IRS Notice 2014-54. Or better yet, refer them to me and I can explain it in plain English!
Even though the salary deferral limit on a 401(k) is only $18,000, the total limit for 2015 is actually $53,000 or 100% of income. So you should first contribute $18,000 to your regular, pre-tax 401(k). Assuming there is no company match or catch-up, you could then contribute another $35,000 to the after-tax 401(k) to reach the $53,000 limit.
Let’s say you do this for five years and then retire or change jobs. At that point, you would have made $175,000 in after-tax contributions which could be converted into a Roth IRA, and since your cost basis was $175,000, there would be no tax due.
The earnings on the after-tax 401(k) contributions would be included with your other taxable sources of funds and rolled into a Traditional IRA. Only your original after-tax contributions will be rolled into the Roth account. Please note that this two-part rollover only works when you separate from service and request a FULL rollover. You may not elect this special treatment under a partial withdrawal or an in-service distribution.
Lastly, before attempting this strategy, make sure your 401(k) plan allows for after-tax contributions and will send separate checks for pre-tax and after-tax money. While this strategy is perfectly legal and now explicitly authorized by the IRS Notice, 401(k) plans are not required to allow after-tax contributions or to split distribution checks by sources. It’s up to each company and its plan administrator to determine what is allowed. The IRS Notice stipulates that this process is also acceptable for 403(b) and 457 plans, in addition to 401(k) plans.
Not sure if this works with your 401(k)? Call me and I will review your plan documents, enrollment and distribution forms, and call your plan administrators to verify. I think this would be a great approach for someone who is a handful of years away from retirement who wanted to stuff as much as possible into retirement accounts. Additionally, anyone who has the means to contribute more than $18,000 to their 401(k) each year might also want to consider if making these after-tax contributions would be a smart way to fund a significant Roth IRA.
Good Life Wealth Management LLC is a registered investment advisor offering advisory services in the state of Texas and in other jurisdictions where exempted.
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