How to Create Your Own Pension

Posted On May 5, 2018 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

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.

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How Much Income Do You Need In Retirement?

Posted On January 13, 2018 By Scott Stratton, CFP(R), CFA In Financial Planning /  

Many people significantly underestimate how much income they will need to maintain their lifestyle in retirement. We’re going to point out how people underestimate their needs, explain why a common “rule of thumb” is a poor substitute, and then share our preferred process.

If we begin with the wrong budget, then our withdrawal rates, target nest egg, and portfolio sustainability are all going to be inaccurate, which is very difficult to correct after you’ve retired.

In general, when I ask someone to estimate their monthly financial needs, they use a process of addition. They think of their housing expenses, utilities, taxes, food costs, etc., and try to add those up. Unfortunately, the number many arrive at can be significantly too low, and here’s how I know.

They tell me that they spent $5,000 a month, or $60,000 last year. But I ask how much they made and they tell me $150,000. How much did they save last year? $30,000. To me, that suggests they spent $120,000, not $60,000. If they only spent $60,000, they would have saved more than $30,000. You either spend or save money; if it wasn’t saved it was spent, even if that spending wasn’t discretionary.

Here’s why most people fail with the “addition method” of trying to create a retirement income budget:

  • They don’t include taxes. Taxes don’t go away in retirement; pensions, Social Security (up to 85%), and IRA withdrawals are all taxable as ordinary income.
  • Unplanned expenses such as home repairs, emergencies, or car maintenance can be substantial and fairly regular, if not consistent or predictable.
  • Your health care costs may be much higher in retirement than you anticipate, especially in the later years of retirement.
  • You may finally have time to pursue activities which you did not have time for while working, such as travel, golf, or spoiling your grandchildren. With an additional 40 hours a week available, you will likely be spending money in new ways.

Some financial calculators use a rule of thumb that most retirees will need 75% (or 70-80 percent) of their pre-retirement income. This is called the “replacement rate”. And while there have been a number studies that confirm this 75% estimate as an average, its applicability on an individual basis is poor.

We know for example, that lower income people will need a higher replacement rate than higher income people. That’s because the lower income levels may have had a lower savings rate, a smaller proportion of discretionary spending, and little tax savings in retirement. Higher income workers may have been saving more and find significant tax savings in retirement, and therefore have a lower replacement rate.

Instead of trying to use an addition method or a one-size-fits-all rule of thumb, I’d suggest using subtraction:

  1. Begin with your current income.
  2. Subtract any immediate savings you will experience in retirement, including: the amount you were actually saving and investing each year, payroll taxes (7.65% if a W-2 employee), and work expenses, if significant.
  3. Examine your sources of retirement income and if you calculate any income tax reduction, subtract those savings.
  4. Consider any increases in retirement spending, starting with health care costs and discretionary spending (travel, hobbies, etc.). Add these back to your spending needs.

Unless you are planning to have paid off your mortgage, substantially downsize your house, get rid of a car, or stop eating out, I think most people will initially continue their spending habits in retirement very much the same as they did while they were working. Like everyone else, retirees spend a significant portion of their income on things which they did not want (property tax, income tax, insurance) and on things which were not planned (replacing a roof, medical expenses, etc.).

Underestimating your retirement income needs could lead to some very painful outcomes, such as depleting your nest egg, being forced to downsize, or impoverishing your spouse after you pass away. You have to still plan for occasional expenses, such as replacing a car, home repairs, and emergencies, in a retirement budget.

If you’ve calculated your retirement income needs and your planned budget is significantly less than your pre-retirement income, please be careful. When the number you reached through addition isn’t the same number I reach through subtraction, it’s possible you are not budgeting for some costs which you currently have and are likely to still have in retirement.

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When Can I Retire?

Posted On August 27, 2017 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

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.

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Income Planning by Retirement Age

Posted On August 19, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning /  

What is often missing in most academic articles about retirement is a consideration of age at retirement. Most articles just assume that someone retires at 65 and has a 30 year time horizon. We know that is not always the case! If you retire early or later, how does that impact your retirement income strategy?

Let’s consider three age bands: early retirement, full retirement age, and longevity planning.

Early Retirement (age 50-64)

Fewer and fewer people are retiring early today. In fact, more than 70% of pre-retirees are planning to continue to work in retirement. Kind of makes you wonder what “retirement” even means today? However, I can see a lot of appeal to retiring early and there are plenty of people who could pull this off. Here are four considerations if you are thinking of retiring early:

  1. Healthcare. Most people who want to retire before 65 abandon their plans once they realize how much it will cost to fund health insurance without Medicare. Let’s say you have a monthly premium of $1250 and a $5000 deductible. That means you have $20,000 a year in potential medical expenses, before your insurance even pays a penny! If you want to retire at 55, you might need to set aside an additional $200,000 just to cover your expenses to get you to Medicare at 65. It’s a huge hurdle.
  2. If you have substantial assets, you will need to have both sufficient cash on hand for short-term needs (1-3 years), and equity investments for long-term growth. This is why time-segmentation strategies are popular with early retirees: setting aside buckets for short, medium, and long-term goals. While time segmentation does not actually protect you from market volatility or sequence of returns, there may be some benefit to a rising equity glide path, and it may be more realistic to recognize that spending in future decades will depend on equity performance, rather than assuming at 55 that your spending will be linear and tied to inflation.
  3. For those who do retire early, taking withdrawals often makes them very nervous, especially after you realize that you must invest aggressively (see #2) to meet your needs that are decades away. If you have $1 million and want to take a 4% withdrawal, that works out to $3333 a month. Taking that much out of your account each month is more nerve wracking than having $3333 in guaranteed income, which leads us to…
  4. A Pension. Most people I have met who retired in their fifties have a Pension. They worked for 20 or 30 years for a company, school district, municipality, branch of the military, etc. At 55 or so they realize they could collect 50% of their income for not working, which means that – in opportunity cost – if they continue to work it will only be for half the pay! It’s kind of a convoluted way of thinking, but the fact remains that a pension, combined with Social Security and Investments, is the strongest way to retire early.

Full Retirement Age (65-84)

  1. The primary approach for retirees is to combine Social Security with a systematic withdrawal strategy from their retirement and investments accounts. We choose a target asset allocation and withdraw maybe 4% or so each year. We often set this up as monthly automatic distributions. We increase our cash target to 4% (from 1%) and reduce our investment grade bonds by the same amount. Dividends and Interest are not reinvested, and at the end of the year, we rebalance and replenish cash as needed. That’s the plan.
  2. Depending on when you start retirement, I think you can adjust the withdrawal rate. The 4% rule assumes that you increase your withdrawals every year for inflation. It also assumes that you will never decrease your withdrawals in response to a bear market. What if we get rid of those two assumptions? In that case, I believe a 65 year old could aim for 5% withdrawals and a 75 year old for 6% withdrawals. This can work if you do not increase withdrawals unless the portfolio has increased. Also, a 75 year old will have a shorter withdrawal period, say 20 years versus 30 years for a 65 year old retiree.
  3. Although retirement accounts are available after age 59 1/2, most clients don’t want to touch their IRAs – and create taxable distributions – until age 70 1/2 when they must begin Required Minimum Distributions (RMDs). Investors who are limiting their withdrawals to RMDs are following an “actuarial method”, which ties your income level to a life expectancy. This is a good alternative to a systematic withdrawal plan.

Longevity Planning (85+)

  1. Many retirees today will live to age 90, 95, or longer. It is certainly prudent to start with this assumption, especially for couples.
  2. Social Security is the best friend of longevity planning. It’s a guaranteed source of lifetime income and unlike most Pensions or Annuities, Social Security adjusts for inflation through Cost of Living Adjustments. Without COLAs, what may have seemed like a generous pension at age 60 will lose half of its purchasing power by age 84 with just 3% inflation. If you want to help put yourself in the best possible position for longevity, do not take early Social Security at age 62. Do not take benefits at Full Retirement Age. Wait for as long as possible – to age 70. Delaying from 62 to 70 results in a 76% increase in monthly benefits.
  3. If you are concerned about living past 85 and would also like to reduce your Required Minimum Distributions at age 70 1/2, consider a Qualified Longevity Annuity Contract (QLAC). A QLAC will provide a guaranteed income stream that you cannot outlive. Details on a QLAC here.
  4. While equities are probably the best investment for a 60 year old to get to 85 years old, once you are 85, you may want to make things much more simple. There is, unfortunately, a significant amount of Elder abuse and fraud, and frankly, many people over age 85 will have a cognitive decline to where managing their money, paying bills, or trying to manage an investment portfolio will be overwhelming. Professionals can help.

There is no one-size-fits-all approach to retirement income. We have spent a lot of time helping people like you evaluate your choices, weigh the pros and cons of each strategy, and implement the best solution for you.

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Reducing Sequence of Returns Risk

Posted On July 23, 2017 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

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.

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Can You Reduce Required Minimum Distributions? (Updated for 2026)

Posted On June 25, 2017 By Scott Stratton, CFP(R), CFA In Retirement Planning, Tax Strategies /   1 Comment

Required Minimum Distributions (RMDs) are withdrawals the IRS mandates from most traditional retirement accounts once you reach a certain age — and those ages are changing under current law. This article explains when RMDs begin in 2026, how they are calculated, and practical ways to reduce the tax impact of RMDs as part of a broader retirement income plan.

What Are RMDs and When Do They Begin in 2026?

An RMD is the minimum amount the IRS requires you to withdraw from eligible retirement accounts each year once you reach a specified age. These withdrawals are generally taxable as ordinary income.

Under current law:

  • Age 73: You must begin RMDs if you are born between 1951 and 1959.
  • Age 75: You will begin RMDs if you are born in 1960 or later, with this rule in effect starting in 2033.

The first RMD is due by April 1 of the year after you reach the applicable age. After that, all RMDs must be taken by December 31 each year. However, I recommend you do not delay your first RMD until the following year as it will require to take two (taxable) distributions in the same tax year.

Important Notes

  • RMDs apply to traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k)s, 403(b)s, and other defined contribution plans.
  • You can withdraw more than the minimum in any year.
  • Roth IRAs do not require RMDs during the account owner’s lifetime, though beneficiaries must take distributions after the owner’s death.

Required Minimum Distributions often force income at inconvenient times, which is why they should be addressed within a comprehensive retirement income planning strategy rather than reactively each year.

Can You Avoid RMDs?

No — once you reach the age where RMDs begin, you generally must take them. However, there are a handful of legitimate strategies to reduce their impact on your taxes and retirement planning. Reducing future RMDs often requires coordinated Roth conversion planning.

Reducing RMDs is rarely about a single tactic. It requires coordinated decisions around Roth conversions, charitable giving, and income timing as part of an overall tax planning for retirees approach.

Strategy 1: Use Qualified Charitable Distributions (QCDs)

Qualified Charitable Distributions (QCDs) allow you to give up to $105,000 per year directly from your IRA to a qualified charity, and the donated amount counts toward your RMD without adding to taxable income.

This means:

  • Your RMD requirement is satisfied
  • Your taxable income is lower
  • You remain in potentially lower tax brackets

QCDs are especially useful for retirees who are charitably inclined and want to lower adjusted gross income (AGI) for Medicare, taxation of Social Security benefits, or subsidy eligibility such as ACA planning. (See also: Using the ACA to Retire Early) You do not have to itemize your tax return to benefit from a QCD.

Strategy 2: Roth Conversions Before RMD Age

A Roth conversion means paying tax now to move money from a traditional IRA to a Roth IRA — and Roth IRAs do not have RMDs during your lifetime.

Benefits:

  • Decreases future RMD amounts
  • Reduces future taxable income
  • Provides tax-free income later

Roth conversions work best in years when your taxable income is lower than usual or before RMDs begin. This strategy is one core reason many retirees coordinate Roth conversions with Social Security timing and other planning moves. (See: Roth Conversions After 60) Converting assets during a Bear Market, when their value may be temporarily lower, is a very effective strategy.

Strategy 3: Qualified Longevity Annuity Contracts (QLACs)

A QLAC is a deferred annuity that allows you to remove a portion of your traditional IRA from RMD calculations while deferring income until a later age (as late as 85).

Key points:

  • The amount invested in a QLAC is excluded from your IRA balance when calculating RMDs.
  • Payouts begin at a future date you choose.
  • QLACs can be effective for mitigating large RMDs during certain years.

Strategy 4: Still Working Exception With Employer Plans

If you are over the RMD age but still working, and not a 5% owner of the business, you might be able to delay RMDs from your current employer’s retirement plan (e.g., 401(k)), though this exception does not apply to IRAs.

This can provide additional flexibility in managing your income and taxable distributions. Ask your 401(k) if they can allow you to roll your IRA into your 401(k).

Strategy 5: Asset Location

Placing bonds in your IRA will also benefit because it will keep your IRA from having high growth.  Otherwise, if your IRA grows by 20%, your RMDs will grow by 20%.

It is more tax efficient to keep growth stocks and ETFs in a taxable account and your bonds in an IRA. This allows you to receive favorable long-term capital gains treatment (0%, 15%, or 20%) for stocks, a tax benefit which is lost in an IRA.  Lastly, if you hold the stocks for life, your heirs may receive a step-up in basis, which they will not in an IRA.

How RMDs Are Calculated

The IRS calculates RMDs using your retirement account balance at the end of the prior year divided by a life expectancy factor from the IRS tables. IRS

If you have multiple traditional IRA accounts, the IRS lets you aggregate your RMDs — calculate each separately, then take the total from any one or combination of traditional IRAs. However, RMDs from 401(k)s generally cannot be aggregated with IRAs.

What Happens if You Miss an RMD

If you fail to take your RMD or do not take enough, the IRS may impose a penalty. Previous penalties were 50% of the amount not withdrawn, but under later interpretation and relief provisions, a 25% excise tax may apply, reduced to 10% if corrected within two years using Form 5329. IRS

Recent IRS reminders underline the importance of meeting deadlines and taking RMDs accurately to avoid costly penalties.

How RMD Planning Fits Into Retirement Income Strategy

RMDs are just one piece of a larger retirement income plan. Thoughtful planning should consider:

For many retirees with $500,000–$5 million in investable assets, reducing the tax impact of RMDs can meaningfully improve their retirement cash flow and legacy goals. This topic is often part of a broader retirement or tax planning conversation. If you’d like help applying these ideas to your own situation, you can request an introductory conversation here.

Frequently Asked Questions

What age do RMDs start in 2026?
Most people are required to begin RMDs at age 73 if born in 1951–1959. For individuals born in 1960 or later, the RMD age will rise to 75 starting in 2033. Congress.gov

Can I avoid RMDs entirely?
No, you cannot avoid RMDs once you reach the required age, but strategies like Roth conversions, QCDs, QLACs, and delaying employer plan RMDs while working can reduce the tax impact.

Do Roth IRAs have RMDs?
No — Roth IRAs do not require RMDs during the account owner’s lifetime, making conversions a valuable planning tool.

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What Are Today’s Projected Returns?

Posted On June 18, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning, Portfolio Management /  

One of the reasons I selected the financial planning software we use, MoneyGuidePro, is because it offers the ability to make projections based on historical OR projected returns. Most programs only use historical returns in their calculations, which I think is a grave error today. Historical returns were outstanding, but I fear that portfolio returns going forward will be lower for several reasons, including:

  • Above-average equity valuations today. Lower dividend yields than in the past.
  • Slower growth of GDP, labor supply, inflation, and other measures of economic development.
  • Higher levels of government debt in developed economies will crowd out spending.
  • Very low interest rates on bonds and cash mean lower returns from those segments.

By using projected returns, we are considering these factors in our financial plans. While no one has a crystal ball to predict the future, we can at least use all available information to try to make a smarter estimate. The projected returns used by MoneyGuidePro were calculated by Harold Evensky, a highly respected financial planner and faculty member at Texas Tech University.

We are going to compare historical and projected returns by asset class and then look at what those differences mean for portfolio returns. Keep in mind that projected returns are still long-term estimates, and not a belief of what will happen in 2017 or any given year. Rather, projected returns are a calculation of average returns that we think might occur over a period of very many years.

Asset Class Historical Returns Projected Returns
Cash 4.84% 2.50%
Intermediate Bonds 7.25% 3.50%
Large Cap Value 10.12% 7.20%
Small Cap 12.58% 7.70%
International 9.27% 8.00%
Emerging Markets 8.85% 9.30%

You will notice that most of the expected returns are much lower than historical, with the sole exception of Emerging Markets. For cash and bonds, the projected returns are about half of what was achieved since 1970, and even that reduced cash return of 2.50% is not possible as of 2017.

In order to estimate portfolio returns, we want two other pieces of data: the standard deviation of each asset class (its volatility) and the correlation between each asset class. In those areas, we are seeing that the trend of recent decades has been worse for portfolio construction: volatility is projected to be higher and assets are more correlated. It used to be that International Stocks behaved differently that US Stocks, but in today’s global economy, that difference is shrinking.

This means that our projected portfolios not only have lower returns, but also higher volatility, and that diversification is less beneficial as a defense than it used to be. Let’s consider the historical returns and risks of two portfolios, a Balanced Allocation (54% equities, 46% fixed income), and a Total Return Allocation (72% equities, 28% fixed income)

Portfolio Historical Return Standard Deviation Projected Return Standard Deviation
Balanced 8.53% 9.34% 5.46% 10.59%
Total Return 9.18% 12.20% 6.27% 14.23%

That’s pretty sobering. If you are planning for a 30-year retirement under the assumption that you will achieve historical returns, but only obtain these projected returns, it is certainly going to have a big impact on your ability to meet your retirement withdrawal needs. This calculation is something we don’t want to get wrong and figure out 10 years into retirement that we have been spending too much and are now projected to run out of money.

As an investor, what can you do in light of lower projected returns? Here are five thoughts:

  1. Use projected returns rather than historical if you want to be conservative in your retirement planning.
  2. Emerging Markets are cheap today and are projected to have the highest total returns going forward. We feel strongly that they belong in a diversified portfolio.
  3. We can invest in bonds for stability, but bonds will not provide the level of return going forward that they achieved in recent decades. It is very unrealistic to assume historical returns for bond holdings today!
  4. Investors focused on long-term growth may want more equities than they needed in the past.
  5. Although projected returns are lower than historical, there may be one bright spot. Inflation is also quite low today. So, achieving a 6% return while inflation is 2% is roughly comparable in preserving your purchasing power as getting an 8% return under 4% inflation. Inflation adjusted returns are called Real Returns, and may not be as dire as the projected returns suggest.
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Replacing Retirement With Work/Life Balance

Posted On June 4, 2017 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

72% of workers over the age of 50 plan to keep working in retirement, according to a 2014 Study. It seems to me we need a new word for “retirement”, because it no longer has the same meaning as it did 50 years or even 20 years ago. And then when we talk about Retirement Planning, people think it doesn’t apply to them.

Today’s workers are redefining how we think about work, life, money, and prosperity. The idea of achieving The Good Life varies from person to person, but there is a rising recognition that our sense of satisfaction and well being comes from a work/life balance and not simply having more money.

The traditional Retirement of working full-time to age 65, collecting your pension, and never working again, is disappearing. This change doesn’t just affect people in their sixties. Workers in their thirties, forties, and fifties are saying “Why should I work 50 hours a week during the prime of my life and not enjoy myself?”

And older adults don’t want to be thrown on the trash heap of obsolescence. They still have much to contribute, enjoy the challenge of work, and want to know that they can make a difference in the world.

The revolution is in how we think about work. People are no longer content to sacrifice their life for a company, career, or 401(k) account. Some call this The New Retirement, and while it does replace our old ideas about Retirement, these approaches have nothing to do with age. You could be 65 or 35 and embracing a whole different approach to work and retirement.

Below are 8 ways people are working and living differently today. Which are you? Which do you want to be? Where is your ideal work/life balance?

1) The Encore Career. Leave behind your practical first career and embark on something that fills you with joy. For some it may be working in the non-profit sector, or on a hobby, or passion. For others, it may be volunteer work if they do not need an income.

2) The Frugals. Many Americans will have to work forever to afford a huge house, new cars, and luxury lifestyle. More people today are rejecting consumerism with the belief that working to try to “Keep up with Joneses” is actually preventing you from enjoying your life. The Frugals are self-reliant and happy to find what they need used, on sale, or go without!

3) The Minimalists. They may live in a tiny house, have a very small wardrobe, or just hate clutter. It is surprising to me how many Minimalists used to have a lot of debt (student loans, car payments, credit cards. mortgages), and made a 180-degree turn to believing that less is more. Simplicity is happiness. Like the Frugals, Minimalists recognize that if you cut your annual expenses from $50,000 to $25,000, you only need half the assets or income to support your needs. That changes your reasons for work.

4) The Part-Timer. Also called the Phased Retirement, it’s a move from working full-time to less than full-time. Many part-timers work just enough to cover their bills. While that sounds spartan, if you are not touching your IRA or 401(k) for years, you are still letting those assets grow! Some companies are happy to have their veteran employees continue part-time, bringing their wealth of experience and knowledge to projects. And for many people, working 10-20 hours a week is the perfect amount to be enjoyable and rewarding, without being exhausting or too stressful.

5) The Retirement Entrepreneurs. Leave behind the 9-5 gig and start your own business as a consultant or by providing a good or service where you have some expertise. Be your own boss, have flexible hours, and work as much or as little as you need. Coupled with a pension, Social Security, or planned withdrawals, and you can still generate plenty of income. Or better yet, “retire” at 50 and use the business to bridge the years until you can tap into those real retirement income sources. In the past, many new businesses were very capital intensive, took long hours (50 hours or more per week), and had high rates of failure. Today’s lifestyle entrepreneurs want the 4-Hour Work Week, to not be an hourly slave, but to make money without huge risks or time commitments. And in the internet age, it can be done!

6) Multiple Income Streams. Many of the most financially secure people I know do not just have one job, they have multiple sources of income. Maybe one job is their main gig, and they also do consulting work, are a Reservist, own real estate, or have a weekend business. This gives you options. If one income stream takes off, you can drop the others and work part-time. In the mean time, you can save aggressively to become independent sooner.

7) The Traveler. Many people want to be able to see the world and spend more time with family. Today, with a laptop and a cell phone, more and more jobs are no longer tied to a desk. Smart people are looking for those positions – or creating them – so that they can work from anywhere. What if you could do your work from the Beach in the winter and the mountains in the summer?

8) The Contract Worker. In many fields, there are needs for short-term positions that may last 1-9 months. Some people will take a contract for 6 months, work hard, and then take off the next 6, 12, or 18 months. They can wait until they find another contract opportunity that interests them.

Francis Bacon said that Money makes a good servant but a bad master. Today more workers are asking how work can support their life and dreams, and not the other way around. They don’t want to be working forever and risk missing out on life. So, let’s put together your budget, look at the numbers, and start making plans. Financial Planning today is no longer just Retirement Planning – it’s helping you achieve your own path to independence, however you want to define it.

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Resources for Helping an Aging Parent

Posted On May 28, 2017 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

Many Americans are helping to care for an aging parent or relative. Even if you’re not today, you may well find yourself in that situation in 5, 10, or 15 years from now. Sometimes that care is directly assisting with daily living, but often that care may be helping someone navigate the challenges of maintaining their independence for as long as possible.

Below are links to resources which can help. Organization and planning are key, and these are areas where a CFP professional like myself can help in ways that go way beyond just managing investments. We’ve organized this into three categories: Planning, Health, and Financial.

PLANNING

The Retirement Problem: What Will You Do With All That Time? From Knowledge@Wharton

Can We Talk? A Financial Guide for Baby Boomers Assisting Their Elderly Parents (book)

10 Tips for Holding a Family Meeting from Psychology Today

HEALTH

Getting Started With Medicare from Medicare.gov

NCQA Health Insurance Plan Ratings for comparing Medicaid Supplement Policies available in your state.

Long Term Care: Costs, How to Pay, Staying in Your Home, from the US Department of Health and Human Services

10 Early Signs and Symptoms of Alzheimer’s from the Alzheimer’s Association

Advance Care Planning from the National Institute on Aging

FINANCIAL

Social Security Retirement Planner

10 Things You Can Do to Avoid Fraud from the FTC

Getting Your Affairs in Order from the National Institute on Aging

Estate Planning for Second Marriages from the American Bar Association

Working with a financial planner is a way to bring a third party to help facilitate important discussions. There are so many vital questions to consider: Where would you like to live as you age? What health issues may impact this decision? Do you have a plan for care or extra help? Who will manage your assets and pay your bills? How will you communicate decisions and wishes to your family?

Planning for health issues, financial objectives, and family communication means parent’s wishes can be honored if or when a crisis occurs. Aging can be very stressful on family members, not to mention potentially a significant financial obligation. I think a lot of us would rather not think about our parents or relatives as aging, but we are doing everyone a disservice if we don’t talk about this and plan ahead.

Extracted from: Planning Concerns for the Aging Population, Susan Korngay, Journal of Financial Planning, April 2017, pp. 27-30.

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What is the Best Way to Take Retirement Withdrawals?

Posted On May 21, 2017 By Scott Stratton, CFP(R), CFA In Retirement Planning /   1 Comment

If you are looking to retire in the near future or are recently retired, you may be interested to learn that how you take withdrawals from your portfolio may have a dramatic impact on the success of your retirement plan. Here’s a summary of a recent article in the Journal of Financial Planning.

Researchers considered a 60/40 portfolio with 4% withdrawals for retirement to examine different withdrawal strategies. They used historical equity returns since 1970, an assumed 2% rate of return for bonds, 1% in fees, 3% annual inflation increases, and a 30 year retirement horizon. They tested four different ways of withdrawing funds from a $1 million portfolio and calculated the percentage of success of each approach as well as the median portfolio value that was left over at the end of 30 years.

Strategy Success Percent Median Ending Value
Spend Stocks First 72% $912,593
Annual Rebalancing 80% $730,302
Simple Guardrail 94% $1,390,418
Spend Bonds First 97% $4,222,468

Most advisors suggest annual rebalancing. This approach keeps your portfolio pegged at a 60/40 allocation even as 4% annual withdrawals are taken. Note the success rate here was 80%, which means that in 1 out of 5 trials, the strategy failed to provide 30 years of inflation adjusted withdrawals. Annual Rebalancing also had the lowest Median Ending Value, which is important for a cushion if you or your spouse should live longer than 30 years, or if you would like to leave assets to heirs or charity.

The best result was obtained by Spending Bonds First. That means that a retiree would not touch their stocks at all while they spent down their entire 40% in bonds. At 4% withdrawals, it would take about 11 years until you had depleted your bonds and for the following 19 years, you would have a 100% equity portfolio. This type of strategy is sometimes called a “Rising Equity Glidepath” by Michael Kitces and other researchers.

Spending Bonds First might provide the best return because it begins with more than a decade of stock growth, with no withdrawals, which in most periods would have been a significant rate of return. However, this approach is controversial, because most practitioners (and regulators) believe that the typical retiree in their seventies or eighties does not have the risk tolerance to be 100% in equities. But, if you did have the stomach for this type of approach, there is evidence from this article and several others that validates the potential benefits of spending bonds first.

The Simple Guardrail may be easier for most retirees to tolerate and for advisors to adopt because it does not require moving to a 100% equity portfolio. The guardrail is simply this: no withdrawals are taken from stocks following a down year to give them a chance to rebound. The portfolio is also rebalanced back to 60/40 annually. While it doesn’t have the dramatically higher median ending value of Spending Bonds First, the guardrail still offers a noticeable improvement in success versus standard rebalancing, from 80% to 94%.

While Spending Bonds First may offer the best hypothetical results, it may be too aggressive for most retirees. The Simple Guardrail improves results on a more basic premise of giving equities an opportunity to rebound after a down year. In our next down year in equities, we will be talking with clients who are taking distributions about this idea.

The study is interesting, but it assumes one account and does not consider the real world complexities of taxes, multiple types of accounts, or Required Minimum Distributions. We look very thoroughly at each client’s withdrawal strategy to fulfill their income needs in the most efficient manner possible.

Source: Determinants of Retirement Portfolio Sustainability and Their Relative Impacts, DeJong and Robinson, Journal of Financial Planning, April 2017, pp. 54-62.

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