Planning for Retirement the R.I.T.E. Way?

Most Americans spend decades of their lives working and planning to save for retirement. However, when they get close, there is very little discussion on how best to properly plan for retirement income and distributions. 

At STA Wealth, we believe that there are right ways and wrong ways to plan for retirement income and the best way is by have a R.I.T.E. Plan. Our retirement planning process helps better plan for “Retirement Income Taxed Efficiently”. With proper financial and tax planning, we believe you will be better positioned to achieve your retirement goals and/or to close any Retirement Income Gap you may have to reach them.

During your working years, you've probably set aside funds in retirement accounts such as IRAs, 401(k)s, or other workplace retirement plans as well as in taxable accounts. Your challenge during retirement is to convert these multiple savings plans and accounts into an ongoing income stream that will provide adequate income throughout your retirement years and/or to leave a legacy to your heirs or to charities.

 Setting a Withdrawal Rate

The retirement lifestyle you can afford will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. The annual percentage that you take out of your portfolio, whether from portfolio earnings or from both earnings AND principal, is known as your withdrawal rate. Figuring out an appropriate initial withdrawal rate is a key issue in retirement planning and presents many challenges. Why? Take out too much too soon, and you might run out of money in your later years. Take out too little, and you might not enjoy your retirement years as much as you could. Your withdrawal rate is especially important in the early years of your retirement, as it will have a lasting impact on how long your savings last.

One widely used rule of thumb on withdrawal rates for tax-deferred retirement accounts states that withdrawing slightly more than 4% annually from a balanced portfolio of stocks and bonds would provide inflation-adjusted income for at least 30 years. However, some experts contend that a higher withdrawal rate (closer to 5%) may be possible in the early, active retirement years if later withdrawals grow more slowly than inflation. Others contend that portfolios can last longer by adding asset classes and freezing the withdrawal amount during years of poor performance. By doing so, they argue, "safe" initial withdrawal rates above 5% might be possible(1). Don't forget that these hypotheses were based on historical data about various types of investments, and past results don't guarantee future performance. There is no standard rule of thumb that works for everyone--your particular withdrawal rate needs to take into account many factors, including, but not limited to, your asset allocation and projected rate of return, annual income targets (accounting for inflation as desired), and investment horizon.

Therefore, at STA Wealth we believe that to determine your safe withdrawal rate, you need to formalize your overall goals in your financial plan that encompasses both a thoughtful retirement AND investment plan while being coordinated with your estate plan for any legacy planning goals that you have. The primary goal in retirement and investment planning is typically to support your standard of living (given inflation) for the rest of your life without running out of money. By creating a formal plan, you are able to identify: 

1. All your sources (sometimes called “buckets”) of future retirement income incorporating pieces from your IRAs, 401(k)’s, Pensions, Social Security, Deferred Compensation, and other assts.
2. Your cash needs (now and into the future - sometimes referred to as a retirement budget) to help you determine the current and future withdrawals that you will need to supplement your expected and guaranteed income sources (e.g. pensions or Social Security).
3. Any tax issues and opportunities that may need to be addressed – especially if you will be in higher tax brackets and/or if you retire early (especially if you retire before age 59 ? where you may encounter penalties as described below).
4. How to create better tax-efficiency in your overall portfolio allocation by reviewing all of your accounts and the underlying holdings to make sure that where possible less tax efficient investments are held in pre-tax accounts (like IRAs and 401(k)’s) and more tax efficient investments (like those that will create long-term capital gains) are held in after-tax accounts.
5. Your needed or required distributions (such as RMDs described below).
6. Your family or charitable obligations/goals.
7. How much risk you want and/or need to take in terms of your portfolio allocation and ongoing investment strategy. To do this effectively, you need to both “stress test” your plan and know your “hurdle rate” (the minimum return you need to reach your retirement distribution goals).
8. Bottom Line: Proper planning will help you know what you can and should be able to distribute as a withdrawal rate from your retirement portfolio now and into the future (sometimes referred to as a “Retirement Paycheck”).

 Which “Bucket” Should You Draw from First?

You may have assets in accounts that are taxable (e.g., CDs, mutual funds), tax deferred (e.g., traditional IRAs or deferred annuities), and tax free (e.g., Roth IRAs or possibly life insurance cash values). Given a choice, which type of account should you withdraw from first? The answer is… “It Depends”.

For retirees who don't care about leaving an estate to beneficiaries or charities, the rule of thumb is simple in theory: withdraw money from taxable accounts first, then tax-deferred accounts, and lastly, tax-free accounts. By using your tax-favored accounts last, and avoiding taxes as long as possible, you'll keep more of your retirement dollars working for you.

For retirees who intend to leave assets to beneficiaries, the analysis is more complicated. You need to coordinate your retirement planning with your estate plan. For example, if you have appreciated or rapidly appreciating assets and/or have highly concentrated stock positions with a low tax-basis, it may be more advantageous for you to withdraw from tax-deferred and tax-free accounts first. This is because these accounts will not receive a step-up in basis at your death, as many of your other assets will.

However, this may not always be the best strategy. For example, if you intend to leave your entire estate to your spouse, it may make sense to withdraw from taxable accounts first. This is because spouses are given preferential tax treatment with regard to retirement plans. A surviving spouse can roll over retirement plan funds to his or her own IRA or retirement plan, or, in some cases, may continue the deceased spouse's plan as his or her own. The funds in the plan continue to grow tax deferred, and distributions need not begin until the spouse's own required beginning date. 

Know How to Better Optimize Your plan…and Be Tax Smart

In addition, if you retire early and have low tax years in some years, you can really “turbo charge” your retirement plan by identifying appropriate strategies and by being tax smart (remembering the “Tax Efficiently” part of the R.I.T.E. Plan). This can be done by planning for and knowing your: 

1. Options to maximize the value of your Social Security Benefits – especially if you are married.
2. Pension Plan distribution options and determining how to best choose options in light of your plan and goals.
3. Knowing your 401k Plan Rollover Options – especially if you you have employer stock that could benefit from Net Unrealized Appreciation (NUA) in a rollover/distribution – especially if you have After-Tax dollars? 
4. Expected tax brackets during retirement to assure that you better utilize any years where you would be in a a lower tax bracket. When this is known, you can utilize various retirement rollover and Roth IRA Conversion strategies that may be very beneficial while avoiding typical Rollover Mistakes.

Certain Distributions are REQUIRED 

In practice, your choice of which assets to draw first may, to some extent, be directed by tax rules. You can't keep your money in tax-deferred retirement accounts forever. The law requires you to start taking distributions - called "required minimum distributions" or RMDs - from traditional IRAs by April 1 of the year following the year you turn age 70?, whether you need the money or not. For employer plans, RMDs must begin by April 1 of the year following the year you turn 70? or, if later, the year you retire. Roth IRAs aren't subject to the lifetime RMD rules. Beneficiaries of either type of IRA are required to take RMDs after the IRA owner's death.

If you have more than one IRA, a required distribution is calculated separately for each IRA. These amounts are then added together to determine your RMD for the year. You can withdraw your RMD from any one or more of your IRAs. (Your traditional IRA trustee or custodian must tell you how much you're required to take out each year, or offer to calculate it for you.) For employer retirement plans, your plan will calculate the RMD, and distribute it to you. (If you participate in more than one employer plan, your RMD will be determined separately for each plan.)

It's important to take RMDs into account when contemplating how you'll withdraw money from your savings. Why? If you withdraw less than your RMD, you will pay a penalty tax equal to 50% of the amount you failed to withdraw. The good news: you can always withdraw more than your RMD amount.

Annuity Distributions

If you've used a tax-deferred annuity (typically in the form of a fixed, variable or equity indexed annuity) for part of your retirement savings, at some point you'll need to consider your options for converting the annuity into income. You can choose to simply withdraw earnings (or earnings and principal) from the annuity. There are several ways of doing this. You can withdraw all of the money in the annuity (both the principal and earnings) in one lump sum. You can also withdraw the money over a period of time through regular or irregular withdrawals. By choosing to make withdrawals from your annuity, you continue to have control over money you have invested in the annuity. However, if you systematically withdraw the principal and the earnings from the annuity, there is no guarantee that the funds in the annuity will last for your entire lifetime, unless you have separately purchased a rider that provides guaranteed minimum income payments for life (without annuitization). Please note that some annuities have very complicated contractual living or death benefit riders(2) that should be understood and reviewed before making any distribution decisions.

In general, your withdrawals will be subject to income tax--on an "income-first" basis--to the extent your cash surrender value exceeds your investment in the contract. The taxable portion of your withdrawal may also be subject to a 10% early distribution penalty if you haven't reached age 59?, unless an exception applies.

A second distribution option is called the guaranteed (2) income (or annuitization) option. If you select this option, your annuity will be "annuitized," which means that the current value of your annuity is converted into a stream of payments. This allows you to receive a guaranteed (2) income stream from the annuity. The annuity issuer promises to pay you an amount of money on a periodic basis (e.g., monthly, yearly, etc). 

If you elect to annuitize, the periodic payments you receive are called annuity payouts. You can elect to receive either a fixed amount for each payment period or a variable amount for each period. You can receive the income stream for your entire lifetime (no matter how long you live), or you can receive the income stream for a specific time period (ten years, for example). You can also elect to receive annuity payouts over your lifetime and the lifetime of another person (called a "joint and survivor annuity"). The amount you receive for each payment period will depend on the cash value of the annuity, how earnings are credited to your account (whether fixed or variable), and the age at which you begin receiving annuity payments. The length of the distribution period will also affect how much you receive. For example, if you are 65 years old and elect to receive annuity payments over your entire lifetime, the amount of each payment you'll receive will be less than if you had elected to receive annuity payouts over five years. 

Each annuity payment is part nontaxable return of your investment in the contract and part payment of taxable accumulated earnings (until the investment in the contract – or tax basis – is exhausted). 

Life Insurance Planning and Decisions 

Life insurance can be a very powerful, flexible and tax efficient retirement and estate planning tool. In addition to paying a tax-free death benefit to your heirs (creating a guaranteed (2) legacy), some policies also have cash value that can be used (when done correctly) as tax free retirement income. 

Typically, you can take distributions of life insurance cash value as loans, partial surrenders, and full surrenders. Each distribution option has different tax implications.

With a loan, the policy owner borrows money from the insurance policy (or more specifically the insurance policy issuer), using the cash value of his or her policy as collateral to secure the loan. The amount of the loan balance reduces both the cash surrender value of the policy and the death proceeds until the loan is repaid. Policy loans generally do not generate immediate income tax liability for the policy owner because they are not treated as distribution for tax purposes. The loan proceeds are not included on your 1040 return as income as long as your policy remains in force. These loans accrue interest changed by the insurance company and can affect the policy performance significantly going forward. Sometimes, loans, the underlying interest and lowered policy performance can cause your policy to lapse. If your policy lapses or if you surrender the policy, you will be required to include the outstanding loan proceeds as income on your tax return to the extent that the proceeds exceed your investment in the policy (also called the policy’s “tax basis”.

You may also choose simply to withdraw and keep all or part of the cash value buildup in your policy. This is known as a “partial surrender”, which reduces the cash surrender value of the policy and the death benefit amounts. Generally, a partial surrender is taxed on a first in/first out (FIFO) basis. Thus, only amounts received in excess of your tax basis will be treated as taxable income.

A full surrender occurs when you discontinue your policy. Typically, the insurance company sends you a check for the net cash surrender value at such a time. In terms of taxation, the excess of the cash surrender value of the policy (plus any outstanding loans) over your basis in the contract is treated as taxable income.

To help assure the best tax treatment of these life insurance distributions and to assure the ongoing performance of your policy going forward, you should meet with a qualified financial planner or life insurance agent to create, review and illustrate your options. This planning can help you determine how best to utilize your life insurance cash value to meet your planning needs.

Bottom Line

You have spent decades saving for retirement. Given that investment of time and money, as you approach or enter retirement you should take the time to review your available alternatives, options, opportunities to meet your financial planning goals and objectives. This will help you make the best decisions for you and your family. At STA Wealth, we provide a very thoughtful review of your financial planning needs to help determine the R.I.T.E. plan for you and your family. Please call me at (713) 600-9000 to see if we can help you make plan for the best possible retirement outcome.

Footnotes: 

(1) Sources: William P. Bengen, "Determining Withdrawal Rates Using Historical Data," Journal of Financial Planning, October 1994; Jonathan Guyton, "Decision Rules and Portfolio Management for Retirees: Is the 'Safe' Initial Withdrawal Rate Too Safe?" Journal of Financial Planning, October 2004.

(2) Life insurance and annuity riders and guarantees are contractual promises made by the issuers. If you purchase an insurance or annuity contract is important to read and understand both the contractual promises and to review the financial stability of the issuing company.

Planning for Retirement the R.I.T.E. Way is Registered in U.S. Patent and Trademark Office.  

_______________________________________________________________ 

IMPORTANT DISCLOSURES 

Financial Planning and Investment Advice offered through STA Wealth Management (STA), a registered investment advisor. 

STA does not provide tax or legal advice and the information presented here is not specific to any individual's personal circumstances. To the extent that this material concerns tax matters or legal issues, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. 

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice. As always, a copy of our current written disclosure statement discussing our services and fees continues to be available for your review upon request. 

IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.