Retirement Focus - Converting Your Nest Egg To Income
FORECASTS & TRENDS E-LETTER
By Mike Posey
IN THIS ISSUE:
1. Retirement Income Planning Is Nothing New
2. The Five Basic Retirement Income Options
3. Projection Protection
4. A Word About Taxes
5. Periodic Monitoring Is Essential
In my July 24, 2007 Retirement Focus E-Letter, I kicked off a series of discussions about the various aspects of post-retirement planning. In that first installment, I dealt with the pros and cons of taking an annuity payment from a retirement plan. Later on, in my August 21, 2007 Retirement Focus issue, I discussed the issue of taking lump-sum distributions from retirement plans, and also how scam artists are gearing up for the millions of Baby Boomers who will soon be receiving these large payouts.
In this next installment of post-retirement income planning, I’m going to set the stage for a detailed discussion of the various ways to convert your retirement nest egg to income. As I have noted before, one of the biggest areas of concern that I get from E-Letter readers is how to take income from their retirement nest eggs, and how to invest so that they won’t run out of money.
This week, I will be listing the various ways you can approach your retirement income needs. I’m also going to provide some important background information that you will need to know before seeking out the best way to convert your lump-sum distribution into income.
Since I am neither an attorney nor tax professional, it is important that you realize that what I present will be very broad guidelines and generalizations based on my retirement planning experience, and not specific tax, legal or investment recommendations. My goal is to briefly discuss enough options to at least give you some direction as you seek more specific advice.
Retirement Income Planning Is Nothing New
It amazes me that the financial services industry is treating the thought of retirement planning as if it never existed before. The fact is that there has always been a need for retirees to figure out how much income they could take from their accumulated assets and how to invest those assets. Of course, today there are 78 million Baby Boomers bearing down on retirement, and the financial services industry sees this as a potential bonanza, the likes of which has never before been seen.
Thus, they are rolling out new “retirement” products, as well as dusting off some existing products with new names or marketing plans to appeal to those needing retirement income. Some are probably good, some are bad, but all are creatures of a new marketing emphasis on retirees. So, just be prepared for the onslaught of ads and promotions aimed at you, especially if you are at or near retirement.
Since retirement planning is nothing new, allow me to list some of the very basics of converting a lump-sum distribution into retirement income. When wages from employment cease and you are faced with managing a lump sum of accumulated retirement assets, there are essentially five broad options available to you:
I will discuss each of these options in more detail in future Retirement Focus issues, along with ideas about how to invest for each of them. However, because of the importance of the decisions you need to make in regard to taking retirement income, I think it is necessary to first cover some information you need to know before making such a decision.
As I noted above, financial services companies are working overtime to promote their retirement planning services, usually with an aging movie star touting their particular approach. The obvious goal of all of this promotional material is to get you to sit down with one of their representatives, discuss your retirement goals, and then produce a plan for what you need to do. With any luck (for them), this plan will convince you to invest with that firm.
Retirement projections are usually produced with the help of computerized programs that are designed to factor in a variety of variables. Obviously, some software programs are better than others, but all attempt to boil down the myriad of alternatives in order to help you make a decision about your retirement needs.
Now for the sad truth – much of the material you will receive will likely be what we call “boilerplate,” which is just a term that means it is general information that applies to pretty much everyone, but is presented in such a way as to look as though it was customized just for you. It’s not that there’s anything wrong with the information, just that you don’t need to feel sorry for the person presenting this, thinking they were up all night typing this stuff into a word processor.
Boilerplate aside, the real value of the planning process is that it forces retirees to focus on planning for retirement income rather than just putting the money in the bank and hoping for the best. However, it’s important to note that the value of any pre-retirement or post-retirement computerized projection depends upon: 1) the accuracy of the input; 2) the number of variables considered; and 3) the way in which these variables are factored into the equation. At the very least, any retirement income projection should include the following variables:
In the end, however, you should know that a projection is a very imprecise planning tool designed to get you to take action. To the extent that it prompts you to do something about saving for retirement or making a decision on how to withdraw income from your nest egg, it is beneficial. However, you should not place too much confidence in any projection as it is, at best, an educated guess about the future, which is unknowable.
That brings up another point – just as you would get a second opinion about a serious medical condition, you need to get a second opinion in regard to your retirement decisions. After all, these decisions will determine your well-being for the rest of your life. So let me be characteristically blunt: if insufficient or inaccurate assumptions were made, it’s not going to be your broker or financial planner who may be faced with the consequences of outliving your money – it will be YOU.
So, you need to do all you can to make sure you make the best possible decision, and this includes getting a second opinion. It also means that you should periodically monitor your progress, but I’ll talk more about that later on.
Planning Retirement Income Needs
As a financial planning professional, I personally think it is unproductive to simply select a certain percentage of assets to withdraw each year for income purposes. Sure, it may be fine as a general guideline for someone far away from retirement, but for someone nearing retirement, I think better alternatives exist.
I personally like the budgeting approach to assessing retirement income needs for those about to retire. As you near retirement, get out your pencil and ledger pad and start budgeting what your expenses will be. One good way to do this is to use your pre-retirement budget as a guideline, and make adjustments where necessary. If your home will be paid off by then, you can take off the mortgage payment and leave only insurance and taxes. If you plan to travel a lot, gasoline and other travel-related expenses may actually be greater after retirement, but you may be able to get by with just one car for everyday needs.
You may find that your post-retirement expenses will be far less than pre-retirement levels, but you might also discover that they’re not going to be much (if any) less. Doing a line-item budget is one way to customize the retirement planning process for your own personal situation.
Once you get your estimated budget together (and don’t forget to add a little “fudge factor” for an occasional Starbucks coffee or expenses you didn’t think of), then see how that compares to your estimated Social Security and any pension income you may be able to count on. The difference (if any) will be what you will need to fund from your accumulated retirement assets.
The benefit of this exercise cannot be overstated. In many cases, it’s necessary for the retiree to go back and adjust estimated spending to “fine tune” the withdrawal percentage in order to have a better chance of making the nest egg last throughout retirement. It’s far better to budget expenses early on than to draw down on assets so far that you’re destitute in your golden years.
More About Taxes
Just as important as the investment planning for retirement is tax planning. When you have multiple sources of retirement income that may include a combination of personal savings and investments, Roth-type retirement programs, IRAs and other qualified retirement plans, it’s important to consider all of the tax issues.
While I’m not a CPA or tax professional, there are some general guidelines I can provide as you plan for your retirement. That way, you can do some of the necessary groundwork before consulting with your Certified Financial Planner, CPA or other professional tax counsel. In general, you should categorize your retirement assets into the following broad categories:
Tax-Free Sources of Retirement Income: Principal withdrawals from these assets do not create a taxable event, but earnings may be taxable each year. Many Financial Advisors will recommend taking initial retirement income withdrawals from these assets, thus allowing any tax-qualified accounts such as traditional IRAs and annuity contracts more time to grow tax-deferred (more about that below).
However, it’s generally not a good idea to completely deplete these assets, since it may be wise to keep some as a “cushion” that can be withdrawn tax-free for emergency expenditures. The various types of assets that can be withdrawn without tax consequences include the following:
Tax-Advantaged Sources of Retirement Income: There are some assets you may have that enjoy favorable tax treatment under certain conditions. If you have no tax-free sources of income as discussed above, or have drawn down these assets to the point that you need to supplement your income from other sources, these assets are usually the next in line. Examples of tax-advantaged sources of retirement income include the following:
Fully Taxable Sources of Retirement Income: As the heading suggests, this final category describes sources of retirement income that are taxable from the first dollar. Because of this tax treatment, some Advisors recommend that, where possible, these “fully taxable” assets be allowed to grow tax-deferred and utilized last, when taxable income from other sources may be less. Examples of fully-taxable retirement income are as follows:
Other Tax Issues: Depending upon where you live, you may have other tax benefits available to you during retirement. For example, many of the states with state income taxes offer special provisions for taxpayers over age 65. In addition, some states offer property tax relief for seniors, such as expanded homestead exemptions, freezing of valuations, and some even offer deferment of property taxes.
Thus, tax planning above and beyond income taxes may pay dividends after you retire. This is especially true if you plan to move to another state. One good place to check out the total taxation issues by state is the Retirement Living state tax information web page at the following Internet address: http://www.retirementliving.com/RLtaxes.html
Conclusion - Periodic Monitoring Is Essential
I hope that you have benefited from the above discussion about retirement planning. I’m sure that many of you are thinking that these points are really just common sense, and you’re right. Unfortunately, some retirees will suspend their common sense when presented with a professional-looking computerized proposal. Just remember that any proposal is only as good as the assumptions used to generate it.
Even if you have never, ever used professional tax guidance before, I recommend you do so prior to retirement. I also recommend that you use a local tax professional rather than one on the Internet or through an infomercial. Some retirement tax benefits depend upon the state in which you live, and a local professional is more likely to know about them than someone who is headquartered all the way across the country.
And finally, it is essential to monitor your progress in regard to investment returns, living expenses, taxes, health care costs, etc., etc. to make sure you stay on-track. The nifty computer illustrations and Monte Carlo projections will not comfort you if they turn out to be off-target. It’s not that financial services professionals don’t care or have it out for you, it’s just that they have no way to predict what’s going to happen in the future. Yet, what happens in the future will have everything to do with your ability to live well in retirement.
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.