Retirement Focus - Answering Your Retirement Planning Questions

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
March 18, 2008

By Mike Posey

IN THIS ISSUE:

1. Reader Questions & Comments

2. Retirement Tidbit

3. Conclusion – There’s No Such Thing As Saver’s Remorse

Introduction

Over the past year or so, I have discussed various ways to convert your nest egg into actual income for your retirement years. One of the benefits of having the privilege of writing these periodic E-Letters is the opportunity to read all of the responses from you, the readers. From the comments I have received so far, these Retirement Focus issues have been well received.

In addition to notes of appreciation, I have received many e-mails providing valuable feedback. Some responses agree with me, others disagree, and still others suggest additional topics or information that I might include in future E-Letters. And yes, some responses even correct the spelling and grammatical errors that occasionally make their way into the text, but all of these communications are greatly appreciated.

My favorite communications, however, are from those of you who are already retired and have provided insights from your own personal experiences, both good and bad. Getting news from those who are “in the trenches” in relation to retirement not only helps me in knowing what to write about, but also helps other readers who may be in the same situation.

While I had originally planned to discuss the topic of post-retirement investing in this week’s E-Letter, I’m instead going to mop up a few loose ends, as well as address some of the questions and comments that I have received from readers. Since these questions and comments relate to the material I have covered over the last few months, I feel it would be best to address them now rather than later. My hope is that combining general retirement topics with real-life issues from actual readers will make this resource more interesting and valuable to you in your retirement planning. As always, be sure to let me know.

Before beginning, it is always important to note that the information in this article should not be construed as specific investment, tax or legal advice. While some of the topics discussed are based on actual reader circumstances, the solutions may or may not fit your specific needs, since your situation may be different. Your best alternatives should only be determined after reviewing the details of your personal retirement situation with a qualified professional.

Topics From Reader Questions & Comments

As I noted above, some of you have responded to my E-Letters and raised issues about retirement income planning that have not been covered in my previous articles. Some of these issues have been too specific to merit mentioning in this format, but others have been good suggestions that would likely apply to a wide range of retirees. That being said, I hope that the variety of topics discussed below will better empower you to plan for your retirement, even if you are already there. So, here goes.

Traditional IRA Minimum Distributions:

One of the more common questions I received when discussing ways to take retirement income was in regard to Traditional IRA Required Minimum Distributions, or RMDs for short. In a nutshell, Traditional IRAs are required to begin distributing assets held within the account after you reach age 70½. The amount of the distribution is based on an IRS formula that is designed to deplete the account over your life expectancy, and these distributions cannot be rolled over to a Rollover IRA to escape taxation.

There are literally trillions of dollars now being held in Traditional IRAs, almost all of which represents a potential source of future income tax revenue for the government. However, some account holders can afford to delay taking distributions for a long time, thus making the IRS wait for the tax revenues held in these accounts. The governmental solution is to require Traditional IRA distributions to begin by age 70½ whether the accountholder needs the money or not.

While there are a number of methods to address income and estate taxation of these assets, those issues are far beyond the scope of this E-Letter. Instead, in the paragraphs below I want to concentrate on how RMDs may affect your retirement income planning.

One way that RMDs can have an effect on a retiree is in regard to taxation of the assets. Back in my November 13, 2007 E-Letter, I briefly discussed that it is generally better to draw down your personal savings and investments that are not tax sheltered before tapping Traditional IRAs. This not only lessens any income tax bite on your distributions, but also allows assets to continue to grow tax-deferred in the Traditional IRA.

However, if your personal assets are enough to last you beyond age 70½, you’ll need to factor in at least some income taxation on the Traditional IRA RMD that will then be required. In fact, depending upon your income needs, the combination of the IRA RMD, Social Security and any other pension benefits you may receive might provide sufficient income so that you no longer have to draw on your personal savings and investments.

And speaking of Social Security, the additional income generated by the Traditional IRA RMD may also affect the amount of your Social Security benefit subject to income taxation. As I discussed in my June 5, 2007 Retirement Focus issue, up to 85% of your Social Security benefit may be considered taxable income, depending upon other taxable income you may have.

A final planning consideration for Traditional IRA RMDs is the timing of the first distribution. Under current law, you are allowed to defer the first distribution until April 1st of the year following the calendar year in which you reach age 70½. This provision can help to reduce income taxes on the RMD for anyone who has a high level of other taxable income during the year they reach 70½, but not the following year.

However, what some retirees do not realize is that the second RMD must be taken by December 31st of the same year they take the April 1st initial distribution. This will mean two taxable RMDs during that year, and depending upon the size of the RMD, these distributions could subject part of your Social Security benefit to taxation as discussed above. Thus, it’s always a good idea to talk over your RMD and other taxable income situation with a qualified tax professional prior to December 31st of the year in which you reach age 70½.

Converting Traditional IRAs to Roth IRAs before age 70½:

One of the more interesting comments I received related to how one reader was converting his Traditional IRA to a Roth IRA after he retired. The law allows individuals with Traditional IRAs to convert them to Roth IRAs under certain conditions. Beginning in 2008, distributions from qualified plans such as 401(k)s can also be rolled directly into a Roth IRA, but for purposes of this discussion I’ll just stick to a Traditional IRA conversion.

The Traditional IRA owners pay income taxes on the amount converted and, after the required 5-year holding period, subsequent distributions from their Roth IRAs are tax-free. Depending upon your personal situation, a Roth conversion may be a good move since not only are distributions tax-free, but there is no minimum distribution requirement at age 70½. Plus, Roth IRA balances can have important estate tax advantages under the right set of circumstances.

As with most benefits bestowed by the IRS, there are limitations on this ability to convert Traditional IRAs to Roth IRAs. One such restriction is that prior to the year 2010, taxpayers (single or married) with adjusted gross incomes over $100,000 cannot participate in this conversion. In 2010, this restriction disappears, but some current retirees (including our reader) are finding that their post-retirement taxable income is reduced to the extent that the Roth conversion becomes feasible for them even with the $100,000 AGI limitation.

Thus, they can convert all or a portion of their Traditional IRA each year and pay taxes on the amount converted. The amount so converted can be carefully calculated to maximize the benefits of the current low tax rates in effect through 2010. After that, we’ll have to see what happens in the political spectrum as to whether the Bush tax cuts are made permanent or allowed to expire, or if they are replaced with something better (or worse, more likely).

If you are already receiving Social Security benefits at the time of conversion, you’ll need to be aware that the taxable conversion may subject more of that benefit to taxation than would otherwise be the case. However, by converting only a portion of your Traditional IRA each year, you might be able to minimize the tax hit. Plus, once your Traditional IRA is converted, tax-free Roth IRA withdrawals are not currently deemed to be “tax-exempt income” that would otherwise be counted for purposes of making your Social Security benefit taxable. The result is that, even if you had to take a current income tax hit on the conversion, it might result in long-term tax savings over time, depending upon your situation.

Of course, it’s not all a bed of roses. You would have to have the ability to pay the taxes due on the conversion from personal funds (it’s usually best not to use IRA funds to pay the taxes), and you’ll have to be able to leave the money in the Roth IRA for five years before taking withdrawals. Even so, if you can handle these and other requirements, this may be a planning opportunity for you. This is true even if you are over age 70½ and are currently taking RMDs. Just be sure to consult a qualified tax professional before making any moves.

Note: I also receive questions about a variety of “Roth vs. Traditional IRA” issues from individuals of all different ages, and I plan to address them in a future Retirement Focus issue.

Retirement Planning Software:

In my last Retirement Focus E-Letter, I noted that I would discuss retirement planning calculators and projection software. Unless you have been living under a rock lately, I’m sure you’ve heard and seen numerous ads from bank and brokerage firms about their free retirement calculators. Some of these packages are good and some are not so good, but all do essentially the same thing – they seek to help you determine how much you need to save for retirement and then project whether this amount will produce a stream of income that will last as long as you do.

The problem with many of these online resources is that they eventually lead to a product presentation, which may or may not be to your liking. Even AARP, whose calculator I have recommended in the past, is active in the money management business. Don’t get me wrong, these companies offer retirement calculators as a valuable service to their current and prospective clients and I applaud them for doing so. It’s just that some people like having a resource that is not tied to a product sale.

Fortunately, such software packages do exist. If you do a Google search for “retirement planning software” (include the quotes), you’ll get over 50,000 hits. Many of these are software packages specifically designed for Investment Advisors, CPAs, and other financial professionals, and have price tags to match. However, some are designed for individuals to use on their own, and some are available free of charge.

If you only want to see only the free software packages, just type “free retirement planning software” in your Google search and you’ll still get over 15,000 hits. While doing such a search, I found the following website with 20 links to free retirement planning software. I have not checked any of these out, but this website may give you a head start in your software quest:

http://3d2f.com/tags/retirement/planning/

Since there are so many alternatives on Google and in the above link, it’s literally impossible for us to evaluate each one and select the most appropriate. I can’t even go so far as saying that the paid software is better than the free software. While the general rule is that you get what you pay for, that’s not always the case in regard to Internet software. What I can tell you is that the software packages that I have reviewed are much more comprehensive (read: complex) than many of the free calculators offered by banks, brokerage firms and mutual fund companies.

Actually, this complexity can sometimes be a good thing for planning purposes. The more comprehensive a software package, the more it requires you to think of all of the various assumptions and variables that will affect your financial well-being during retirement. The “simple” calculators offered by some financial services firms reduce the complexity by leaving some of these very important items out. Of course, their goal is usually to get you to contact one of their representatives, who may then reintroduce these complexities back into the mix.

To help save you a little time, I can provide a recommendation made by one of our readers. Bill from Atlanta recommended the calculator found at www.torrid-tech.com. He says, “It’s not free, but is very comprehensive, and has a free demo.” I downloaded the demo program, and found it to be very complete, and the $89 price tag won’t set you back much. Remember, however, that just because this software package fit Bill’s needs doesn’t necessarily mean it will fit yours, but it may be a good place to start your search.

A free retirement calculator that I discovered can be found at the following link:

http://toolsformoney.com/retirement_calculator.htm

This software provider offers a scaled-down version of its regular (paid) software free to those who want to download it. While some of the features of the paid software are disabled, the free version still allows you to do a decent job of both pre- and post-retirement planning. Note, however, that this free software is not as user friendly as the Torrid-Tech software mentioned above, at least in my opinion.

When I discussed retirement planning software in the past, I told you that it can be helpful to have software that can project many different future investment return scenarios in order to give you an idea of the probability of hitting your goals in light of the assumptions you have made.

Some software providers use what is called “Monte Carlo” simulation to test your nest egg’s ability to provide an income stream that will last throughout retirement. While Monte Carlo is not a perfect tool, it does help you focus on the fact that investment losses can and will occur along the way under many scenarios. Unfortunately, Monte Carlo simulation is very complex, and is usually not available on free software packages, and often not in packages designed for personal use. For example, neither of the software options listed above have Monte Carlo simulation modules.

A final caveat when dealing with retirement planning software is that your output will only be as good as the assumptions you make. In other words, it can be “garbage in – garbage out.” Sure, you can make a relatively small nest egg last forever by assuming no inflation and a 10% long-term investment return, but how realistic are those assumptions. Not very!

For this reason, I always recommend that investors seek out the help of a professional when doing retirement planning, and most especially when they are at the point of retiring and needing to plan for income for the rest of their lives. Some hesitate to do this because many professionals are in the business of insurance or investment sales, and they fear a retirement planning analysis that is little more than a prolonged sales pitch.

While this is often true, there are financial planners that offer limited services for a fee. These professionals can do as much or as little as you want, but charge for their time like a CPA or attorney would do. You can find such individuals in your local area by looking in your phone book under “Financial Planners Consultants” and/or “Retirement Planning Consultants.” Look for those who offer “fee-only” services, and then call them and ask if you can get a retirement planning evaluation without asset management thrown in.

Be careful, though. Virtually anyone can call themselves a “financial planner” these days, and there are a whole host of bogus financial and retirement consultant designations that require little more than paying a fee and getting a certificate. (For a list of the more common designations, see the Financial Industry Regulatory Authority [FINRA] website at http://apps.finra.org/DataDirectory/1/prodesignations.aspx.) As a general rule, I’d suggest you only consider retirement planning consultants who have a CPA, legal background or Certified Financial Planner (CFP) designation, or someone recommended by a satisfied client.

Post-Retirement Budget Surprises:

Of the responses from actual retirees, some of the most valuable in the way of advice came from those who had experienced unplanned budgetary “surprises” during retirement. Ranging from weddings (for twin daughters in the same year, no less) to post-graduate education, the common thread was that these expenses were either unplanned or cost more than anticipated, and arose after retirement had begun.

Thus, it is vitally important for the sake of your retirement planning for you to realistically consider any potential large, out-of-pocket expenses that may hit you after you retire. This is especially true if you retire early, since your pension or 401(k) will not be as large as if you had stayed until normal retirement, and if you retire before age 62, Social Security benefits will not be payable. Plus, early retirees are more likely to be hit with college expenses (which always seem to be more than we plan for), weddings (ditto), health insurance premiums and possibly even care of elderly parents.

One e-mail I received from a retired couple commented about how they had retired early so they’d be healthy enough to travel, only to find out that their travel expenses put a much larger hole in their nest egg than they had planned. They have since curtailed their travel schedule.

There are a number of other potentially large expenditures that should be considered as part of your retirement planning process. For example, how often do you plan to get a new automobile? When you do, will you pay cash or make monthly payments? Also, don’t forget about insurance and property taxes, which may have been paid as part of your monthly mortgage payment. Depending upon where you live, these expenses could be substantial.

There are a number of other types of major expenses to consider such as home repair and maintenance, new appliances, etc. The most unplanned of all typically come from adult children who may seek assistance when going through a divorce, loss of a job, major illness or even setting up their own business. While it’s impossible to list every potential extraordinary expense, the key is to analyze your own personal situation, try to anticipate these expenditures to the extent possible, and then plan accordingly.

Relocation After Retirement:

Another retirement issue that was raised by several readers was the idea of relocating to another city or state after retiring. Most of the questions and comments along this line suggested that there are lower-cost communities across the country that are actually advertising for seniors to move there. Actually this has been the case for many years, with many retirees relocating for reasons of health, climate and/or cost. While I can’t answer the question as to which is the best retirement community, I can provide some things to consider when thinking about a post-retirement relocation.

It can sometimes be advantageous to move to another state in order to get the most bang for your retirement buck. A 2004 Del Webb study showed that 55% of all Baby Boomers plan to relocate when they retire. Some other studies cite an even higher percentage. Reasons include not only cost of living, but also a desire to scale down to a smaller home, reduce or eliminate mortgage payments, or the desire to live in a more “senior friendly” location.

It goes without saying that before making such a move, you need to carefully consider all of the various costs involved. For example, many like moving to Texas because we currently have no state income tax. Once here, however, they are often surprised at our property tax burden, especially those who move here from California. You should also check out all related costs of living. A good way to do so is to pull out your checkbook and see what expenses are represented there. Then, check out the level of these same expenses in your proposed new location.

Another cost factor that you might not otherwise think about involves the location of your family. If your parents and kids are already spread across the country, then moving to a new location might not affect your travel plans to be with them. However, if you move away from a concentration of family in one location, you might find yourself spending more money than planned going “back home” to visit.

I can speak from experience on this last issue, though I’m not retired. Back in 1999, my wife and I moved to Austin and away from an area where virtually all of our combined families still live. We had assumed that we might go back to visit once a month or so, but the reality has been that we travel back home much more frequently than that. Thus, relocation may or may not be in your best interest if your travel expenses to visit family members run more than you anticipate, or if your budget prevents you from seeing your loved ones as often as you would like. Of course, it sometimes works out that the relocation is actually closer to loved ones, in which case travel costs might actually drop.

Another thing to consider in relocating is the availability of medical care. Statistically speaking, the older we get, the more we will need medical care. While it’s true that you may be able to live more economically in a smaller town, it may also be true that medical care is limited, or may lack a specialist that is important to your ongoing health. Plus, there are some cities in which it’s getting harder to find a doctor who will accept Medicare patients. You definitely need to check this out before making a move.

Retirement Tidbit – Transferring Your Tax Refund Directly To Your IRA

This is a repeat of a Retirement Tidbit from last year, but it’s still timely advice for those who would like to transfer their tax refund directly into their IRA account. For the most part, investors are aware that the IRS will allow you to claim an IRA deduction on your 1040 that you have not yet made, as long as you use your refund to fund it prior to the tax filing deadline (usually April 15th). This allows individuals to fund an IRA contribution for the prior tax year that they may not have otherwise been able to make.

Originally, direct transfers of IRS refunds could go to only one account. This caused a problem if a taxpayer wanted the refund to go into an IRA, but the refund exceeded the maximum limit of $5,000 ($6,000 for taxpayers over age 50). In 2006, the IRS solved this problem by allowing tax refunds to be distributed to more than one account. Form 8888 gives taxpayers the ability to designate up to three accounts to automatically receive portions of a tax refund.

With this new rule, you can now file electronically and have only a portion of your refund sent to your IRA account with a bank, mutual fund, brokerage firm or other financial institution. If you want to take advantage of this feature, keep the following important tips in mind:

1. Your refund can be deposited directly to your traditional IRA, Roth IRA or SEP IRA. It cannot, however, be used to fund a SIMPLE IRA. Be sure to document the correct account and routing numbers, as these must be placed on Form 8888.

2. The receiving IRA must already be established and it’s important to make sure the IRA sponsor will allow direct deposits. A married couple, filing jointly, may establish an IRA in each spouse’s name and then have direct deposits made into each of these accounts.

3. Many IRA custodians credit IRA contributions in the calendar year in which they are received. Thus, a tax refund IRA contribution made now will likely be considered a 2008 contribution unless you call the custodian and tell them to designate it for 2007.

4. You need to be sure that the direct deposit will be made to your account by April 15th, this year’s tax filing deadline. Keep in mind that it usually takes a couple of weeks for refunds to be processed on returns filed electronically, and possibly even longer for paper returns. If you miss the deadline, you will have to file an amended 2007 return without the IRA deduction, so don’t try this unless you are comfortable that the refund will be credited by the deadline.

5. In addition to an IRA, direct deposits may be made to a Health Savings Account (HSA), Archer Medical Savings Account (MSA), or a Coverdell Education Savings Account (ESA).

If you have any interest in using your income tax refund to fund your 2007 IRA contribution, it is very important that you file your return as soon as possible so that your refund will be processed and deposited into the account before April 15th.

Conclusions

I hope you have enjoyed the above discussions based on input received from our readers across the country. In closing, I wanted to address the reader comments that had the very best advice. I received several e-mails containing what I consider to be retirement planning success stories. Of these, there were several common themes that they wanted me to share with you:

1. Live frugally – All of the retirement success stories I received said how they credit at least part of their success to the fact that they lived below their means, both before and after retirement. Why is this so important? Because I think it is impractical to believe that someone who cannot live below their means before retirement can somehow magically transform into a frugal individual after retirement. It’s possible, but I don’t think it’s very likely.

2. Save money – In one of my past Retirement Focus E-Letters, I made the comment that I have never heard of “saver’s remorse.” This is further supported by comments from readers, who stressed the importance of saving as much as possible as early as possible.

3. Monitor your investments – All of the success stories I received also mentioned how they invested in more than just CDs or savings accounts, and continue to monitor their investments closely during retirement. In fact, some monitor them much more closely now than before they retired. This sage advice is sometimes contradicted by today’s financial services firms, who claim they have programs that you can set and forget.

In the next Retirement Focus issue, I plan to take on the issue of how to invest after retirement. This is the next logical step in my series of how to convert your nest egg into retirement income, and a discussion of this sort has also been requested by many readers. Part of this discussion will also address retirement annuities, which is another frequently mentioned issue in reader feedback.

Best regards,

Mike Posey

SPECIAL ARTICLES

Obviously, the latest Fed bailout of Bear Stearns - a major Wall Street bank/broker-dealer - and takeover by JP Morgan for pennies on the dollar is the big news this week. Many have criticized the move, while others applaud it. The first two articles below offer differing views on the issue. -GDH

Was Bear Stearns the Sacrificial Lamb?
http://www.realclearpolitics.com/articles/2008/03/was_bear_stearns_the_sacrifici.html

The Fed Can't Do It Alone
http://www.washingtonpost.com/wp-dyn/content/article/2008/03/17/AR2008031702152.html

A 1930s Loan Rescue Lesson
http://www.washingtonpost.com/wp-dyn/content/article/2008/03/13/AR2008031303174.html