There are many rules of thumb in financial planning. One such rule of thumb states that if you withdrawal 4% of your account balance each year in retirement, adjusted for inflation, your money should last forever (for what it’s worth, I am not a big fan of rules of thumb. But for this exercise, we need something to work with).
An example: Let’s assume a retiree has $1,000,000 saved. No small feat. The 4% rule of thumb would suggest this retiree can withdrawal $40,000 per year, inflation adjusted, and should never run out of money
To create a total annual expected income for this retiree, we would add Social Security income (and other income sources, if any). Assuming a married couple collecting the average social security benefit, we would add to this amount $23,592/yr. (The average retired worker collects $1,305 and the average benefit for a spouse of a retired worker is $661).
For this couple, a simplified calculation would suggest a total retirement income of $63,592/yr.
Where the rule of thumbs ends is where the real work begins.
A Look at Income Taxes
For many retirees, an income of $63,592/yr or just over $5,000 per month would be very comfortable. However, a simplified calculation leaves out a critically important part of the planning. Income Taxes!
If we enter the above figures into a 2014 federal tax return (assuming standard deduction), we learn that an expected income tax liability from $40,000 of IRA distributions and $23,952 of Social Security income is $3,581 (it doesn’t sounds like a lot, I know, but continue reading).
Therefore, after putting money aside to cover income taxes, the true “spendable” amount available to this retired couple is $60,011 (total income less tax owed).
What If I Have Non-IRA Assets?
While I would argue paying $3,581 in income taxes is very low, it’s still income taxes. And no-one wants to pay income tax. Unfortunately for many retirees, most if not all their retirement savings is in tax deferred IRA’s. This leaves very little income tax planning opportunities
For the smaller percentage that has non-IRA assets as a portion of their retirement savings, there are additional opportunities to strategize distribution planning and save a few bucks in taxes.
If we assume $40,000 of withdrawals from a non-IRA asset (with the basis equal to the withdrawal) in lieu of an IRA distribution, the projected income tax impact would be $0.00. Leaving a total “spendable” withdrawal of $63,592. Alternatively, this retiree could withdrawal $36,059 and create the same income as the IRA strategy mentioned above ($60,011 equals $36,059 of non-IRA distributions plus $23,952 Social Security).
Planning a ROTH Conversion
We now know that the current taxable income assuming the non-IRA strategy above is zero dollars. The next question to ask is this. How much can I withdrawal from my IRA and continue to keep my taxable income zero?
By working a tax return, we can calculate that amount to be $21,900. A distribution of $21,900 from an IRA would create a total income tax liability of $11. To say this another way, this retiree could withdrawal a total of $85,492 from their accounts… and pay $11 in income tax! Pretty cool!
As a planner, I would often suggest the retiree consider converting this $21,900 into a ROTH IRA (assuming they do not need the withdrawal for living expenses). This $21,900 would continue to grow tax deferred, and any growth would be tax free (this conversion would also lower the total RMD required at age 70.5).
Who Cares About Saving Just $3,500
Good financial planning is achieved over years and years of good decision making. If you plan and implement the above strategy for 1 year, that’s certainly better than not at all. But it may not change your world.
What if you consider the impact of 5 years of such a strategy? In 5 years, you would have saved over $15,000 in income taxes, withdrew nearly $20,000 less from your portfolio, and converted over $100,000 of presumably taxable IRA dollars with nearly zero tax impact, into tax deferred, tax free ROTH IRA money.
If you have $2,000,000 saved, the opportunity to save income tax and convert to ROTH IRA’s is compounded. A person with 2 million dollars might save over $60,000 in income tax and convert $200,000 into a ROTH IRA.
Now we are talking!
What Does This Mean?
When planning for retirement, a simple calculation of how much income you will have only scratches the surface of comprehensive planning. It’s important to consider what type of money you have saved (IRA, non-IRA, or ROTH). It’s important to understand your other income sources and how they are taxed. It’s important to understand how your money is invested. And it’s important to know what, if any, other planning opportunities exist.
This example above intends to address the thought process of one financial planner in one singular situation. Every situation is different and every retiree should have their own analysis completed.
But as you can see, sound retirement and financial planning goes far beyond “Is this mutual fund better than that mutual fund”?
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.