Retirement Income Blog

Traditionally, about 50% of people eligible to collect Social Security at 62 do so. But if you do, you’ll receive about 25% less income (i.e. Social Security benefits) than waiting until your full retirement age – between 65 and 67 depending on your birthday. What implication does your early retirement have on your spouse?

Everyone whose work earnings make him or her eligible for Social Security benefits (i.e. income) receives his full Social Security benefit when he reaches his full retirement age (FRA). You can retire as early as 62 but your benefits will be permanently reduced by about 25% from the full benefits you’d get at your FRA. Waiting longer than your FRA to begin receiving Social Security benefits increases your benefits. Waiting to age 70, will increase them by about 32%.

A spouse (i.e. a married person) always has the option of taking the larger of her own working benefit or a ‘marriage entitlement’ benefit that’s based on the benefit her husband collects (assuming the husband was the higher earner in this example).

A spouse’s benefits while husband is alive
Since men generally have worked and earned more, it’s their wives that are in the position of collecting the larger of their own working Social Security benefits or their social security spouse’s benefit.

 A wife’s spousal benefit can be as high as 50% of her husband’s full retirement benefit. To receive this, she must wait for her own FRA and he must do the same.

If he retires early, but she waits for her FRA, she still get 50% of her husband’s benefit – but his is less because his benefit is reduce due to his early retirement. If he retired at 62, his benefit would be reduced by about 25% from his FRA benefit.

If she retires early at 62, and he waits for his FRA, her spousal benefit will be a reduced about 30% below whatever her 50% spousal benefit would have been. 

A surviving spouse’s benefit
A surviving spouse is entitled to the greater of 100% of the deceased spouse’s social security benefits or his/her own working benefit. As stated above, this option is more typical for a surviving wife to make.

Here, the wife’s 100% of her husband’s benefit is affected by what he actually received. So if he retired early, then her 100% benefit will be smaller to the same extent that his benefit was reduced for early retirement. Her 100% benefit would increase if he delays his retirement to age 70.

So a married man’s decision when to collect Social Security has direct implications not only on how much he’ll receive in Social Security benefits, but how much his wife and survivor will receive. But remember, there’s more to life than financial gain, men don’t live as long as women; they deserve some decent retirement time too.

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Once you’ve reached age 70½, you must take a minimum required IRA distribution (MRD) each year.  But if you don’t need the cash to live on and you expect your IRA stock to increase in the future, consider taking an ‘in kind’ IRA distribution for improved tax benefits.

Recent economic conditions have hit many equities hard. Their lowered values have lowered the value of the IRA they’re in. Since this year’s MRD is based on possibly a higher IRA value at the end of previous year, you will pay tax on an irritatingly large MRD for 2008.  To mitigate this, IRS has waived the 2009 MRD requirement altogether. 

Equities – such as stocks – you bought in your IRA have a ‘zero’ tax basis. Whatever value you take out for your IRA distributions is taxed at ordinary income tax rates. And that includes all gains those equities made. Also,  there’s no deduction for any loss within an IRA.

Keeping those depressed equities in your IRA for a possible comeback within a year or two will have you paying ordinary income tax rates when you take them out in the future for both their value and any gains. That’s a bad tax consequence of IRAs for appreciating equities.

Take an In Kind IRA distribution for reduced taxation

But if you expect those equities to appreciate, you have to withdraw your MRD, and you don’t need the cash for living, you can capitalize on that future growth at a much lower capital gains tax rate.  Do this by taking an ‘in kind’ IRA distribution.

You take an ‘in kind’ IRA distribution by requesting your IRA custodian to transfer the stock directly from your IRA account to a taxable account without cashing them in. Keep records on the value of that stock when it’s transferred. It’s on that value that you’ll have to pay ordinary income tax as an IRA distribution. You’ll have to come up with cash elsewhere to pay this tax.

But that stock value now becomes the basis of that transferred stock. If the stock appreciates three better tax consequences occur:

• Any gain will be subject to the low long term capital gains tax – and that’s for gain above its new basis. 
• You’ll not have to pay any tax on any gain until you wish to sell it.
• Dividends will be tax yearly – but if they’re qualified dividends, you pay at no more than the 15% rate (current rate in effect for 2009 and 2010)

Lastly, if the equities fall further and you decide their not worth holding for the future, you’ll be able to take a capital loss deduction and use it to offset other tax on other income or IRA distributions.

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There can be no question that saving for your own retirement is a financially sound and important thing for you to do, and one of the most common and popular methods of doing this is by investing in a 401K plan at your place of work. But what you may not know is that not all 401K plans are the same.

If you are like many people in the United States, the chances are that you have had several jobs over your working life and, as a result, still have a number of 401K plans with different former employers. Or perhaps you have recently retired, but are not yet ready to cash in your 401K plan(s). Whatever your individual circumstances may be, you should be aware that your 401K plans could actually be costing you money.

Under the current laws, not only are the companies administering your 401K allowed to charge maintenance and service fees, but they are also not required to inform you what those maintenance and services fees are. Some insurance companies and stock brokerage houses are charging as much as 4% or 5% per year off the top for the plans they administer, which can significantly decrease the annual yield and value of your plan. (There are also fees and charges associated with maintaining IRA accounts, and generally there will be management or transaction fees associated with most products.)

Specific fees that are considered to be “hidden” are:
 Trading costs, commissions between fund managers and brokerage firms
 Soft dollar “excess commissions” paid to brokerages pursuant to Securities
 Exchange Commission (“SEC”) rule 28(e)
 Sub-shareholder (participant) servicing fees - called “sub-transfer agent fees”
 (“Sub-TA”)
 Account distribution (sales) based 12(b)-1 fees
 Account servicing based 12(b)-1 fees
 Unitized variable annuity wrap fees
 Variable annuity mortality costs
 “On-the-fly” pass through fees
 Retail versions of institutional funds (i.e. funds that could be purchased at a lower price but are not, due to fiduciary ignorance)

Unfortunately, managers at many companies have signed on with 401k sponsors and simply do not understand the fees involved.  Since the fees are not paid by the company, bu rather by you and the other participants, they have small motivation to look hard at the fees.  In fact, a study by Spectrem Group showed that most plan sponsors don’t know what they pay. 

So unless you ask and thoroughly read the prospectus and make sure onerous fees are not being levied against your account, it’s best to do an IRA rollover and not leave your funds in a high priced qualified plan.

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 If a recession becomes severe, dollars may suffer from deflation rather than inflation. This would change the rules you have for retirement investing over the past 30 years. What should retirees consider doing if deflation sets in?

We’re familiar with the effects of inflation. Our dollars just don’t buy as much as they used to. Too much ‘easy money’ from too much credit puts more dollars into everyone’s hands so each dollar is worth less than before. So too many dollars are chasing too few goods and the prices of goods are bid up. In this typical inflationary environment, retirement investing rules are to get rid of cash and hold hard assets like real estate.

But when recession occurs, everyone becomes afraid of consuming. Businesses feel the pinch and people lose jobs. Government may try to ‘prime the pump’ by offering and instigating low interest rates. That reduces the cost of credit and hopefully to get people to begin borrowing and ‘consuming more’.

But if the turn down is too severe, very few people will be enticed to spend money. The money supply actually contracts. The results in a low demand to buy most things and can force prices down. And deflation is the general decrease in the prices of goods. Your dollars are worth more!  Rather than get rid of dollars, you want to own them and convert them selectively to assets that have fallen in value (real estate, stocks, etc).

Most retirees have no job to lose. They’re living off Social Security, pensions and their investment earnings. Most of this  retirement income may be fixed income.  Those in such a circumstance can actually benefit from deflation – mostly from the benefit of lower prices for things.

But under deflation, dollars become more valuable and debt – i.e. owing a fixed amount of dollars – becomes more of a burden. So retirees should reduce the cost of their debt by reducing payments or restructuring.

As deflation sets in you’re paying off debt in more expensive dollars. So any way to reduce the dollars you must commit to debt payments is beneficial.

Restructure your debt payments. With recessions comes falling interest rates. Take advantage of lower interest rates to restructure debt payments you can’t pay off quickly.

Refinance your home. If you have a mortgage, refinance at lower interest rate to cut your monthly costs – or to pay it off over a reduced time period.

Since the value of cash is increasing, holding it will increase your wealth – but only during deflation. Aside from preserving your emergency funds, you’ll want to hold dollars for retirement investment opportunities at low prices.

If you do have extra cash, stay aware of overly depressed investment prices and commodity prices (oil and gold)that will recover after the recession ends and present low risk retirement investing opportunities. Real estate investments – especially condos – are a typical case. It may even be worth a small remortgage of your paid off house for some investments (this strategy is not suitable for everyone as any borrowing will incur a fixed payment commitment while the return on investments is not assured).

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Generally, your IRA and or company 401(k) distributions are taxed as ordinary income. That’s because you funded them with tax-deductible contributions and all the earnings of these contributions have been tax-deferred. So nothing has been taxed. Taking a distribution before turning 59½ will add a 10% penalty tax to the income tax.

Nevertheless, you may have made some ‘after-tax’ contributions to them, and those – not their earnings – will come out tax free. So let’s see how this to handle these.

Taxable and non taxable distributions for company-administered plans such as a 401(k)
This is pretty easy because it’s your employer who is responsible for tracking both your tax deductible and after-tax contributions to the plan. They’ll report those amounts to you, either on your statements or on a 1099-R when you take a distribution from the plan. 

IRA distribution
You’re the administrator of your IRA. So keeping track of after-tax contributions is your job. That’s done on IRS Form 8606 each year you make an after-tax contribution and each year you take an IRA distribution.

This form – each time it’s filed - carries forward the total of prior year after-tax contributions and adds them to any current year contribution. It also formulates the non-taxable portion of any distribution you take in the year. And, of course subtracts out that amount from the total after-tax contributions among your IRAs.  Normally, form 8606 is attached to your tax return. 

The non-taxable portion of your IRA distributionsduring the year is the ratio of all your after-tax contributions (from your latest Form 8606) divided by the total value of your IRAs. No, you don’t get to take out just the ‘tax-free’ part!  Each time you take an IRA distribution, part is taxable, part is return of after tax money (not taxable).

What if you forgot to file your Form 8606 over the years? Just get the form and its instructions; it’ll give you some suggestions on documentation you can use to substantiate your prior after-tax contribution amounts.  If you think the amount of after tax contributions you have forgot to document is significant, then get help form a tax professional so that you don’t need to pay tax twice when you take distributions.

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How you Use or Spend Your Savings Determines how much Retirement Tax You Pay

When it comes time to tap your savings and investment accounts, investors often ignore which source should come first for retirement distributions. In general, many experts often advise investors to draw from their taxable accounts first, then tap qualified accounts such as IRAs and 401(k)s further down the road.

There is a logical reason for this – prolonging withdrawals from your qualified accounts or tax sheletered accounts gives these assets additional time to grow with the benefit of tax-deferral. There are other reasons why this strategy for retirement distributions could be efficient from a federal income tax perspective.

Let’s say that you have three sources of investment funds: a regular taxable account (which could hold individual stocks, bonds, or mutual funds,) and two qualified accounts: a traditional IRA and a Roth IRA. What happens if you tap your traditional IRA? First, all retirement distreibutions from a traditional IRA are taxed at your current ordinary income tax rate. Second, a 10% federal income tax penalty will usually apply to traditional IRA withdrawals taken prior to age 59½ (subject to a few limited exceptions explained in IRS Publication 590, among the exceptions include but are not limited to withdrawals for qualified higher education expenses, first-time home buyer, and medical insurance premiums for certain unemployed taxpayers, and withdrawals taken by disabled taxpayers).

What about retirement distributions from a Roth IRA? First, your principal contributions from the Roth can be withdrawn without occurring any tax. Additionally, any withdrawals from your Roth are first treated as being taken from your principal. Should you have to tap into your earnings, these withdrawals are subject to ordinary income taxes at your respective tax rate. And if you are less than 59 ½ years of age “or” you do not hold the Roth for more than five years, the distribution could also be subject to the 10% federal income tax penalty. 

However, by leaving the money in the Traditional and Roth IRAs, you have the opportunity to accumulate tax-deferred investment growth over the life of both the owner and the beneficiaries. Assuming the age and holding period requirements are met, all Roth retirement distributions also come out free of future federal income taxes to the account owner as well as the beneficiaries.

What if you tap your taxable account first? First, you will owe taxes on any capital gains you realize from the sale of investments in this portfolio. Assuming you have held the asset for more than one-year, your rate will be lower than your current income tax rate (0% for taxpayers in 10-15% brackets; 15% for all tax brackets exceeding 15%). You might also be able to offset any capital gains with capital losses, which can soften the blow of your annual tax bill. 

As you gradually tap your taxable account, the distributions you receive from these investments will slowly recede as well, thus lowering your tax burden from dividends and capital gains paid to you. Moreover, your qualified accounts could potentially have longer time to grow with the power of tax-deferral, which could enhance the value of your qualified retirement funds.

Eventually, you will have to take required minimum distributions from your traditional IRA, once you reach age 70½. Although these retirement distributions will be taxed at your ordinary income tax rate, you could be in a lower tax bracket by then. As previously mentioned, these distributions are taken, in many cases, over the life expectancies of the owner and the beneficiaries. On the other hand, traditional IRAs do not receive a step-up in income-tax basis when they are transferred to younger beneficiaries at the owner’s death. Although there is something to be said about the power of deferring taxes, one should also consider future income tax consequences to younger family members before making a decision.  

Assuming you have assets in Roth IRAs, you should know that minimum distributions are not required. In view of this and the fact that retirement distriubutions will come out free of federal income taxes (assuming the age and holding period rules are met), you may want to consider your Roth assets as your source of last resort.   
Deciding which account to tap first depends on your financial and tax situation now and during your retirement years.   In general, leave your IRA and qualified accounts to grow but don’t proceed with this advice until you have had a tax consultant or retirement advisor confirm.

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Some foreign governments may offer a higher interest rate on their bonds than the US Government does. Additionally, some foreign corporations might offer a higher interest rate than the US companies. For retired investors, this could be an opportunity to diversify in an area that offers potentially higher returns, more stable returns and a hedge against the value of the US dollar–all goals for sound retirement investing.

Also, international bond funds can provide diversification and potentially higher returns. International bond funds invest primarily in bonds issued by foreign governments and corporations. There are different types of international bond funds—single country, single region, global (which includes US bonds), and foreign (no US bonds included).  There are also industry and sector funds—utilities, government, telecommunications, and so forth.

What are some other reasons to consider international bond investments?  Interest rates can move in different directions throughout other parts of the world. For instance, when US rates are low, rates in other stable countries may be higher. The same could happen to movements in the stock markets. Of course, the opposite could also come about. }

When you buy international bonds or bond fund shares you are opting for the potential of higher returns in exchange for accepting some additional risks. For example, foreign markets are often more volatile than the U.S. markets. These investments involve other special risks, including currency exchange, political and economic uncertainties as well. Professional managers can sometimes help to mitigate these risks by monitoring international market developments and by adopting strategies to hedge against currency exchange rates. However, the additional time involved in managing these risks will usually result in higher management fees. 

There are also international bond funds that invest in the area of emerging market bonds. Investing in emerging markets involves greater risk and potential reward than investing in more established markets. These markets tend to help when trade barriers are reduced (as is the case with NAFTA), or when privatization occurs in formerly communist or socialist countries. However, the risks associated with emerging markets include the risks relating to the relatively smaller size and lesser liquidity of these markets, high inflation rates, and also adverse political developments.

Investing a small percentage of your assets in international bond funds could potentially increase your income by giving you the opportunity to profit from growth in other economies. However, you should have a complete understanding of the associated risks of these investments.

The biggest risk (and potential reward) is the change in the currency rate relative to the US dollar.  For 2008, you would have been well off being in the US dollar as it did well realtive to other currencies.  But had you held Japanese Government Bonds, you could have gained 23%–just having your funds in a Japanese treasury bills as seen below (click on chart to see full view)

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Most people think about charitable bequests as part of their will or trust to be consummated when they die.  However, you will miss some senior tax breaks if you wait until death.   If you attend to these charitable giving issues while alive, there are some big tax breaks available and a decent income for life.

Charities are happy to pay you money if you help them. It’s called a charitable gift annuity and here’s how it works. You make a single contribution and based on the amount of that contribution, your age and current interest rates, you receive a set income for life.  Think of this like making any other retirement income investment.  You invest and get a lifetime income.

Don’t shop around with charities for the highest rate of return, though, because most large U.S. charities offer yields set annually by the American Council on Gift Annuities in Dallas. This benign collusion among charities, which began casually about 70 years ago, was finally legalized by Congress.

A gift annuity’s yield varies according to your age and the date you make your gift (see table below effective 1/1/09). Since a portion of your income will be considered a return of principal, part of your annual income will be tax-free. How much depends on your age. Additionally, you get a tax deduction for your gift as shown on the above table.

Age                  Payout Rate Deduction as % of gift
65                         5.7                34.2
70                         6.1                38.4
75                         6.7                43.4
80                         7.6                48.3
85                         8.9                51.9
90 and over         10.5 

If you have charitable intentions but want to retain income from your donation, most any charity will show you how to set up a charitable gift annuity.  Your donation does not need to be cash—you could donate appreciated securities or land that currently pays you nothing and also save on capital gains tax.

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People invest in variable annuities for many reasons including the tax-deferral of earnings, the ability to name beneficiaries and avoid probate, the growth potential of the managed sub-accounts and potentially the death benefit.

Then whenever they are ready to withdraw an income from their annuity, they have the opportunity to select lifetime income payments. However, with a variable annuity you do not know what that income will be when you open the account since the future value can vary depending on the investment’s performance. Sometimes though, investors overlook an important option that may help them plan for a predictable income.
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The Guaranteed Minimum Payment (GMP) option assures that you will receive no less than a specific amount of income each month, no matter what the markets do. And if the investments go up, your future monthly income goes up too.
How the GMP is determined varies among annuity companies. One example is to base it on the greater of:
• The value of your purchase compounded at 6% a year, or
• The highest account balance reached on any contract anniversary date

Another version of the GMP promises that future payouts will never be less than a certain percentage, say 80%, of your first payment. For instance if your first check is for $1,000, future distributions will be no less than $800, regardless of what happens to the markets and the value of your sub accounts.

The trade-off for this GMP rider is the extra cost.  These costs can range from .1 to .5% of your annuity value ($100 to $500 annually on a $100,000 variable annuity).  So you must read the prospectus to see what you pay for this benefit.  And ask the retirement consultant you use to compare different companies for you or based on what comparison did he decide on recommending a particular annuity (If it becomes obvious he has not done any comparisons, go elsewhere. Better yet, ask him what he thought of Professor Moshe Milevsky’s paper on this issue and if he is unfamiliar, you’re dealing with a salesperson, not a professional).

recommended:  http://econpapers.repec.org/article/eeeinsuma/v_3A38_3Ay_3A2006_3Ai_3A1_3Ap_3A21-38.htm

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Perhaps noments word is scarier to a fixed income investor than inflation – especially for those who depend on the yields from bond investments for their retirement income needs. For example, inflation can reduce the payout rate of bonds over the long-term, as the higher costs of living can often weaken the purchasing power of bond’s return over time.

However, retirement investors can factor in the effects of inflation in their investment portfolios. You can also help protect your portfolio and your cash flow from inflation by adding Treasury inflation-protected securities (or TIPS) to the bond portion of a diversified investment portfolio. In these times, with talk of asset deflation TIPS are also a reliable choice as the principal is not reduced for deflation as it is increased for inflation as explained below.

TIPS were introduced a few years ago by the U.S. Treasury to offer investors a means to protect assets from inflation. TIPS help to protect against inflation by adjusting the principal amount by a rate equal to the Consumer Price Index (CPI) – the primary barometer of inflation on the consumer level. When the bond reaches maturity, the TIPS investor receives either the principal value of the bond adjusted for the CPI rate over the term of the bond or the bond’s original par value, whichever is greater upon maturity (and thus protection from deflation). The TIPS investor also receives the interest amount on the bond. Because the principal amount of the TIPS bond rises over time, this helps to protect the purchasing power of the bond. Every 6 months when the investor receives interest, the interest is based on the inflation adjusted value of the bond so your income rises with time in an inflationary environment.

TIPS can also be a suitable choice for a diversified portfolio, because they have a low correlation with stocks and other bond securities. That means they often react differently than stocks and other bonds to market and interest rate risks and can potentially reduce the volatility of your overall portfolio. However, TIPS are not a risk-proof investment. To receive the full inflation-protection potential of a TIPS holding, it must be held for the term of the bond. Also, TIPS may under perform regular Treasury bonds, should inflation remain low. In a deflationary environment, TIPS could also lose value, although investors would be guaranteed to receive at least the par value of the security upon maturity. The key is to buy and hold to maturity.

TIPS may also provide you with some tax benefits. Like other Treasury notes and bonds, TIPS are exempt form state and local income taxes but interest payments are subject to federal income tax. However, gains from inflation adjustments to the value of the TIPS’ principal are taxable in the year they occur, even though you won’t get the cash until maturity.

Should asset deflation occur, the value of stocks, real estate and other assets fall.  But since your TIPS are protected form deflation when held to maturity, your maturing TIPS would buy more of the deflated assets.

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