Retirement Income Blog

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 First, your principal contributions from the Roth can be withdrawn without occurring any tax.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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Use of nontraditional mortgages has increased among home buyers, according to a Wall Street Journal Online/Harris Interactive poll–could you benefit too?

There are four major types of non-traditional mortgages:

1. Interest-only mortgages, which have received considerable media attention as home prices have skyrocketed, allow borrowers to pay interest but no principal during the early years of the loan.
2. Piggyback mortgages combine a standard first mortgage with a home-equity loan or line of credit, thereby allowing the borrower to avoid paying private mortgage insurance or higher interest rates on jumbo loans.
3. Miss-a-payment mortgages let borrowers skip up to two mortgage payments per year, and up to 10 payments over the life of the loan, without damaging their credit rating.
4. Payment option mortgages give borrowers four-payment options–not when they take out the mortgage, but every single month.
   These include
   1) a payment based on a 30-year amortization table which, if made every month, will pay off the mortgage in 30 years;
   2) a payment based on a 15-year amortization table, which, if made every month, will pay off the mortgage in 15 years;
   3) an interest-only payment, in which the principal balance will remain unchanged; and
   4) a partial-interest payment, in which part of the interest is deferred and added to the principal balance.

The chart below illustrates the reduced payment on an interest-only loan.

Source: Archer Pacific, as of October 2006 (www.archerpacific.com/compare%204%20mortgage%20loans%20calculator.html). This example is hypothetical. You may not be eligible for any of these loans, and if you are, interest rates on loans will vary based on your financial circumstances and prevailing interest rates.

If you want to buy more house than you can afford with a traditional mortgage, these options can be good tools, and more people are using them. The Wall Street Journal Online/Harris Interactive survey found increased usage of three of four types of nontraditional mortgages from 2005 to 2006.

But borrower beware: Non-traditional mortgages can be riskier than standard fixed-rate or adjustable-rate mortgages. For example, with payment option mortgages, borrowers who elect to make the minimum payment could see their loan balance rise, rather than fall. That’s because the deferred principal and interest payments get tacked onto the home owner’s total debt, a process known as negative amortization.

Specifically for seniors are reverse mortgages.  If you have sufficient equity, these will allow you to pay off your traditional mortgage and even pay you.

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As one spouse of a married couple, you must choose when you will start collecting Social Security benefits. And when you do–whether you will receive Social Security benefits based on your own earnings or as a spouse’s entitlement based on his or her social security benefits. The ‘entitled spousal’ amount maximizes out at 50% of the other spouse’s benefits. You will naturally receive the higher of these two options.
But if your spouse is receiving social security benefits when he or she dies, you are entitled  –as the surviving spouse–to 100% of his or her Social Security payment rather than the maximum 50%. In this case, you will choose the larger of that benefit or the Social Security benefit based on your own earnings. Let’s consider an example.

John and Jane are married and both are collecting social security. John receives a monthly benefit of $1,200. Jane collects another $600 of monthly benefit as the ‘spouse’s entitlement’. This is larger than the $500 per month she would collect based on her own earnings history. If Jane survives John, she would naturally file for 100% of John’s benefit–$1,200 per month.

Alternatively, if Jane’s monthly benefits were $1,000 based on her own earnings history, she would not have collected the lower ‘spouse’s entitlement’ of $600 per month while John was living. But at John’s death she will file for his $1,200 monthly benefit as a spouse’s entitlement, since it is greater than her own benefit.
Incidentally, your deceased spouse is not entitled to a Social Security benefit for the month he or she dies. So when the payment is made on the third of the next month, you should return it to the SSA. But as surviving spouse, you will receive a $255 death benefit.

As surviving spouse, you can begin receiving benefits as early as 60 years of age. See the Table for a summary of circumstances. Benefits are naturally reduced for beginning ‘survivor benefits’ before 65. See the table below for a summary.

What about remarriage?
If you are getting survivor benefits, you will not lose them if you remarry after you are 60 years old. However, a person applying as a widow/widower cannot receive benefits if they remarry before the age of 60 unless the latter marriage ends, whether by death, divorce, or annulment.

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It’s common to find retirees who are asset rich and cash poor.  You may own some of these assets named below that don’t produce much or any income that you can convert to a much larger income stream.

Investment Real Estate
In many parts of the US, investments in rental houses or apartment buildings will yield less than 4% after expenses.  In other words, in the current value of the property is $1 million, you realize $40,000 or less in cash flow.  You could earn the same in a simple bank certificate of deposit.  Of course, the reason you purchase the real estate was for appreciation and that’s the #1 reason to invest in real estate.  But you may have now reached a stage of life where the cash flow is more important than future appreciation.  You can sell and reinvest for more cash flow.  (There are several methods to defer or avoid capital gains tax when selling real estate including a CRT and a 1035 exchange from residential to triple net commercial property which yields higher cash flow).  of course, raw land produces no cash flow and is the best candidate for conversion to an alternative retirement income option.

Your Residence
A reverse mortgage allows you to tap the equity in your home as income.  Many people don’t realize that the equity in their home has a yield of 0%.  Therefore, if you need income and are at least age 62, it’s easy and financially sensible to convert that equity into cash.  You make no payments on this mortgage as long as you reside in the home.  The main criticism of these mortgages is that the initial cost is higher than a conventional mortgage, typically 5% (e.g. $10,000 on a $200,000 mortgage).  But this is a foolish reason to  ignore this option because if you invest $190,000 that you receive in a 6% tax free bond, that’s $11,400 of tax free cash to enjoy that you did not have before. 

Your Life Insurance Policy
You can sell your insurance policy.  Many investors will buy policies from you for more than you can get if you surrender it to the insurance company.  These transactions are called insurance life settlements or senior life settlements.  The buyer will continue to pay premiums on your policy and collect the death benefit when you die.  But they will pay you cash today.  For example, if you have a $1 million policy (pays $1 million to your beneficiaries when you die), that may be worth $250,000 ore more to an investor, the price being a function of your age, health and type of policy.

Growth Mutual Funds
It’s not uncommon for a retiree to own growth mutual funds which pay very little in dividends.  In today’s market, you can buy plenty of high quality, “blue chip” stocks that pay dividends of 6% or higher.  So get out of growth mutual funds into value stocks with handsome dividends.

Just these few tips could increase retirement income so that retirement becomes financially most comfortable.

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Let’s first state three fundamental principles and then add the details.

1.      Start retirement with sufficient retirement savings

2.      Protect your retirement savings from erosion due to taxes and inflation

3.      Never lose money

Start with your desired retirement income and expenses.  Then, you can use a retirement income calculator to determine how much retirement savings you will need. You need to know how large of a nest egg is required for a comfortable retirement.  Most people don’t like to do this rigorous exercise of charting your expenses and income over time.  If you won’t do it, then hire a retirement planner who will.  I highly recommend the retirement planning software from J&L planners as it allows you to account for detailed changes in your income and expenses year by year.  Only by doing the math do you know how much you need and when you are able to retire. 

Next, you need to take advantage of as much tax shelter as possible.  For most retirees, that means using your unsheltered money first (e.g. your non-IRA, non-401k funds) .  You want to let your tax sheltered money grow as long as possible.  The caveat here is the uncertainty of future tax rates. Future income tax rates may be higher than today. You can have a retirement planner calculate for you the tax rate at which it is better to use your sheltered funds first.  In fact, understand that the plans you make at the beginning of retirement can change because of changes in tax rates or other variables.  That’s why smart retirees will update their retirement plan every 24 months.

Last, you need to be sure your principal never declines.  That would seem impossible based on the advice in the retirement-Income.net web site that recommends you keep 50% of your funds in stocks and everyone knows stocks go up as well as down.  BUT, you will never rely on these stocks for retirement income.  Your money will always be in at least 2 baskets—your liquidity basket from which you make withdrawals for your living expenses and your growth basket which replenishes your liquidity basket at long intervals.  You will never take funds from your growth basket to live on and the long intervals create a very high probability that you will only have gains in your growth basket between transfers to your liquidity basket.  Consider for example that over the last 80 years, when stocks have been left alone for 10 year time intervals, they gained in value 97% of the time.

Of course, in terms of protecting your retirement savings, there may be other asset protection measures such as trust and estate planning that you do for your heirs.

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One of the advantages of immediate fixed annuities is the feature that provides you with income for the rest of your life, for both you and your spouse, or simply to pay you for a fixed number of years. But what’s the best choice for you? Let’s consider some payouts based on annuity type and other factors to get a feel for what to potentially expect.

We’ll hypothetically assume a man has $50,000 to invest in an annuity. He’s 70 years old with a remaining average life expectancy of 16 years. What kind of payouts can he expect to get?

If he wants an immediate fixed life annuity on himself, a hypothetical insurance company  determines a monthly payout for him based on his sex, age, investment amount, and the current interest rate. The current interest rate is particularly important since their profit will be based on how much they’ll get for investing his $50,000. They’re predicting the man will die 16 years later (at least that’s their bet based on the average life expectancy of males age 70) so they know how many monthly payments they must make. They’re obliged to keep paying if the man lives longer, but also get to keep the investment if the he dies earlier than expected.

Life Expectancy
In our hypothetical case, the monthly payout is $385.  Incidentally, if the man were 80 years old his remaining life expectancy would be 11 years. So the insurance company would pay out $554 per month since they’ll be statistically paying for fewer months.

Gender
Women statistically live longer than men. A 70 year old woman has a remaining life expectancy of 20 years. This implies more monthly payouts by the insurance company so her payout is only $352 for that $50,000 investment. And if she were 80 years old, her monthly payout would be $498 – somewhat less that then 80 year old man’s, because of her still longer life expectancy.

Joint Life
A married couple may opt for a joint life annuity where payments will continue until the second spouse dies. In the case that both are 70 years old, the insurance company would pay $318 since statistically it turns out that between the two, the survivor would statistically live longer. The payout remains the same even if only one remains alive 

Finally, if the single 70 year old man chose an annuity for a certain period – 10 years – under the prevailing rates, he’d receive $515. But in this case, the insurance company would pay his beneficiary the remaining payments if he died. The payout is the same for the women since there’s no age or age-related sex difference issue here.

For the most current rates, use the immediate annuity calculator.

Immediate fixed annuities are the payment of a single premium to an insurance company in return for periodic payments over a specific period or life.  Once payments begin, the annuity cannot be surrendered for value (there are a few companies that do allow commutation–the surrender of the annuity for a discounted refund).  Income from annuitization is taxed part as ordinary income and part as return of capital and a 10% penalty could apply if the recipient is under age 59 1/2. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. For other ways to generate income in retirement, visit the retirement planning center.

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Let’s work up the ladder of rates that you can get from guaranteed retirement income sources. We skip treasury securities because bank deposits pay more and they also have a federal guarantee (up to $250,000 per depositor through 12/31/2009)

Bank Certificates of Deposit – in terms from 3 months to 5 years.  Generally, the longer the term, the higher the rate.  Interest is available monthly for a guaranteed retirement income or can compound. FDIC insured.  Rates available daily across the US at bankrate.com.   One year CD is 4% at most banks as of 10/28/08.  After inflation and taxes, you actually lose money.  Therefore, holding large sums for long periods in CDs is financially foolish.

Annuities—guaranteed by the issuing insurance company, safest companies rated AAA by Standard and Poors.  Large companies like Prudential and New York Life actually lent money to the US Government during the depression so deposits with them are pretty safe.  Use deferred annuities  (paying 5% or so) if you don’t need the income or immediate annuities if you need the income (often called retirement annuities).  A 70 year old male can get $769/month for life on a $100,000 deposit (equal to a 9.2% cash on cash return).  Payments end at death and nothing is left.  Some immediate annuities provide a feature for payments to heirs in case of early death.

Federally Backed Mortgage Notes—Although you’ve heard a lot in the news about Fannie Mae and Freddie Mac, the US government has backed their securities 100% giving them AAA safety.  The same goes for Ginnie Mae Securities.  Your money gets loaned for mortgages and the government agency guarantees your investment.  At 15 years, rates approximately 6%.  Actual term is uncertain as people can pay off their mortgages early.  Income is monthly.

Municipal bonds—a source of guaranteed retirement income from cities, states or municipal districts.  Buy those rated AAA for best security. Income is paid twice annually. Or, for another idea of guaranteed retirement income, build a ladder of zero-coupon municipal bonds.  Interest and principal is paid all at once at maturity.  Example:  male age 52 buys $75,000 face value of municipal bonds to mature starting at age 62 and for each year thereafter for 20 years to provide $75,000 of tax free income annually.  Cost today of each bond averages less than 40 cents per face value. Yields of 6% tax free currently.

Corporate bonds and preferred shares can be are a reliable source of guaranteed retirement income from corporations.  Again, for safety, buy those that are highly rated, at least A.  Some opportunities to get 8% at the current time.  Bonds pay interest twice annually and preferred shares pay dividends quarterly.  Dividends from preferred shares qualify for a reduced 15% income tax to help with tax planning.

Diversify amongst these guaranteed sources of retirement income and enjoy a more comfortable senior citizen retirement.

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A 457 retirement plan is a non-qualified (i.e. does not need to meet the restrictions set up by IRS under section 401) deferred compensation plan for government employees and tax-exempt organizations. The plan designed to comply with the rules of Internal Revenue Code section 457 is referred to as a Section 457 retirement plan. Employees are allowed to defer compensation on a pre-tax basis through payroll deductions that further allows them to defer federal and sometimes state taxes until the assets are withdrawn. In effect, a 457 retirement is quite similar to a 401k plan used by for-profit employers.

Participants in the Section 457 retirement plan can defer income up to 100% of the employee’s compensation limited to an annual amount set by IRS–$15,500 for 2008 plus a $5,000 catch-up contribution for people age 50+.

The types of entities that can establish a 457 retirement plan are states, subdivisions of states, instrumentalities or political subdivisions of states, or any entity other than a governmental unit that is exempt from federal income taxes. Governmental units that are exempt from federal income taxes include the following types of organizations:

charitable organizations
religious organizations
educational organizations
private hospitals
private foundations
labor unions
trade associations
fraternal orders
farmers cooperatives

Note that these tax exempt entities may also have a 401k plan for their employees and the employees may contribute to both plans up to the $15,500 maximum for each. There are no contributions by the employer with 457 retirement plans as there are with 401k plans. Additionally, your account in a 457 retirement plan can be rolled over just like a 401k, into an IRA or other qualifying tax sheltered plans. Unlike a 401k, if you retire or leave an employer before age 59 1/2, there is no 10% penalty for accessing your 457 retirement plan balance. Typically, employers that provide a 457 retirement plan will also provide assistant from retirement consultants to help understand the intricacies.

Below is a chart showing the differences and similarities between a 457 retirement plan and 401k plan. If you are eligible to participate in a 457 retirement plan, the decision to contribute would be part of the considerations of your whole retirement income plan.

Post provided by Javelin Marketing

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There are several types of employer sponsored retirement plans and your employer likely provides ONE of these.  You don’t have a choice but you want to have a basic understanding of the plan being offered to you and you want to participate as a way to maximize your retirement investing. Employers have these plans in place as a benefit that helps then attract better employees.  By making use of the plan, there is typically a tax savings to you.  In prior years, the money that went into the plan was contributed by the employer but that’s less and less true.  Most employer sponsored retirement plans now call for contributions from the employee such as 401k plans in for-profit companies and 401 and 403 plans in non-profits.
Employer sponsored retirement plans are called qualified plans because they comply with section 401(a) of the Internal Revenue Code. Employer contributions are tax-deductible and may be subject to vesting schedules. Participant contributions are always immediately vested. All contributions (employer and participant) and earnings are tax-deferred until they’re withdrawn.
Money purchase plans
A money purchase plan is a pension plan that has a mandatory annual contribution by the company. Company contributions can be as high as 25% of wages, up to IRS limits which change annually. The contribution formula is set by the plan terms. Contributions can be subjected to a vesting schedule. For example, if you leave after 2 years of employment, you may get 20% of your accounts value, after 3 years, 30% of your account value, and so on.
Profit-sharing plans
This is not a good name because profit sharing plans have nothing to do with sharing profits. In fact, with a profit-sharing plan the company management arbitrarily decides how much to contribute to the plan each year, up to 25% of wages. Vesting typically applies as described above as it does with most any employer sponsored retirement plan where the employer is contributing money.
401(k) plans
Most popular in for profit companies is the 401k because the company does not need to contribute anything to the plan, although many companies do.  These employer sponsored retirement plans allow you, the employee, to contribute funds for your retirement, similar to putting money in an IRA but you can contribute more to a 401k. By making pretax contributions, participants have an opportunity to reduce their current taxable income while saving for retirement. Some 401k plans also allow Roth contributions (no tax deduction today, but all earnings are withdrawn tax free, thereby maximizing retirement income).  Some companies provide a matching contribution as an extra incentive for the participants to contribute.

Participant deferrals do not count toward the deductible limits. Matching contributions may be subjected to a vesting schedule. Both participant and employer-matching contributions are subject to discrimination testing which is a way that the government insures that the plan is benefiting many employees, not just the highly paid.
Other employer sponsored retirement plans:
Simplified Employee Pension plans (SEP)

SEP contributions are funded with employer discretionary contributions and can be up to 25% of pay for each eligible employee. Participant contributions are not allowed except for some SARSEP plans still in existence. All employer contributions are made to IRAs for the benefit of the eligible employees and are 100% immediately vested. Contributions and earnings grow tax-deferred until the money is withdrawn by the participant but these types of plans have become less popular with the increased use of 401k plans.
Savings Incentive Match Plans for Employees (SIMPLE) IRAs
A SIMPLE IRA is a retirement plan for small businesses. The company must either match participant contributions (dollar for dollar up to 3% of pay) or make a contribution of 2% of pay for all eligible participants. Contributions are 100% immediately vested. To sponsor a SIMPLE, a business cannot have more than 100 eligible employees during the preceding calendar year.
403(b) plans
A 403(b) is a retirement plan for employees 501(c)(3) organizations on-profit organizations. Participants can make pretax contributions of up to $15,500 for 2008. Some organizations match participant contributions. Similar to a 401(k) plan, participant pretax contributions are 100% immediately vested, but matching contributions may be subjected to a vesting schedule.

Here are the contribution limits for 2008:

Employer-Sponsored Retirement Plans — 2008 Contributions

^* For individuals who are age 50 or older.

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