The Bogleheads' Guide to Retirement Planning (32 page)

If you take a lump-sum distribution, you should first open an IRA account and then roll the money into that account directly from your employment account. That will allow you to defer paying income tax on the lump-sum rollover amount until you begin withdrawals from the IRA during retirement. If you annuitize the account, then you will get steady income for life, although you will not be able to change this option once you make that decision.

 

Be aware that income taxes are due on all annuity income and on any lump sum that is not rolled into an IRA. A lump-sum distribution to a taxable account may well put you in a higher tax bracket. However, if you were born before 1936, you may qualify for 10-year income averaging. Consult your tax adviser.

 

Before making any decision on rolling over a lump sum into an IRA or taking an annuity payment you must be
thoroughly
familiar with the advantages and disadvantages of both. Part of that includes a complete understanding of benefits that go to your heirs. Once you annuitize, you cannot go back. If you take a lump sum, you can always take a portion of that amount and buy an SPIA, perhaps with a higher payout rate than is offered by your employer.

We are not ready to decide on withdrawal strategies just yet. First, you need to determine what income you have coming in before taking any money out of savings. Also, we will look at alternative retirement income sources that do not add to your taxable income.

Chapter 11 offers a great summary of Social Security benefits, and this is simply a recap. As discussed in Chapter 11, your benefits depend on when you retire and how much you put into Social Security over the years. When you are paid benefits, up to 85 percent of those benefits may be taxable. The taxation of Social Security creates a tax hump in that if you are normally in the 15 percent bracket, your effective tax rate can go from 15 percent to 27.75 percent during a certain income level and then back down to 15 percent. If you are below or in the middle of the Social Security tax hump, it may be best to avoid increasing taxable income by not taking distributions from IRA accounts and other accounts that may cause higher taxable income. However, once you are past this hump and still within the 15 percent bracket, you might as well use up the 15 percent bracket by taking taxable income out of tax-deferred retirement accounts. All these scenarios should be discussed with your tax adviser or calculated on your own with tax software.

Converting equity in your home to retirement income creates tax-free income. You can downsize to a less expensive home or area of the country. That could provide an immediate tax-free gain of up to $500,000 for a couple or $250,000 for a single person. A second option is to take out a home equity loan or reverse mortgage. That will provide you with tax-free income without having to sell your home. All of these maneuvers should be considered carefully.

Before retiring, spend some time thinking about housing. It often makes sense to downsize. You may no longer need that five-bedroom house on an acre of ground. Often, a two-bedroom townhouse will meet your needs nicely, and you’ll reduce a long list of expenses, including property taxes, utilities, insurance, and home maintenance expenses. Also consider location. If you do not already live near your family, you may want to relocate to be closer to your children and grandchildren. Or you may want to move to a warmer climate and/or a state with low taxes. You’ll also want to look toward the future when deciding where to live and consider how difficult it might be for your children to care for you long distance. Here is an example: if you own a fully paid-for home valued at $300,000 and you sell it to buy a new $200,000 home, the extra $100,000 can be used to generate income for retirement. If you move to a less expensive home, your housing expenses for electricity and property taxes should also go down.

If you are in a cash crunch and need steady income, a reverse mortgage provides you with a tool to access your home equity without having to move. Here’s how it works: a lender agrees to lend you money, and the amount you get is based on the equity in your home, your age and the age of your spouse, and current interest rates. The money can be paid out in one lump sum, paid out in monthly checks, drawn on as a line of credit, or some combination of these. If you choose monthly payments, these usually continue for as long as you live in the house. You do not have to make any payments. The interest on the loan compounds over the life of the loan. The loan is due when you die or when you sell the house. After the house is sold and the loan paid off, you or your heirs get to keep anything that is left. In most cases, if the value of the house goes down and more money was paid out than can be recovered by selling the house, you or your heirs are not liable for any shortfall.

There are disadvantages, and due to these disadvantages, a reverse mortgage is recommended only as a last resort. The money you get from a reverse mortgage is not free money; it just enables you to access a portion of your home equity. Your home equity is the difference between the value of your home and how much (if any) you owe on it. All banks and lenders are in business to make money, and a reverse mortgage lender is no different. Reverse mortgages are more expensive than traditional home loans. The reverse mortgage lender, not you, is taking on the risk that you live to be 100 years old because, for that entire time, they cannot ask for a payment from you. You usually need a lot of equity to qualify for a reverse mortgage. Reverse mortgage lenders do not offer you the full amount that your house is worth—after all, they’re not buying your home. You do not have unlimited amounts of home equity, and a reverse mortgage does not change that. It is merely a means of tapping into the home equity that you do have. You will qualify for a given amount of money up front. Once you use up that money, it is gone, although you will not owe any monthly payments. If you are concerned about running out of money, then you should choose the tenure income option, which guarantees you a monthly amount.

If you are retiring and have a mortgage, and you have excess savings available in your taxable account, consider paying off the mortgage. If you have owned your home for 20 or 25 years, there is a good chance a significant portion of your monthly payment is principal anyway. And since your retirement income puts you in a low tax bracket, you may no longer be getting a meaningful tax deduction on the mortgage interest. Many retirees take the standard deduction rather than itemize. Paying off the mortgage is the same as receiving a risk-free rate of return equal to the mortgage interest rate.

Paying off the mortgage also reduces risk. During significant market declines, one critical tool available to retirees is the ability to temporarily reduce spending. A monthly mortgage payment limits the amount of spending that can be reduced.

Although you may not count on receiving an inheritance, if you believe you have one coming, you may want it to play an important role in your retirement plan. You may or may not know the specifics of the financial situation of your parents or whoever is leaving you money, and even if you do, you don’t know the timing of the inheritance. Also, those leaving you money could suddenly need their money or decide to give much of it to charity. Only if you are the trustee over your parents’ assets or the beneficiary of an already funded trust should you count on an inheritance as a retirement fund source. Since receiving an inheritance is not a sure thing, the best thing to do is ignore it when planning unless you are guaranteed to receive it and confident of the amount.

Finally, we have come to the key question: How much should I withdraw, and which accounts should I take it from? There is not a one-size-fits-all answer. Some retirees have enough income from pensions and Social Security that they have no need for a fixed withdrawal from their portfolio. Others have no income from pensions and depend on their portfolio to provide the majority of their future income.

There are at least two different ways to think of withdrawing your assets. The first is a minimum tax scenario where you spend down most of your taxable money first and may end paying higher taxes later on. The second is where you pace your tax payments over time by taking money out of both taxable and tax-advantaged accounts.

Investments in taxable accounts generate taxable income, unless they are tax-free municipal bonds. Taxable bonds or bond mutual funds provide taxable income. Most stocks and stock mutual funds pay dividends that are taxed at a preferred dividend rate. You will owe taxes on income and dividends even if you don’t take the income out for expenses.

Investments in taxable accounts may not generate enough interest and dividend income to cover your liabilities. In that case, you can withdraw principal to supplement your income by selling some investments. That could generate a capital gain, on which you will have to pay taxes but at the more favorable capital gains tax rate.

There are no taxes due on tax-advantaged accounts unless you take money out. With Roth IRAs, there is never a tax due unless you take money out before age 59½ and pay a penalty. Traditional and rollover IRA accounts have required minimum distributions (RMDs) starting at age 70½. That means you must start taking out a minimum distribution and pay ordinary income tax on that amount, whether you want to or not. For more information, see IRS Publication 590.

The required amount is calculated by taking the value of your IRA as of December 31 of the previous year, divided by your life expectancy. If you have a spouse who is more than 10 years younger than you and is the sole beneficiary of your IRA, then you can use a joint life and last survivor expectancy table that will lower the minimum amount of the distribution. In a sense, our government is giving a tax break to people who marry a much younger person.

For example, John is 80 years old. The value of John’s IRA as of December 31, 2007, was $185,000. According to the uniform lifetime table, his life expectancy was 18.7 years, so his RMD for 2008 was $8,893 ($185,000/18.7). Now, if John’s wife was 30 years his junior, then the joint life expectancy is 33.6 years and his RMD for 2008 is only $5,500 ($185,000/33.6). Assuming John is in the 25 percent federal tax bracket, he would pay $848 less in federal taxes each year because his wife is 30 years his junior. The purpose for this is so that the IRA is made to last longer to support a younger spouse.

It is extremely important that you take your RMD each year because the penalty for not taking the RMD is 50 percent of the amount you should have taken. However, due to a poor stock market in 2009, the penalty for not taking an RMD was waived, effectively meaning that there are no RMDs in 2009 and no penalties for not taking a withdrawal.

If you have done budgeting for retirement and have calculated all the sources of income you will have from Social Security, pension plans, and perhaps rental property or as a silent partner in a business, then the shortfall in income must be replaced by investment withdrawals. How much is a safe withdrawal amount so that you do not outlive your money?

There are many Internet-based calculators that can help you decide on a sustainable withdrawal rate in retirement. The rule of thumb is 4 percent in early retirement. However, the true safe rate of withdrawal will depend on your life expectancy, your spending habits through retirement, and how your portfolio investments perform. For most of us, life expectancy is an unknown number, and there are no guarantees concerning how the investments in your accounts will perform in the future.

These historical return studies do not take investment expenses into account. If your safe withdrawal rate is 4 percent based on market returns, but you are paying a wrap fee of 1 percent and average fund expense ratios of another 1 percent, your actual safe withdrawal is only 2 percent. The same $100,000 now provides only $2,000 in income after 2 percent fees and expenses. It makes a lot of sense to reduce your investment expenses at any time, and it is particularly important in retirement.

The greater the amount you take over 4 percent in withdrawals, the less your heirs are likely to inherit when you pass away. Of course, the markets may be good to you and your heirs, but you should not count on a bull market to make your retirement plan work.

Many retirees end up withdrawing only part of their principal and leaving the balance to their heirs or to charity. You really need to ask yourself if you want to live frugally and leave the maximum amount to your heirs and/or charity, or if you want to enjoy your remaining years in style. The choice is up to you.

The 4 percent withdrawal rate can be used in two different ways in planning for retirement. The first is to withdraw 4 percent of the portfolio value in the first year and then increase that dollar amount by the rate of inflation each year. The second is to take 4 percent of the portfolio each year based on each year’s beginning value. The first method, where 4 percent is used initially and then annually adjusted for inflation, could jeopardize the long-term viability of your portfolio if the investments significantly decrease in value early in your retirement. The second method, withdrawing 4 percent of the current value of the portfolio each year, will result in your income varying along with your portfolio value, sometimes dramatically.