Scott Peterson was a guest writer on the popular White Coat Investor blog—a blog esteemed amongst physicians and other high-income professionals. Scott’s blog outlines our proprietary process for investing, The Perennial Income Model™. The article also presents a retirement income plan creation example of a couple who have accumulated $1 million for their retirement.
“You must pay taxes. But there is no law that says you gotta leave a tip.” -Morgan Stanley
How can any retiree make a good decision about reducing taxes in retirement, or any financial professional recommend a proper course of action, without first mapping out, and projecting a future income stream?
The answer is . . . they can’t. Retirees often end up making only short-term, immediate tax-saving decisions, while missing out on more advantageous, long-term tax reduction opportunities because neither they nor their advisor project income streams across a full retirement. Focusing only on the current tax year ends up costing retirees many thousands of dollars because they fail to recognize, and then to organize, their finances to take advantage of long-term opportunities to reduce taxes.
A comprehensive retirement income plan must consider a lifetime tax reduction strategy that focuses on how today’s decisions to withdraw money from the various types of accounts will impact their tax liability years into the future. The Perennial Income Model™ is the ideal tool to help retirees recognize and organize long-term tax-saving opportunities to keep more of their wealth.
Three retirement account tax categories
Before looking at strategies to maximize your lifetime tax savings, you must first understand the categories of retirement accounts and the tax implications of each. How your investments are taxed depends on the type of account in which they are held. There are three categories of accounts to consider:
Tax-deferred retirement accounts
The money in IRAs/401(k)s and a variety of other company-sponsored retirement saving plans are 100% taxable upon withdrawal unless you use the Qualified Charitable Distributions exception (to be explained). Non-IRA annuities can likewise be lumped into this category with the exception that only the interest earned on the non-IRA annuity is taxed upon withdrawal, not the entire value of the annuity.
Tax-free retirement accounts
The funds in Roth IRAs and Roth 401(k)s can be withdrawn tax-free.
Non-retirement accounts (after-tax money)
Investments that are individually owned, jointly owned, or trust owned have their dividends and interest taxed annually. They are also subject to capital gains taxation in years when investments are sold at a profit.
Three strategies to reduce your taxes in retirement
At Peterson Wealth Advisors we use our Perennial Income Model to provide the organizational structure to recognize and benefit from major opportunities to reduce your taxes. Let’s consider three of these tax-saving strategies that can benefit you in retirement:
1. Managing investment income according to tax brackets
Thankfully, your retirement income stream can come from a mix of tax-deferred, tax-free, and non-retirement accounts used in combination to lower your tax liability. Even though income stemming from tax-deferred accounts is 100% taxable, Roth IRA funds can be withdrawn tax-free and money coming from non-retirement accounts hold investment dollars that can oftentimes be withdrawn with limited tax consequences.
The key is to determine which of the above categories of accounts should be tapped for future income needs . . . and when. Tax-efficient income streams that are thoughtfully mapped out at the beginning of a retirement, as we do with the Perennial Income Model, can be extremely effective to help minimize your lifetime tax burden. With advanced planning, you can avoid the costly mistakes of conventional wisdom: paying almost zero tax from retirement date to age 72, then paying high taxes and higher Medicare premiums until death. The Perennial Income Model shows us that it is better to pay minimal taxes from retirement date to age 72, along with how to be able to pay minimal taxes and minimal Medicare premiums from age 72 to death. When you structure your retirement income streams from a variety of tax locations within your portfolios, thoughtfully planned out, you can experience a higher standard of living while still paying very low tax rates.
2. Qualified Charitable Distributions
The most overlooked, least understood, and one of the most profitable tax benefits recognized by forecasting income streams through the Perennial Income Model comes from the use of Qualified Charitable Distributions. A Qualified Charitable Distribution, or a QCD, is a provision of the tax code that allows a withdrawal from an IRA to be tax-free if that withdrawal is paid directly to a qualified charity. Our clientele consists of retired people who regularly donate generous sums to charities. By simply altering the way contributions are made to charity, you can make the same charitable contribution amounts and reduce your taxes at the same time.
The ability to transfer money tax-free from an IRA to a charity has been around for a while, but the doubling of the standard deduction from the 2018 Tax Cuts and Jobs Act, was the catalyst that brought this valuable benefit to the forefront. With larger standard deductions, only 10% of taxpayers itemize deductions. Here is the catch: you only get a tax benefit from making charitable contributions if you itemize your deductions, and with the higher standard deduction, fewer of us will be itemizing. So, a 65-year-old single taxpayer, with no other itemized deductions, could end up contributing up to $13,000 and a 65-year-old couple could end up contributing up to $27,000 to charity and it would not make any difference on their tax returns, or their tax liability, because both generous charitable contribution amounts were lower than the standard deduction. So, they will just end up taking the standard deduction. Another way of saying this is that these charitable donors will not receive a penny’s worth of tax benefit for giving so generously to charity.
Doing a direct transfer of funds to a charity by doing a QCD versus the traditional writing a check to a charity, can restore tax benefits lost to charitable donors. QCDs are only available to people older than age 70 1/2, they are only available when distributions come from IRA accounts, and a maximum of $100,000 of IRA money per person is allowed to be transferred via QCD to charities each year.
3. Roth IRA Conversions
Converting a tax-deferred IRA into a tax-free Roth IRA can be a valuable tool in the quest to reduce taxes during retirement. Unfortunately, few retirees get it right deciding when to do a Roth conversion, deciding how much of their traditional IRA they should convert, or even deciding if they should convert any of their traditional IRAs at all. Without a projection of future income that the Perennial Income Model provides and the subsequent projection of future tax liability, it is virtually impossible to determine whether a Roth IRA conversion is the right course of action. Perhaps the greatest unanticipated benefit that we have observed since creating the Perennial Income Model is its ability to clearly estimate future cash flows and subsequent future tax obligations for our retired clients. Given this information, the decision whether to do a Roth conversion becomes apparent.
As advantageous as Roth IRA conversions can be, they are not free! The price you pay to convert a traditional IRA to a Roth IRA comes in the form of immediate taxation. 100% of the conversion amount is taxable in the year of the conversion. For this reason, investors must carefully weigh whether doing a Roth conversion will improve their bottom line.
Too much of a good thing usually turns a good thing into a bad thing. So, it is with Roth conversions. Excessively converting traditional IRAs into Roth IRAs without fully considering the tax consequences, can cause some investors to pay more tax than they otherwise would if they didn’t do a Roth conversion in the first place. So, it’s important to recognize when, and when not, to do a Roth conversion.
The Perennial Income Model™ as a tax planner
We first designed the Perennial Income Model to provide the structure to reinforce rational decision-making. It started with a focus on helping retirees match their current investments with their future income needs. Now, we see that the Perennial Income Model’s role is much bigger, including providing the benefit of reducing your taxes throughout the entirety of your retirement.
The Perennial Income Model™ was created and launched in 2007. Through all the ups and downs of the stock market, it has withstood the test of time. The initial goal of the model was to provide a logical format for investing and for generating inflation-adjusted income from investments during retirement. In the beginning, we did not fully anticipate all the accompanying benefits that would result from projecting a retiree’s income over such a long timeframe. However, our eyes have been opened to a number of benefits, one of them being how the Perennial Income Model acts as a ‘bad luck insurance policy’.
The Perennial Income Model can help protect your retirement income during a bad market
The Perennial Income Model can protect you if you are unlucky and happen to retire about the same time as a stock market crash. Every stock market correction is temporary, but that knowledge isn’t helpful if you are ill-prepared and are having to liquidate equities in down markets to support yourself.
Let me share with you an example, Mike had been carefully planning for his retirement for years and it was finally his turn. He wanted to be conservative as he selected investments for his retirement years, but he knew enough about investing to realize that a good part of his investment portfolio had to be invested into equities if he was going to keep ahead of inflation.
So, he reluctantly invested more than half of his portfolio in stock-related investments. Mike retired, and almost immediately his worst fears were realized, as the stock market dropped by 50%. His money was invested in a balanced mutual fund that was composed of 60% stock and 40% bonds. Unlike the working years, Mike couldn’t just wait for the stock market to recover, he had to withdraw a portion of his money every month from his mutual fund just to pay the bills. As Mike withdrew his monthly stipend, he realized that he was liquidating a proportional amount of stocks and bonds each month from his balanced mutual fund. This meant, he was systematically selling stocks at a loss every month that the stock market was down, and it could take months, or even a couple of years before the stock market recovered.
Mike was frustrated, and even a little angry. He thought to himself, “why did this happen to me? I anticipated, and planned for, every contingency of my retirement in detail, then the one thing that I have no control over trips me up. I must be the unluckiest person on the planet!”
Mike is not alone; this exact scenario happens and will continue to happen to millions of new retirees every time there is a market correction. It’s true when we are no longer contributing and we begin taking withdrawals from our accounts, the temporary ups and downs of the market can have a much bigger impact on our investments than when we were working and had time to wait out market corrections.
To be clear, Mike’s mistake wasn’t in being too aggressively invested because a 60% stock, 40% bond portfolio is a very reasonable allocation for a new retiree. His mistake was failing to have a plan that allowed him to only liquidate the least impacted, non-stock portion of his portfolio to provide immediate income during a market downturn.
To illustrate this point, let’s take the example of two investors, Mr. Green and Mr. Red. Both have decided to retire at age 65 and both have saved up a $1,000,000 nest egg. Each of them plan to withdraw 5% of their initial balance each year to have an annual income of $50,000. As you can see from the table, both average the same 6% return during their 25-year retirements, but Mr. Green ends up with more than $2,500,000 to pass on to his heirs at death, while Mr. Red runs out of money halfway through his retirement. How can this be?
Every aspect of their retirement experience is identical except for one thing: the sequence of their investment returns.
As you can see from the chart, Mr. Green experiences overall positive returns at the beginning of his retirement and a string of negative returns towards the end. Mr. Red experiences the same returns only in reverse. He goes through a series of negative returns at the beginning of retirement and the more positive returns come at the end. Again, both investors average the same 6% return over their 25 years of retirement. The sequence of those returns is the only difference. We can see from the table just how much of a difference the order of returns makes.
Set yourself up for retirement success
The good news is that it’s possible to set ourselves up to be successful no matter what the markets happen to do year by year. The Perennial Income Model is the bad luck insurance policy that can protect you from the pitfalls that Mr. Red experienced.
I’m not suggesting that following the Perennial Income Model will guarantee that your account balance will never go down, or suffer temporarily because it will. What I am saying is, that by following the Perennial Income Model, you shouldn’t find yourself having to sell stocks at a loss during a stock market correction.
Mr. Red’s losses are realized as he liquidates equities in down years at a loss to cover his expenses. If Mr. Red were to have his portfolio organized according to the investment regimen provided by the Perennial Income Model, he would not be in a position where he would have to liquidate stocks in down years to provide income. He would have a buffer of conservative investments to draw income from while giving the more aggressive part of his portfolio a chance to rebound when the stock market temporarily experiences periods of turbulence.
The Perennial Income Model’s design is intended to give immediate income from safe, low-volatility types of investments. At the same time, it furnishes you with long-term, inflation-fighting equities in your portfolio, equities that won’t be called upon to provide income for years down the road. Market corrections typically last for months, not years. So, even if you are the unluckiest person on the planet and your retirement coincides with a market crash, your long-term retirement plans won’t be derailed as long as you are following the investment guidelines found within the Perennial Income Model.
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Creating a retirement plan can be a daunting task. At Peterson Wealth Advisors, we use our propriety process, the Perennial Income Model™, which outlines three ‘building blocks’ to a retirement plan. Whether you use the Perennial Income Model or another type of retirement plan, these building blocks will make sure you are on the right track to a successful retirement.
The three building blocks to a retirement plan are income and investments, taxes, and legacy. If your plan is built on these three blocks you should have the necessary information to answer the following crucial questions retirement planning questions.
4 Questions your Retirement Plan Should Answer
1. Do I have enough money to satisfy my income needs in retirement?
2. How do I invest my money to ensure this income lasts throughout retirement?
3. What can I do to protect my income from taxes?
4. How can I make sure my money goes to who I want it to go to when I want it to go to them?
If your retirement plan doesn’t give you the necessary information to answer those four questions, then it’s a poor plan and you should find something better. If it does, then you’re on the right track.
3 Building Blocks to a Retirement Plan
Block 1: Income and Investments
The income and investment block is the foundation to a retirement plan. Income and investments go hand in hand because how much income you can expect to have in retirement is determined in large part on how you invest your money.
The income portion of the block is where your different sources of retirement income – investments, social security, pensions, rentals, etc. – are gathered to create a consistent single stream of income throughout your retirement. To maximize your income, you must look at each source in the context of your entire plan, not in a vacuum. For example, the goal is not to maximize your Social Security income, but the goal is to maximize your retirement income.
The investment portion of the block determines how to invest your money while balancing risk and return. The money you need to live off in the early years of retirement needs to be invested conservatively to limit volatility, where the money you don’t need for decades needs to be invested aggressively to keep pace with inflation.
The Perennial Income Model achieves both these objectives, letting you know how much income you can expect to have in retirement and how to invest your money to ensure your income lasts throughout retirement. It’s up to you to determine if this amount of income will satisfy your income needs in retirement.
Block 2: Taxes
The goal of tax planning is to pay the least amount of income tax, not just in the first year of retirement but throughout all of retirement. Knowing what your income will be over the next 30 years allows you to build a long-term tax plan. This is exactly what the Perennial Income Model does, allowing you to build an efficient tax plan throughout your retirement.
The different tax strategies that can be used are beyond the scope of this post, you can learn more about them here, but they include using tax-efficient investment funds, minimizing Required Minimum Distributions, utilizing Roth conversion, and charitable giving strategies.
Block 3: Legacy
Once your income is secure throughout retirement you move on to the Legacy building block.
The goal of the Legacy building block is to effectively and efficiently transfer your assets to who you want them to go to when you die.
Knowing how much you will have at the end of your retirement plan gives you the insight needed to make those decisions and to know if you should be concerned about estate taxes. People typically fall into one of three groups:
- Simple: This group wants their money split evenly between their heirs when they die, and their estate isn’t large enough to be affected by estate taxes (an individual’s estate needs to be over $12.06 million, in 2022, before estate taxes affect it).
- Minor Complexity: This group wants more control, outlining when the money goes to their heirs and what they can use it for, and their estate still isn’t large enough to be affected by estate taxes.
- Complex: This group has a large enough estate where estate taxes will be a concern – they need to not only think about who will receive their money and when they will receive it, but also how they will avoid paying estate tax on their money.
The different estate tax strategies that can be used are more than can be covered here but they include creating a gifting plan, knowing which accounts should be donated to charity, and moving money out of your estate to avoid estate taxes.
The Perennial Income Model lets you know how much you will have at the end of your plan, giving you the necessary insight into how much you’d like your heirs to have and when they receive their money. It also allows you to know if you need an estate tax plan.
When presented with a retirement plan, whether it be by Peterson Wealth Advisors or someone else, you need to first ask yourself “will the income from this plan be enough for my retirement needs?” If the answer is yes, then ask your advisor these three crucial follow-up questions to make sure your retirement plan will succeed:
- How do I invest my money to ensure this income lasts throughout retirement?
- What can I do to protect my income from taxes?
- How can I make sure my money goes to who I want it to go to when I want it to go to them?
The Perennial Income Model is based upon the three building blocks of a retirement plan – income and investments, taxes, and legacy – giving you the necessary information to answer these retirement questions.
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