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The funds in Roth IRAs and Roth 401(k)s can be withdrawn tax-free.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.
An emergency fund is a portion of money set aside to be used as a buffer in the event of an emergency or for an unforeseen expense. During the accumulation phase of life, or the years in which a household is reliant on a paycheck and actively saving toward retirement, an emergency fund provides a safety net to balance the budget during events such as loss of work, an expensive medical bill, or a car repair. In every personal finance textbook, you will find details on how to best manage an emergency fund. However, most of these texts focus on the accumulation phase of life. They aren’t focused on applying these beneficial principles to retirees. So, let’s go over the details of an emergency fund for retirees.
How much should I have in an emergency fund?
There is a rule of thumb that is used when determining how much a household should have in an emergency fund. The guidance is to have at least three to six months’ worth of expenses set aside. This can be a good benchmark to measure yourself against. But the problem with a rule of thumb is that everyone’s individual situation is different and may require more customization.
Calculating an emergency fund during retirement is different than during accumulation. For instance, the risk of losing your job when you’re retired is zero percent. However, in most cases, this does not completely eliminate the risk of income loss. You must determine, based on your own cash flow risks, what amount is right. For example, a retiree with multiple rentals and a history of renter turnover will require more cash on hand than a retiree whose only income source is from Social Security and a steady pension.
Where should you invest your emergency fund? How much cash should I have on hand?
The goal of an emergency fund is not to earn the highest return possible. It is to have the funds accessible when needed. A common place for an emergency fund to be kept is in a savings or money market account. You can do this at your preferred bank or credit union. Online banks that pay higher interest rates can also be a good choice. Any of these options will work, as long as your money is easily accessible.
Do not keep your entire emergency fund in hard cash. Having a limited amount on hand in your home is reasonable. However, there are added risks in having large sums of cash in your home.
Investing excess savings
Once you have determined the amount for a comfortable emergency fund, you may need to add or subtract from your current account. If you need to increase your emergency fund, the best way to do this is by adding a portion of your monthly income to the fund until you have the desired balance. Anytime you use your emergency fund, immediately work toward increasing it back to the desired amount.
It can also be common for retirees to accumulate large sums of cash in savings accounts. These are much greater than an adequate emergency fund requires. During the accumulation phase, the guidance is to put 15 – 20% of our income away into savings. In retirement, this mindset changes. Keeping extra savings in the bank, in excess of your emergency fund, can be a missed investment opportunity. This will hamper your ability to keep your investments up with inflation. If you have a balance in your bank account on top of your emergency fund needs and what you might reasonably spend in a short period of time, consider investing these funds for a greater opportunity for growth. You should also consider reducing income from sources such as taxable retirement accounts to avoid paying taxes on this unspent income just to have it accumulate in the bank.
A good question to ask yourself if you are in this situation is “when do I plan on spending this money?” If it is more than five years out, investing the funds in a diversified portfolio will result in greater growth opportunities. Talk to your advisor to determine the right investment allocation.
Though the amount and use of an emergency fund slightly change for individuals moving from the accumulation phase to the retirement phase of life, it is still an important part of a retiree’s financial household. Having too little or too much in savings for a rainy day could cost you thousands of dollars over the course of your retirement. Talk to one of Peterson Wealth Advisors’ Certified Financial Planners with your questions about an emergency fund for retirees.
Entering retirement can be both thrilling and intimidating at the same time. The thought of “hanging up the cape” and permanently leaving the workforce behind can be viewed as unburdening and relieving to one individual, but completely frightening to another. Regardless of the viewpoint you have on retirement, it will undoubtedly come with new challenges and troubles to overcome. Among the different problems to solve for retirement, one of the biggest challenges is that of health insurance options for the early retiree.
For those age 65 and older, or certain younger individuals with disabilities, Medicare has you covered. Medicare is the country’s health insurance program managed by the federal government. Once you enroll, there is very little management that you have to do throughout retirement.
But what about those who retire earlier than age 65? An early retirement is certainly achievable, but requires careful planning, especially when it comes to your healthcare. This article will enlighten you on the different healthcare options available for early retirees, with a focus on the Marketplace. If you are not familiar with what the Marketplace is, don’t worry, we will get to the details soon.
Health insurance options for the early retiree (pre-age 65)?
If neither you nor your spouse will be covered through an employer plan, fear not! There may be more options than you think. Below is a brief summary of a few options. I highly recommend speaking with your financial advisor about which route makes the most sense for you.
COBRA – A law that allows employees and their dependents to keep their group coverage from their former employer’s health plan. This coverage can last for 18 months after termination from the employer, but beware, this can be very costly.
Medicaid – Though unlikely for some retirees to qualify due to the low-income requirements (i.e., in Utah, coverage is available for those with household incomes up to 138% of the federal poverty level), this may be the cheapest option for those that do qualify. However, many doctors don’t accept Medicaid, so you may have to change your primary providers if you qualify for coverage.
Christian Healthcare Ministries – This is not traditional insurance, but rather a Christian-based method of sharing the costs with others around you. Each member pays a monthly premium and those funds are used to help other members cover their healthcare costs.
The Marketplace – Finally, we have the Marketplace, which tends to be the route most early retirees take. For this reason, I want to expound upon how the Marketplace insurance really works.
The Marketplace – What is it?
In March of 2010, the Affordable Care Act (sometimes called Obamacare) was passed with the goal of making health insurance more affordable. The law provides individuals and families with government subsidies (otherwise known as premium tax credits). This helps lower the costs for households with an income between 100% and 400% of the federal poverty line. As a reference, in 2022, 400% of the federal poverty level for a retired couple is $73,240. The federal government operates the Health Insurance Marketplace, or “the Marketplace” for short. This is an online service that helps you enroll for health insurance. You can access the Marketplace at HealthCare.gov.
How does the Marketplace work?
First and foremost, I recommend you work with a trusted, licensed health insurance agent to help you navigate the waters of the Marketplace. Especially if you’ve only ever received health insurance through your employer. There is no additional cost to you to use an agent – they will be compensated by the insurance company directly. You can then tell the agent any specifics you are looking for with your coverage (such as certain doctors, hospitals, etc.). They can help narrow the available plans down to your liking.
That being said, let’s look at how this actually works.
You can enroll in health insurance during open enrollment, which generally runs from November 1st – December 15th. This is for coverage starting January 1st of the following year. You also have the option to enroll during a special enrollment period. This is based upon major life events, such as a change in household or residence.
You’ll be rewarded a special enrollment period when your looking for health insurance options as an early retiree. Don’t feel like your retirement date needs to line up with the open enrollment period. During this special enrollment, you’ll have a 60-day window to enroll through the Marketplace.
During enrollment, you will fill out an application with basic personal information. Included with this application, you will give them your best estimate on what your income will be for the coming year. The Marketplace uses your Modified Adjusted Gross Income – MAGI – to define “income.”
Please note that the Marketplace does not use your previous year’s income, but rather your projected income for the next year. This is an important distinction for retirees. If your projected income falls between 100% – 400% of the federal poverty level, you will qualify for a government subsidy to help cover the premiums associated with your insurance. If your income is above the 400% level, you will not qualify for a subsidy and will have to pay the entire premium yourself. For 2021 and 2022 ONLY, as part of the American Rescue Plan Act (ARPA), the subsidies were extended to those with income beyond the 400% poverty line. Unless more legislation is passed to extend these benefits, starting in 2023, the law will revert back to pre-pandemic rules.
What happens if your income isn’t exactly what I put on the application?
The answer is that you will reconcile any differences when you file your taxes.
If your income was less than what you projected, you’ll get a credit as you qualified for more of a subsidy throughout the year. If your income was more than what you projected, you will have to pay some of that subsidy back. Generally, this isn’t that big of an issue unless you projected your income to be less than 400% of the poverty level but it was actually more. In this case, you are required to pay back the entire subsidy. Even if your income was only $1 more than the threshold.
For this reason, I suggest consulting with your financial advisor to pinpoint what your income will be through your early years of retirement. I also suggest you speak with your advisor on potential planning strategies available to control your Modified Adjusted Gross Income, as there are certain strategies that can help you qualify for a subsidy while enjoying the income you desire throughout retirement. For an example of how this might work, Mark Whitaker wrote an article in 2020 describing a case study that explored these strategies.
As far as the plans that are available, the Marketplace ranks them in four different categories. These categories are Bronze, Silver, Gold, and Platinum. The Bronze plans typically tend to have the lowest premiums, but they are also more catastrophic plans. This means they have high deductibles and out-of-pocket maximums. Gold and Platinum plans typically tend to be better plans as far as coverage but have higher premium costs. Again, working with an agent can help you navigate which plan is best for you.
There is more to the Marketplace and the other health insurance options for the early retiree mentioned than can be discussed in this article. Hopefully, this provides you with a framework of the options you have as an early retiree. Early retirement is achievable for those who are prepared and understand how their healthcare needs can be met.
At Peterson Wealth Advisors, we manage the retirements of several retired commercial pilots. As I have discussed these pilots’ careers with them, one of the retired pilots explained that being a pilot can be described as, “hours and hours of boredom punctuated by moments of sheer terror.” Although these moments of sheer terror are rare, pilots will spend countless hours of training throughout their careers. They are preparing for that moment when their flight plan might not go according to plan.
Just as pilots have a plan, investors also need to have a plan to follow when their investments are not going according to plan. The last couple of years have provided investors ample unplanned and unforeseen market turbulence. A pandemic, a supply chain crisis, the highest inflation rate in our lifetimes, and the prospects of another world war in Europe have certainly rocked the investment world. It’s even caused the best-made investment plans to not go according to plan.
Investors should always be asking, “what is my plan when things temporarily aren’t going according to plan?” Let me share with you the Peterson Wealth Advisors’ perspective and what we are doing for our clients. Especially when it appears that things aren’t going according to plan due to ‘investment turbulence’.
Embrace the Volatility
First, temporary downturns are not a deviation from the plan. Rather, they are an expected part of the plan. Stock and bond market downturns are always temporary. Historically the duration of almost every major decline is measured in months, not years. The media would have you think that market corrections, “are unexpected events that are shocking in both their occurrence as well as their impact.” As investors with longer-term perspectives, we understand that the price you pay for inflation-beating investment returns consist of enduring occasional periods of market volatility. Few of us would pass up a Hawaiian vacation because there will surely be some turbulence in our flight to and from Hawaii. We likewise need to keep temporary market downturns in perspective and remember that turbulence is a planned for event.
Even though the exact timing of a correction is difficult, we should expect and even embrace market volatility. Investors should seize the opportunity to make wise tax moves during declining markets by doing Roth conversions, rebalancing portfolios, and tax-loss harvesting. They should also be opportunistic by purchasing depreciated equities while they are being sold on discount.
We believe that investors should never be in a position where they need to liquidate depleted investments due to a temporary market downturn. This is difficult to do if an investor is not preparing for the downturns before they happen. With the Perennial Income Model™, we proactively attempt to protect our clients from selling investments at a loss. This is done by following a rigid, goal-centric, approach to harvesting investment gains once the goal of an investment has been reached. Harvesting is the process of transferring aggressive investments to more conservative investments as goals are achieved.
Navigating retirement with a plan that establishes investment goals and appropriately harvests gains can bring order, discipline, peace of mind, and added security to the retiree.
If you have the flexibility, you can wait out market downturns and wait for good investment opportunities. The best way to add flexibility, and tip the investment odds in your favor, is by increasing your time horizon. The longer you are invested, the better opportunity you have to endure a range of market turbulence. This endurance flexibility lets you stick around long enough to let the odds of benefiting from a positive outcome fall in your favor.
Additionally, flexibility within an investment portfolio allows Peterson Wealth Advisors to select only positive-performing investments within a portfolio to be drawn upon for income. This allows investments within that same portfolio, that may have temporarily dropped in value, to rebound.
Flexibility gives you room for error. Giving yourself a margin of error is the only way to safely navigate the world of investing. The world of investing is governed by probabilities, not certainties.
Create a Plan that has Conservative Projections
In other words, plan for the worst and hope for the best. As the creators of the Perennial Income Model™ we project retirement income streams over decades. This process is unique to our firm. We have concluded that it is in everybody’s best interest to project low. We assume future investment returns 30% less than historical averages in all of our planning and projections. If an acceptable retirement income stream can be created from the conservative assumptions that we use, an actual income stream that spins off more income than originally projected will certainly be welcomed.
Market turbulence has and will continue to afflict investors with regularity. This is why we choose to create retirement income streams. We follow the goal-based, time-segmented processes of the Perennial Income Model.
A retirement income plan is only successful if it can survive reality. A future filled with unknowns is everybody’s reality. That is why we feel it is important that retirees understand and embrace volatility, follow a goal-based plan to protect investment gains, maintain investment flexibility, and use conservative estimates as retirement income streams are projected. If retirees understand and embrace these points, they will be prepared to answer the question, “what is my plan when things temporarily aren’t going according to plan?”
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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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Warren Buffet once called the babies born today “the luckiest crop in history” because they are expected to live longer and enjoy greater prosperity than any previous generation. I believe it would be a fair assumption to add that the baby-boomer generation is the “luckiest crop” of retirees to have ever lived. Today’s retirees are healthier, wealthier, happier, safer, freer, more educated, more equal, more charitable, and more technologically advanced than any previous generation.
4 Common Threats to Retirement Savings
Ironically, the wonderful advancements that current retirees are blessed with are also the root of the problems that retirees will face. Longevity, inflation, and the retiree’s individual responsibility to manage their own investments will be the challenges that this generation of retirees will have to grapple with.
Not only are we living better, we are also living longer. Therein lies the challenge: We are living too long. Life expectancies are steadily climbing. According to the Social Security Administration, a couple who is currently 65 years old have a 48% chance that one of them will live to be the age of 90.
Because of long life expectancies, many retirees face the very real risk that they will outlive their money if they don’t plan for a lengthy retirement. Planning on living to the average life expectancy is not enough. It is best to plan on living longer than your life expectancy, because life expectancy estimates the average time a person will live. To be certain, some people will die before their life expectancy, but some will live beyond, sometimes many years beyond, their projected life expectancy.
Longevity is the catalyst for today’s retirees’ second challenge: their dollars are shrinking.
Every day, the purchasing power of the retiree is eroding as goods and services are getting more expensive. Although inflation has always existed, no previous generation has had to deal with it to the extent that today’s retiree does. Our parents and grandparents lived ten or fifteen years past retirement, inflation never had time to develop into a problem for them.
A retirement lasting thirty years or more is a game-changer. Inflation isn’t something that may happen, it will happen. In our opinion, inflation has confiscated more wealth, destroyed more retirements, and crushed more dreams than the combined effects of all stock market crashes. Historically the average inflation rate has been more than 3% annually. To put that into perspective, at a 3% inflation rate, a dollar’s worth of purchasing power today will only purchase forty-one cents worth of goods and services in thirty years from now.
Inflation poses a “stealth” threat to investors as it chips away at real savings and investment returns. The goal of every investor is to increase their long-term purchasing power. Inflation puts this goal at risk, because investment returns must match the rate of inflation just to break even. An investment that returns 2% before inflation in an environment of 3% inflation will actually lose 1% of its purchasing power. This erosion of purchasing power might seem incidental, but this type of loss, compounded over the duration of a retirement, is life-changing.
Dollars invested into money market accounts, certificates of deposits, fixed annuities, and bonds, never have, and never will, keep up with inflation. Uninformed, anxious, stock market-leery investors that depend on these types of investments for long-term growth may be insulating themselves from stock market volatility, but they are committing financial suicide, slowly but surely. To make matters worse, the paltry gains associated with these products must be taxed, which makes it that much more unlikely that they will be able to preserve purchasing power.
In the current environment of huge government budget deficits and spending, it is likely that inflation will continue to rise at least at the same pace as its historical average. Given the one-two punch of longevity and inflation, it is imperative that retirees are mindful of inflation as they invest and plan for the future.
3. Investment Management Risk
A third challenge for retirees to be aware of is the personal responsibility they now have to manage their own investments.
During the last couple of decades, a subtle transfer happened. The responsibility to provide retirement income shifted from the employers to the employees. The popular pension plans of the past, which guaranteed a lifetime of monthly income to retired employees and their spouses, are disappearing. Pensions have been replaced by 401(k)s and other similar plans that all place the burden of funding, managing, and properly distributing investments to last a lifetime, squarely on the backs of the unprepared employee. Like it or not… you, not your employer, hold the keys to your financial future.
An annual study done by DALBAR, Inc. shows that the average stock fund investor managed to capture only 60% of the return of the stock market over twenty years. Ouch! The largest contributing factor that explains this blatant underperformance was the investor’s own behavior. It appears that the typical investor followed the herd mentality, buying when stocks were high and selling in a panic when stocks were low. Seldom was the investor guided by a comprehensive investment plan. Consequently, little or no discipline was demonstrated. What is most concerning, is that for the most part, the investor failed at the easy part of investment management: the accumulation phase.
4. Retirement Income Distribution Risk
When people enter retirement, they also enter the distribution phase of investment management. In other words, they start withdrawing their investments. The distribution phase is much more difficult to manage than the accumulation phase. In the distribution phase, it is still crucial to know how to properly allocate and invest a portfolio, but additional complexity is added to the mix. Therefore, income-hungry retirees need to know how to create a distribution plan that will provide a stream of income that will last until the end of their lives. They need to create and then follow a Retirement Income Plan.
Retirees need to be kept informed in order to make the best financial decisions. It is also important to work with a financial professional that specializes in retirement issues and that is a fiduciary who puts the retiree’s best interest ahead of their own.
Are you ready to start planning your 30-year retirement? Click here to schedule a complimentary planning session to start creating your own ‘Retirement Income Plan’.
As 2019 came to a close, the president signed into law a sweeping series of changes that will affect how we save for retirement as well as the distribution of IRA proceeds. The new law is officially entitled the Setting Every Community Up for Retirement Enhancement Act, but it is more commonly known as the SECURE Act. This new law includes both welcome changes as well as some controversial elements. As I said, the changes brought about by the SECURE Act were sweeping, but I am only going to highlight those changes that impact the retiree.
First, let’s address the more controversial parts of the law. There is a change to the rules that govern inherited IRAs, or so-called stretch IRAs.
Previously, if you inherited an IRA, you were allowed to take distributions from the retirement account over your life expectancy. That is to say, a healthy 40-year-old person who inherited an IRA from their parents or grandparents could withdraw the funds over several decades.
While there are exceptions for spouses, minor children (until they reach the age of majority), disabled individuals, the chronically ill, and those within 10 years of age of the decedent, the new law requires that you withdraw the assets from an inherited IRA account within 10 years if the decedent passed away after December 31, 2019. There are no changes to inherited IRA accounts for those who died prior to 2020.
In the past, we have commonly recommended that an IRA participant’s spouse be listed as the primary beneficiary and the children be listed as secondary beneficiaries (not the family trust). This, most likely, may still be your best option, but the new law makes listing the children individually as beneficiaries less tax advantageous than before the new tax law went into effect. We look forward to discussing alternatives with you to make sure your family has the right beneficiary designation going forward.
Long Overdue Changes:
While the law governing stretch IRAs is creating challenges, there are also big, positive changes that we believe are long overdue.
- If you turned 70½ after January 1, 2020, the initial required minimum distribution (RMD) for a traditional IRA is being raised from 70½ to 72. Those who turned 70½ prior to January 1, 2020, are still required to take RMDs based on the old rules.
- You may now contribute to a traditional IRA past the age of 70½, if you are working and have earned income. Previously you were unable to make IRA contributions past age 70½.
- Many of you donate to charity directly from an IRA by making a Qualified Charitable Contribution (QCD). Now, even though some of you will not have RMDs until age 72, you are still able to donate to your charities using a QCD starting at age 70½.
Hopefully, this sheds some light on the parts of the SECURE Act that most likely apply to your situation. We appreciate the trust you have placed in us and we look forward to answering any additional questions that you might have.
Peterson Wealth Advisors has taken the academically brilliant idea of time segmentation and transformed it into a practical model of investment management that we call “The Perennial Income Model™”. To get a better understanding of the Perennial Income Model™ you can request our book “Plan on Living, a Retirees Guide to Lasting Income and Enduring Wealth”. For specifics on how the Perennial income Model™ could be applied to your retirement income plan, schedule a complimentary consultation with one of our Certified Financial Planner™ professionals.
Common Estate Planning questions
We often hear the following questions from people we work with:
- What will happen with my estate upon my death?
- Who will look after my spouse and help them make good financial decisions when I am gone?
- If either my spouse or I become disabled, who will look after us and who will help us to not make poor financial decisions as we age?
- When we pass away, what will happen to our hard-earned savings?
- What can I be doing now to protect my family’s savings from taxes?
- Is there any way to make sure our heirs use the money wisely?
All these questions can be answered by crafting a good estate plan. Many people are familiar with, or have at least heard of, the legal documents that are used in an estate plan such as a will, trust, or power of attorney. These legal documents are critical to a good estate plan. However, if these documents are hastily thrown together without first defining what it is you are trying to accomplish, and who it is that you want to carry out your wishes, the outcome can be less than desirable.
Five things to consider when creating an appropriate estate plan
1. The questions that need to be answered to create an estate plan:
- If I become incapacitated, who do I want to appoint to look after my financial and legal affairs?
- Who would I want to make medical decisions for me if I get to the point where I can’t make them for myself?
- What end-of-life decisions do I want to make now and/or who would I want to make life-ending decisions for me?
- When I pass away, what do I want to happen with my possessions and assets?
- Are there any special considerations (needs of a disabled child) or preconditions that I want to put in place for my beneficiaries?
2. Choose one or more people that you fully trust to follow your instructions and carry out your wishes.
You should choose someone with integrity. When choosing one of your children to fill an important role in your estate plan, it is helpful to choose one who works well with others and can build consensus. Conflict and hurt feelings are common between siblings after the death of a parent. Therefore, choosing the child who can cross divides with maturity and grace is more important than one who happens to be good in business or simply choosing a child because they happen to be the oldest.
Roles in a typical estate plan:
- Executor: The person who administers your estate/will
- Trustee: The person responsible for trust administration
- Power of attorney: The person responsible to act on your behalf for legal and financial matters when you are unable to do it for yourself
- Medical power of attorney: The person designated to make medical decisions on your behalf when you are incapable of making them yourself
These roles can be filled by a single person, or by multiple people working together on your behalf. Additionally, each of these roles can be filled by different people. It is also wise to consider choosing a backup for each of these roles if your first choice is unable or unwilling to serve in that capacity.
3. Meet with qualified professionals to help you implement your estate plan.
You will need to work with a licensed attorney to draft any legal documents that are required to carry out your wishes. In partnership with an attorney, your financial planner can help coordinate the attorney’s advice with other areas of your financial plan. Your financial planner can be very helpful by making sure you update your retirement account beneficiaries and that your investment accounts are properly titled to make sure they are in accordance with your overall estate plan.
4. Clear communication is a must when it comes to estate planning.
Your son or daughter shouldn’t learn that you have chosen them to decide when to end lifesaving medical care when you are in the hospital. There may be good reasons to not share all the details of your estate with your family before your death, however, walking through your general intentions and the roles each person is being asked to fill will help prepare those involved for the great responsibility you are asking them to carry out.
5. Review your estate plan often.
There are common reasons why you should consider regularly updating your estate plan:
- It has been several years since you last reviewed your estate planning documents
- There have been major changes in estate or tax law
- There have been changes in your family like deaths, divorce, or disability that could impact your beneficiary’s designations as well as impact your potential choices for trustee, executor, etc.
- After major changes in your financial situation
Spending a small amount of time to periodically review your estate plan can help you avoid major mistakes down the road. Reviewing your estate plan will also ensure your plans still make sense amid life changes.
It is uncomfortable for most of us to have to make decisions regarding our own death or disability. Additionally, finding an attorney, dealing with all the documents, changing beneficiaries, and transferring titles to property can make the estate planning process overwhelming, and therefore it is often put off. Your estate planning attorney and financial advisor have been through this process many times before and can carefully, and easily, walk you through the steps of creating an estate plan.
An estate plan outlines the wishes for your care while you are alive and frees your family members from the burden of second-guessing what you would have done with your estate after you are gone. A well thought out estate plan is truly a gift to your family.