As a recovering CFO, I find helping people with their financial planning especially fascinating. I recently conducted a Retirement Income Class here locally, where I had the chance to sit down with one of the students to answer some questions she had a little more thoroughly. It was quickly discovered that our conversation had a lot more merit to becoming a formal meeting so we scheduled a time for us to visit at her home where she would feel more at ease and would have access to any documentation she would need. Our friend, let’s call her Mildred, is a 70 year old lady, who like most working class her age has all of her assets in IRAs. She has her social security and a small pension that she lives on and like most people who grew up with Depression Era parents, lives quite comfortably within the confines of her ‘fixed income’. Mildred came to our class because one of our emphasis is minimizing taxes throughout retirement and since she now has Required Minimum Distributions, she wanted to learn all she could about how to lower her annual income tax bill.
Our conversation was fruitful in that we learned she was replacing her windows at approximately $14,000. This was important for her to do because she plans on giving her daughter the house once she passes. Mildred does not like to owe money so she called her Certified Financial Planner out in Maryland and told him to liquidate enough money for her RMD and a little extra so she can pay for the windows in cash. So Bob, the financial adviser suggested that she liquidate and distribute about $26,000 out of her IRA where they would hold back about 30% for taxes to the federal and state governments.
Now that sounds like it’s no big deal, right? Well, my CFO training told me to look to mitigate the costs of doing business, especially as slippery as taxes. We projected her taxes for next year by completing this transaction Mildred would be on the hook for over $11,000. The tax laws have become pretty complex especially when it comes to Social Security Income. Any income coming from IRAs is going to be counted 100% when you calculate the “Provisional Income” or how much of your benefit is going to taxable. So not only does the effective rate go up because you received more income, but more of your Social Security Income gets taxed. There are three levels, 0%, 50% and 85% and once you reach those thresholds your tax bill increases at a 46% clip. By pouring income out of her IRA, she went from a 14% effective tax rate to one that was over 20%.
My first thought was to divide up the payment to the window company using this year’s RMD and then again using next year’s RMD. This would keep her effective tax rate closer to 14% that she would incur anyway. Mildred had two options, one is use her home equity line of credit she had at 4% and since she itemized, the effective cost to her would be closer to 3% annually and to consider that she would pay it off in less than 6 months it would have only cost her about $600 in interest. Her other option was of course, using the window company’s interest-free financing that she could pay off in a year. Either way, this would save her $6,000 in taxes.
But our story doesn’t end there… during our conversation we discovered that gives to charity quite a bit, about $13,000 annually. So we talked about a tax law called “Tax Increase Prevention Act” that allows people who a required to distribute earnings out of their qualified accounts to donate directly to their charity while being counted as their Required Minimum Distribution. Mildred is required to distribute $11,000 this year which would be added to her income and at a 14% effective tax rate that is about $1,500 in taxes, instead she can transfer $13,000 directly to her charitable organization, satisfy her RMD and bring her entire tax bill from $5,000 down to just over $1,100. In other words, by understanding the tax laws Mildred is able to increase her ‘take home pay’ from $3,200 to over $3,600. Who couldn’t appreciate a $400 per month increase, especially on a “fixed income”?
Now, the last piece of the puzzle, her current portfolio. An allocation made up of 75% stock mutual funds and 25% bond mutual funds. Never mind how expensive mutual funds are or the fact that someone in their 70’s on a fixed income with minimal assets is allocated so heavily into the stock market, let us talk about distribution. If we go along with the RMD schedule, there will be a time every year that Mildred will have to sell her mutual funds in order to get her distribution. Now, the mindset is to have the entire portfolio making enough money where she can live off the interest and capital appreciation. That is great in theory but when you factor in the embedded fees of about 3%, the market would have to do very well in order to stay that course and we all know the markets don’t always go up (except of course the last 6 years, but I digress). Historically speaking, there is a bear market 3 out of every 10 years and if Mildred lives another 30 years, she will have to sell her assets when they are in decline at least 10 times during her retirement. I have been helping people and businesses for over 20 years and nothing brings a portfolio to its knees faster than having to take money out while the assets are declining in value. Simple math tells us if I start with $1,000 and the market takes $100 and I have to withdraw $100 I am left with $800 and if the market regains what it lost, I am now holding $880 and if we did that math again? 4 years from now it would be $750.
So our student becomes a client when we discover that it would be in her best interest to implement and manage two strategies. The first plan is called “Sequence of Returns” where essentially we pare off Mildred’s portfolio into 3 parts; short term (3 years), medium term (5 years) and long term (longer than 5 years, built to be forever). The basic financial planning fundamental is you never distribute assets out of a volatile account. By placing 3 years of distribution in a non-volatile (doesn’t lose money) account Mildred can be assured that the income will be there if needed. The expected rate of return is something small, about 1 – 3% but it’s guaranteed and will never lose its principal. Her medium allocation would carry a percentage of her assets with 5 years as her minimum but on average about 25% of her assets. This account would carry very minimal volatile assets that should garner between 4 and 7%, we use 6% as a benchmark. The long term allocation can be engaged in the market if needed or can be simply placed in a guaranteed investment so there is no loss of capital (why take the risk if you don’t have to?). In fact, we projected that her standard deviation (amount of volatility) will decrease from where it was originally at 17% down to 3.5% for her overall portfolio while we increased her average rate of return from 3.58% to over 10.5%. The second plan was to convert half of her qualified assets (IRAs) into tax free savings investments. By implementing this tax conversion plan, Mildred is in line to save at least $30,000 in taxes throughout her retirement and increase her assets by $143,000 with no costs to her.
Good financial planning is about being prudent with your financial decisions and not just about “staying the course” when markets go south, re-balancing when things get too good or about diversifying your portfolio allocation to mitigate risk while capturing upside potential. It is about identifying the costs of doing business, the risks associated with a financial decisions and the unknowns that can strip away all the gains just like a CFO for your household.
If you would like a 10 minute, hassle-free private conversation regarding your tax situation or portfolio, send an email to firstname.lastname@example.org and we will get to work for you. Take the next step, it’s time.