Preserving Your Income Stream Through Retirement – Part Two - Rodgers & Associates
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Preserving Your Income Stream Through Retirement – Part Two

Preserving Your Income Stream Through Retirement – Part Two

See Part 1 and Part 3 in this series.

Last week we began a discussion on how to build a retirement income strategy that would provide an increasing stream of income over life expectancy so you can maintain your lifestyle. The three funda­mentals estab­lished in the first part of this series for the investment side of this strategy are:

  • Equities are needed to provide growth
  • Establish an asset allocation strategy to take advantage of market volatility
  • Set a sustainable withdrawal rate

The next step to building an effective retirement income strategy is optimizing the portfolio from a tax stand­point. Tax efficiency will come from three areas:

  • Using all three legs of the New Three-Legged Stool™ strategy
  • Properly diver­si­fying your asset allocation over the three legs
  • Taking tax-smart distri­b­u­tions that will vary based on your circum­stances and market condi­tions

A key challenge to building proper tax diver­si­fi­cation into a retirement income strategy is the fact that many individuals hold a large percentage of their overall savings in tax-deferred retirement accounts. Tradi­tional IRAs, 401(k) plans, and pensions are great to have when you’re working but withdrawals are fully taxable at ordinary income rates when distributed. According to a study from the Employee Benefit Research Institute, among families with assets in tax-deferred accounts, these resources accounted for a median of 62.5% of their total financial assets. Roth IRA accounts, which are funded with after-tax dollars and can produce tax-free distri­b­u­tions in retirement, comprised just 5% of all tax-deferred assets.

Tax Treatment of Various Types of Retirement Income

Type of Income/Account Tax Treatment
Tax-Deferred accounts — 401(k), 403(b), 457 plans, Thrift Savings, Tradi­tional IRA, Annuities Taxable at ordinary income rates upon distri­b­ution. 10% to 35% in 2012.
Pensions Taxed at ordinary income rates.
Roth IRAs and Roth 401(k)s Distri­b­u­tions are non-taxable if owner is age 59 1/2 and the account at least 5‑years old.
After-tax investment accounts Long-term capital gains and qualified dividends: taxed at a maximum of 15% in 2012. Other income: taxed at ordinary income rates.
Social Security May be partially taxable at ordinary income rates.

From The New-Three Legged Stool: A Tax-Efficient Approach to Retirement Planning

Unfor­tu­nately, retirement savings have been building up in tax-deferred accounts at a time when personal income tax rates have declined to histor­i­cally low levels. Histor­i­cally, tax brackets have been at current levels only 14% of the time. Congress is currently trying to reduce budget deficits that have been in the trillions of dollars. The $15.6 trillion of pre-tax assets currently sitting in retirement accounts has to look very appealing to a cash-starved Congress. Retirees who have the majority of their assets in tradi­tional accounts antic­i­pating lower tax rates in retirement could be in for an unpleasant surprise.

A historical analysis of different tax scenarios showed the surviv­ability over various time periods of a diver­sified portfolio of equities, fixed income, and cash when the portfolio is taxed at different rates. Not surpris­ingly, the portfolio with the highest tax bracket had the shortest surviv­ability.

Historical Success Rate1

20 Years

30 Years

40 Years

No Taxes

96%

75%

55%

25% tax rate

75%

40%

15%

35% tax rate

59%

23%

3%

Following the New Three-Legged Stool™ retirement strategy offers several benefits:

  • Provides flexi­bility – the ability to draw income from the three different account sources depending on your tax situation from year-to-year.
  • Sustain­ability – Research shows that a lower tax rate may help your portfolio last longer.
  • Hedge against higher tax rates – We don’t know what will happen with the tax code in the future or who will be affected. Diver­si­fying your savings can help minimize tax changes that affect you.

The final week of this series will look at specific techniques used to achieve tax-efficiency.

See Part 1 and Part 3 in this series.

1This hypothetical illus­tration is based on rolling historical time period analysis and does not represent the perfor­mance of any specific mutual fund, which will fluctuate. This illus­tration uses the historical rolling periods from 1926 to 2011 and a portfolio composed of 60% equities (as repre­sented by an S&P 500 composite), 30% fixed income (as repre­sented by a 20-year long-term government bond (50%) and a 20-year corporate bond (50%)), and 10% cash (as repre­sented by U.S. 30-day T‑bills) to determine how long a portfolio would have lasted given a 5% initial withdrawal rate adjusted each year for inflation. A one-year rolling average is used to calculate perfor­mance of the 20-year bonds. Past perfor­mance is not a guarantee of future results. The S&P 500 Index is an unmanaged index of common stock perfor­mance. You cannot invest directly in an index.

Rick’s Insights

  • Holding all your retirement savings in a tax-deferred account provides few oppor­tu­nities to minimize taxes during retirement.
  • Research shows that lower tax rates can increase the surviv­ability of your portfolio over life expectancy.
  • If Congress could figure a way to tax just 1/5 of retirement assets it could eliminate the current budget deficit.