As a recovering CFO, I find it especially fascinating to help people with their financial planning. I recently led a retirement income class here locally, where I had the opportunity to sit down with one of the students to answer some questions she had a little more in depth. It was quickly discovered that our conversation had far more merit in becoming a formal meeting, so we scheduled a visit to her home where she would feel more comfortable and have access to any documentation she needed. Our friend, let’s call her Mildred, is a 70-year-old lady who, like most working-class people her age, has all of her assets in her 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, she lives comfortably within the limits of her ‘fixed income’ . Mildred came to our class because one of our emphases is minimizing taxes in retirement and since she now has required minimum distributions, she wanted to learn as much as possible about how to reduce her annual tax bill.
Our conversation was fruitful because we learned that he was replacing his windows for approximately $14,000. This was important to her because she plans to give the house to her daughter once she dies. Mildred doesn’t like to owe money, so she called her certified financial planner in Maryland and told her to pay off enough money for her RMD and a little more to pay for the windows in cash. So Bob, her financial advisor, suggested that she liquidate and distribute about $26,000 from her IRA where about 30% would be withheld for taxes to the federal and state governments.
Now that sounds like no big deal, right? Well, my CFO training told me to look to mitigate the costs of doing business, especially the slippery ones like taxes. We projected her taxes for next year by completing this transaction, Mildred would be in trouble for over $11,000. Tax laws have become quite complex, especially when it comes to Social Security. Any income from IRA accounts will be counted at 100% when calculating “Interim Income” or the amount of your benefit that will be taxable. So not only does the effective rate increase because you received more income, but more of your Social Security income is taxed. There are three levels, 0%, 50% and 85% and once you reach those thresholds your tax bill increases at a rate of 46%. By pouring in the income from his IRA, he went from an effective tax rate of 14% to one that exceeded 20%.
My first thought was to split the payment to the window company using this year’s RMD and then again using next year’s RMD. This would keep your effective tax rate closer to the 14% you would incur anyway. Mildred had two options, one is to use her home equity line of credit that she had at 4% and, since she detailed, the effective cost for her would be closer to 3% per year and consider that she would pay it off in less than 6 months. she would have only cost him about $600 in interest. Her other option was, of course, to use the window company’s interest-free financing that she could pay off in a year. Either way, this would save you $6,000 in taxes.
But our story doesn’t end there… during our conversation we found out that he donates quite a bit to charity, around $13,000 a year. So we’re talking about a tax law called the “Tax Increase Prevention Law” that allows people who are required to distribute earnings from their qualified accounts to donate directly to your charity while it counts as your Required Minimum Distribution. Mildred must distribute $11,000 this year, which would be added to her income and at an effective tax rate of 14%, which equals about $1,500 in taxes; instead, she can wire $13,000 directly to her charity, satisfy her RMD, and submit her completed tax bill. from $5,000 to just over $1,100. In other words, by understanding the tax laws, Mildred can increase her ‘net pay’ from $3,200 to more than $3,600. Who wouldn’t appreciate a raise of $400 a month, especially on a “fixed income”?
Now for the last piece of the puzzle, your current wallet. An allocation made up of 75% stock mutual funds and 25% bond mutual funds. No matter how expensive mutual funds are or the fact that a 70-year-old on a fixed income with minimal assets is so heavily allocated to the stock market, let’s talk distribution. If we follow the RMD schedule, there will be a time each year when Mildred will have to sell her mutual fund to get her distribution. Now, the mindset is for the entire portfolio to earn enough money to be able to live on interest and capital appreciation. That’s great in theory but when you factor in the embedded fees of around 3% the market would have to do very well to stay that way and we all know 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 10 years and if Mildred lives another 30 years, she will have to sell her declining assets at least 10 times during her retirement. I’ve been helping people and businesses for over 20 years and nothing brings a portfolio to its knees faster than having to withdraw money while assets lose value. Simple math tells us that if I start with $1,000 and the market takes $100 and I have to withdraw $100, I keep $800 and if the market takes back what it lost, I now have $880 and if we did that math again? In 4 years it would be $750.
So our student becomes a client when we discover that it is in her best interest to implement and manage two strategies. The first plan is called “Return Sequence” where we essentially split Mildred’s portfolio into 3 parts; short term (3 years), medium term (5 years) and long term (more than 5 years, built to be forever). The basic foundation of financial planning is that you never distribute assets outside of a volatile account. By putting 3 years of distribution into a nonvolatile account (that doesn’t lose money), Mildred can be sure that the income will be there if she needs it. The expected rate of return is somewhat small, around 1-3%, but it is guaranteed and you will never lose your principal. Her average allocation would take a percentage of her assets with at least 5 years, but on average about 25% of her assets. This account would carry very minimal volatile assets which should return between 4-7%, we use 6% as a benchmark. The long-term allocation can be contracted in the market if necessary or can simply be placed in a guaranteed investment so that there is no loss of principal (why take the risk if you don’t have to?). In fact, we project that her standard deviation (amount of volatility) will decrease from where it was originally at 17% to 3.5% for her overall portfolio, while we increase her average rate of return from 3.58% to more than 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 in her retirement and increase her assets by $143,000 at no cost to her.
Good financial planning is about being prudent with your financial decisions and not just “staying the course” when markets go bad, rebalancing when things are going too well, or diversifying your portfolio allocation to mitigate risk while capturing potential. bullish. It’s about identifying the costs of doing business, the risks associated with financial decisions, and the unknowns that can wipe out all profit as a CFO for your home.
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