Think of it like playing chess. Making sense of the strategic
interplay between investments, taxes and retirement income can
position you for a winning retirement.
When I was 12, I attended a weekend church camp for young men. I was
brand new to the group, and as the youngest attendee, I was, as to be
expected, mostly ignored by the older boys. But this rebuffing turned
out to be a blessing, as it allowed me to learn one of my favorite
games, chess. I enjoyed other games, like checkers, but the complexity
of chess appealed to me, as it required more thought, planning, and
strategy. In retrospect, it was clear that I was a retirement planner
in the making.
“How is retirement planning like chess?” you may ask. Retirement
planning resembles chess due to the complex number of factors at play
in both endeavors.
Whenever I embark with a new client on their retirement planning
journey, it is as if they have a checkerboard and a baggie full of red
and black checkers, which represent their current investments and
financial plans. My first step is to set up that checkerboard and help
place the pieces in their correct spaces as I organize their finances,
tax situation, and potential legacy issues.
This is where my chess skills come into play as I swap out each
checker with a specific chess piece. Why the replacement? Each chess
piece has a particular job to do, unlike checkers, which all move in
the same way. By assigning each piece of a client’s financial plan a
specific task, our goal is to maximize the efficiency of that piece
and the entire plan.
But that doesn’t entirely do justice to the complexity that can come
with retirement planning, which is why I like to think of retirement
income planning as akin to the tri-dimensional chessboard featured in
Star Trek. Level One is the investments and retirement income; Level
Two is the taxes, and Level Three is the legacy planning.
Understanding that interplay can help position you to reach your goals
in retirement.
When you understand these factors and how they relate to each other,
you can apply these lessons to your own retirement planning. This
involves three steps:
Step #1: Organize your retirement assets
Put pen to paper – or open Excel – and list each of your
investment-type assets. These should include assets in your retirement
accounts and assets earmarked for retirement outside of your
retirement accounts:
Cash
Certificates of deposit
Cash-value life insurance
Stocks
Bonds
Mutual funds
Exchange-traded funds
Investment real estate
Then create a sub-category that groups them according to their tax
treatment. That means anything held in a traditional retirement
account, such as a traditional IRA, 403(b), or 401(k), would be
labeled as tax-deferred. Any accounts outside of retirement accounts
in a brokerage account would be classified as taxable. Any accounts in
a Roth IRA or Roth 401(k) would be categorized as tax-free. Do not
include your primary home or personal property.
Tax treatment is important because assets subject to taxes can be
worthless in retirement than assets not subject to taxes. This means
that assets in a Roth are usually the most valuable because their
qualified distributions are tax-free, while assets in a taxable
account are next in line because they potentially qualify for
favorable long-term capital gain tax treatment. Assets in a
tax-deferred retirement account come in last because you pay taxes at
ordinary income rates when you withdraw money in retirement. In
addition, when you turn 72, you must take a required minimum
distribution from your tax-deferred retirement accounts whether you
need that money or not.
Step #2: Determine your retirement goals, needs, and wishes
If you don’t know where you’re going, then it will be difficult to
determine how to get there. What do you see yourself doing with your
newly discovered free time in retirement? Will you be volunteering?
Working part-time? Turning a hobby into a business? Spending more time
on your hobbies? Traveling? Seeing family?
Also, where will you be living? Will you have two homes? Will you
downsize, upsize or just move? Or maybe you will hit the road as a
full-time RV’er or live on a houseboat.
And then the big question: How long might you live in retirement? Yes,
it’s time to consider longevity. What’s your family history? How do
you take care of yourself? I get it, no one knows how long they will
live, but it helps to have a target. And don’t be afraid to add an
extra five years to it. Medical advancements are growing at an
exponential rate – you may live longer than you planned.
Financial advisers commonly plan for their clients to live to age 90,
95, or 100. It’s much better to overestimate how long you might live
than underestimate.
Step #3: Make a plan on how to get from what you have to what you want
There are many areas here that will need to be addressed, but I feel
the most important is creating a lifelong income plan. This process
starts with estimating the pre-tax income you will need in retirement.
This can be easier said than done, but a good starting point is using
70%-80% of your employment income.
Now that you know your “guesstimated” need, list the income sources
that you can count on. These include Social Security, any defined
benefit pensions, part-time work, etc. That will help you figure out
what gap exists – if any – between the income you need and what you’ll
have. If, for example, your estimated need is $8,000 a month and your
Social Security and part-time work income is estimated at $7,000, you
have a $1,000 gap to fill.
You also need to consider the tax implications of your assets and how
that flows down to your retirement income plan. If, for example, your
income sources – such as tax-deferred retirement accounts – are
subject to taxes, then you will need to subtract the estimated amount
of taxes from the income you will receive. That means if you plan to
withdraw $3,000 a month from your tax-deferred retirement account and
you are in the 20% federal tax bracket, you will owe $600 a month in
taxes, reducing the actual income you can use to $2,400 a month.
Once you’ve determined your income gap and taken any taxes into
consideration, you will need a plan to fill that gap. There are many
options and strategies available, depending on your risk tolerance,
and your knowledge about what is available, as well as the reasons why
and why not for each. Some of the possible strategies could include a
high-dividend investment account, a guaranteed* income annuity, a
laddered bond portfolio, or just taking a chance and withdrawing from
the stock market.
A final word
Whatever you decide, I believe that the income plan is the most
critical part of an overall holistic retirement plan. That’s because
covering your spending needs in retirement brings financial and
emotional stability to your retirement years. When you know your need
for income is covered, you can relax and enjoy your retirement,
confident you will not be running out of money.