The typical affluent Baby Boomer retiree will end up paying hundreds of thousands of dollars throughout their retirement life in unnecessary fees, expenses, taxes and penalties. This happens because most retirees don’t have a comprehensive, integrated retirement income plan that uses at all of their available retirement income planning tools in an efficient manner. (For more, see: 4 Keys to a Satisfying Retirement.)
What's Involved in Retirement Planning?
Take for example a 60-year-old couple that wants to retire and has $500,000 of assets, Social Security, a pension and a house. Between the ages or 60 and 70, this couple will have to make several irrevocable financial decisions that will largely determine their financial future for the next 30 or 40 years. These decisions include:
- Should they take advantage of any in-service distribution withdrawal options that may be available in their 401(k) plans and roll over their monies to an individual IRA while they are still working?
- When and how to file for Social Security benefits to not only maximize lifetime income, but to also receive the optimal, after-tax amount.
- Pension claiming decisions if available – Should they take the lump sum option or the monthly payout?
- How to pay for future long-term care/skilled nursing expenses.
- When to start Medicare – Should they select a Medicare Advantage or a Medicare Supplement plan?
- Can they participate in a Health Savings Account (HSA)? If so, should they take steps to participate in this plan and contribute?
- Should they have life insurance in retirement and if so what kind and how much? How can life insurance be used as an asset class to reduce taxes in retirement?
- IRA/Roth IRA options – Should they convert monies to a Roth IRA? If so, how much and when? How much should they be contributing to retirement plans and should they participate in any of the catch-up provisions?
- Guaranteed income planning – In addition to Social Security and pensions, will they need additional sources of guaranteed income that last for life? Where will that income come from, how much will it cost to set it up?
- Tax planning – What will their gross income and after-tax income be? Are they withdrawing monies from accounts in a tax-efficient manner?
- Estate plan – What will happen to money and accounts when they die? Are they set up to pass to the next generation in an efficient manner, avoiding probate?
- Home equity – Should they pay off their home? Downsize? Rent or own? What are the options regarding the home’s equity to help improve their financial situation?
- Investment planning – What strategy or methodology will they use to invest money? Are they buy and hold/passive investors? Should they adopt any type of tactical strategies to protect profits? What impact will the next bear market have on their current portfolio, and when that happens will they be able to maintain their standard of living in retirement?
An Integrated, Comprehensive Plan Can Save Money
Most retirees and their advisors focus solely on managing the investable assets, which is last on our list of big decisions to make. They fail to take into account the complete picture of how all of these choices impact one another; without a comprehensive, optimized plan, inefficiencies develop and retirees lose monies through unnecessary fees, expenses and penalties. (For related reading, see: 4 Mistakes to Avoid with Your Retirement Plan.)
Social Security is a simple example. According to a recent report by the Center for Retirement Research at Boston College, a staggering 90% of Americans start taking Social Security at or before their full retirement age.
By claiming Social Security benefits early, you not only receive less lifetime income but you are also being terribly tax-inefficient. A retiree who could receive $2,000 a month at age 66 would only receive $1,500 a month if they claim at age 62. If they wait until age 70, they would receive $2,640. This is 32% more income than at age 66 and 76% more income than at age 62. Over a 30-to-40 year retirement life, this adds up to a difference of several hundred thousand dollars.
Tax inefficiencies arise when retirees don’t properly coordinate their Social Security claiming strategies with prudent tax and investment planning. Up to 85% of Social Security benefits can be included in your taxable income. Unsuspecting and unknowing retirees who have paid tens, if not hundreds of thousands of dollars, in Social Security taxes throughout their working lives, are now taxed a second time when they receive their benefits.
The calculation is based on a retiree's “provisional income” and is similar to the Medicare Part B premium penalty which is based on your modified adjusted gross income. Both amounts are means tested and the more you make in retirement, the more your Social Security benefits will be taxed and the higher your Medicare Part B penalty. The Part B premium penalty for some retirees is expected to be higher than $556 a month in 2024. This represents a 434% increase from traditional levels (source: Congressional Research Service report, Medicare Part B Premiums, September, 2015). (For related reading, see: Embracing a Short-Term Boring Retirement Plan.)
Unnecessary Taxes in Retirement
Most retirees think that they don’t make enough in retirement for this to be a problem, but this is the kind of thinking that costs them thousands in lost benefits. The provisional income thresholds for taxation of Social Security have not changed since they were introduced in the early 1980s and more and more retirees will be subject to this unnecessary tax without proper planning.
Additionally, once a retiree hits age 70 1/2, their required minimum distributions (RMDs) kick in from their 401(k) or traditional IRA plans. Monies withdrawn from these accounts are taxed at ordinary income levels and could have the effect of causing up to 85% of their Social security to be included in their taxable income. (For more, see: What to Do to Prepare for Retirement.)
For a retiree who is right at the income threshold of whether their Social Security will be taxable or not, every $1 withdrawn out of a 401(k)/IRA plan belonging to someone in the 25% tax bracket would incur a 46.25% tax on that $1, not 25%. The reason is the $1 withdrawal also triggers 85% of each Social Security dollar to be taxed.
At the 25% marginal rate, $1 of IRA + $0.85 includable Social Security benefit = $1.85 of income. $1.85 x 25% tax rate = $0.4625 or a 46.25% tax on that $1.
Over 20-30 years in retirement this adds up. Without comprehensive, integrated retirement income planning you could be missing out on over $845,000.
In this example above, a 66-year-old couple needs $100,000 of income each year to support their lifestyle. They are currently receiving $48,000 a year from Social Security and are withdrawing $52,000 a year from their IRA/401(k) plans. In 2015, with no tax planning, they would have a total tax liability of $9,734. This represents a 9.7% effective tax rate (tax liability/total income).
In 2016, with proper tax planning, their tax liability is only $2,878. This is an effective tax rate of 2.8% on the same $100,000 of income. They save $6,856 in taxes. Over 30 years, saving $6,856 a year at 8% would grow to over $845,659.
The key in this example is that the couple was able to transition a portion of their monies over to the five types of accounts that don’t count the provisional income or modified adjusted gross income calculations. This reduced the Social Security taxes that they had to pay and reduced their ordinary income liability. Additional tax savings can also be realized by combining planning strategies. (For more, see: How to Know When You Should Claim Social Security.)