GregoryBresiger.com primarily devotes itself to helping people build savings and investments. But for this one time I can going to write a column assuming that you have reached financial independence and you want to ensure that you never lose it. And believe me, we could write endless columns on the number of famous and not so famous people who have blown through tons of money and ended their last days in poverty. For instance, both talk show host Ed McMahon and legendary actor Mickey Rooney, who made tons of money over their fabled careers, ended their lives broke.
So, in ensuring that you will not outlive your money, remember some assets are golden, but others are not.
And it is important to treat qualified assets, assets that qualify for special tax treatment, like a golden goose, a golden goose who you want to live forever. The way you spend retirement assets can make a big difference in whether or not you will run out of them, advisors say.
Who Goes First?
Let us assume that you have a considerable amount of assets and much of them in tax-advantaged accounts. These are called qualified assets, or what some call retirement accounts. You also have taxable assets. How you use these assets, which ones are used first and how you withdraw them, has tremendous importance, many advisors say.
“Accessing qualified assets last is right on the mark. It is the smart thing to do,” according to Charles Hughes, an advisor in Bay Shore, New York. “We tend to delay the use of retirement assets as long as possible,” adds Steve Branton, a San Francisco-based adviser.
Even when you take money from qualified assets, or adding to them if you are still adding to some accounts, the way you do it can be critical. That’s because the longer you keep them away from the taxman, the longer the compounding process takes place, even if it is just a few years or a few months more, generally the better your retirement plan Hughes says. Qualified assets, he says, are “golden.”
Do I Qualify?
Qualified investments, sometimes called retirement accounts, are savings vehicles that qualify for special or reduced taxation under a section of the tax code. These include Individual Retirement Accounts (IRAs), pensions, 401(k)s and Keogh plans. Most work retirement plans offered are qualified plans. Their tax advantages over years can be considerable, especially when compared to saving for retirement outside of them by using regular investments, which generally trigger taxes each year.
For instance, if you buy a mutual fund outside of a qualified plan and earn dividends or capital gains on it over the course of a year you pay taxes. However, with most qualified accounts, you pay no taxes on the gains until you start withdrawing in retirement. Then, in many cases, possibly you are in a lower tax bracket. And by delaying withdrawals one allows the tax benefits of these accounts to go on as long as possible. Here’s one illustration on how you can build up these account balances before retirement.
Are You Taking a Break?
Many qualified accounts also provide a tax deduction in the same year you contribute to a plan. For example, say you made $50,000 in a year, but contribute $6,000 to a qualified plan. You are only taxed on $44,000 of your income. These breaks can be critical in building a healthy retirement stash. One can usually build up much bigger balances much faster than saving the same amount in taxable accounts. And you can also help your children and grandchildren by encouraging them to do this as soon as possible. That’s because the longer compounding goes on—and the idea is for some form of compounding to continue even in retirement—the more likely one is to reach a goal.
(An aside, for our usual audience just starting out and trying to accumulate. I once knew an advisor, Anthony Ogorek of Buffalo, New York, whose daughter did some regular babysitting. This young lady, just 16 years old, had an IRA opened in her name. Some $2,000 dollars a year are entered into the account every year. But, if she sticks to the process, it will take place not over 30 or 40 years of work, as in most cases, but possibly over 50 years. Let us assume an average long-term return of nine percent a year. Imagine what this young lady will have in assets in 50 years? She would have $20,505,000—that’s right over $20 million! — and another fond memory of her father. Who doesn’t want that for their children?).
Building and Tearing Down
For pre-retirees and retirees, it is important not only to understand how to build retirement accounts, but also how very important to know how to draw down assets.
The pay taxes later strategy is so critical, Hughes says, that “I tell my clients to wait and take distributions at the end of the year. Then you have the compounding process go on for a few more months each year.” And possibly more important, you delay having to deal with those pushy publicans called the IRS.
The strategy of slowing down taxes as much as possible can be a critical factor in answering the question will I run out of money in retirement?
“That’s the $64,000 question,” writes attorney and certified public accountant James Lange in his book “Retire Secure. Pay Taxes Later.” A longtime adviser in Pittsburgh, he adds that, since there are many retirement variables, no retirement plan can be 100% secure.
A Smart Strategy
But he says that one strategy can dramatically improve a retiree’s odds of never running out of money: try to reduce what is for most people their biggest or close to biggest cost over the course of a lifetime: “Take action to drastically reduce your taxes,” according to Lange.
By delaying the payment of taxes, Lange says, “you are giving your accounts more time to add capital gains, interest and dividends, instead of interrupting the buildup of the account.”
Advisors say that each retirement plan is different so one idea doesn’t work for everyone every time. However, deferring paying the most pesky, persistent cost, taxes, usually makes sense, they say.
Indeed, Hughes advocates the same kind of strategy in reverse for those preparing for retirement. Make the yearly contribution as early as possible in the tax year—early January—so one can get the maximum of compounding each year. The strategy also works for retirees who work part time and are adding to a Roth IRA each year.
Do you know that you are going to make $7,000 or less this year? Make the qualified account contribution of the earned income early in January, Hughes says. With a Roth IRA you get no tax deduction, but you can contribute to the account for as long as you have earned income.
Withdrawals are tax free. (Another aside: I continue to work part-time because I like to work a bit. And I keep putting money into my Roth, which, since it is one of my four retirement accounts, I may never touch it)
Will You Win?
The name of the game, Hughes says, is to achieve the most important retirement planning goal: “To avoid running out of money in retirement.”
And the preserving qualified assets rule as much as reasonably possible, using non-qualified assets first, can also be extended to how much you take out each year. All things being equal, you should take out as little from your qualified assets as possible each year. Just take the minimum distribution as required by law. Instead, advisors say, first rely on non-qualified, taxable, assets.
Keeping distributions to the minimum or just a little more could help you to maintain the value of your accounts. Let’s say you have $330,000 in a qualified account and your minimum distribution in one year is about $12,000. But say you want a little more. You take an additional 150% more than the minimum distribution, for a total of about $30,000, and have to pay taxes on it. However, you still have $300,000 remaining in the qualified account that is still not being taxed.
And, if it is a good year and you earn 10% on the remaining balance, then, at the end of the year, you once again have about $330,000 and had the benefit of the $30,000 (minus taxes). And this is why advisors argue that retirees, who expect to live at least another 15 or 20 years, should continue to have some part of their retirement savings in stocks, generally the best long-term investment.
Stocks return about 9.5 percent a year over the long term, the best of most major investment categories, according to the book “Stocks for the Long Term,” by Jeremy Siegel. Deferring taxes as long as possible tends to help those stocks gains get bigger.
“As a general principle, with some exceptions, one should defer qualified assets as long as possible,” says Boyan Doytchinov, an adviser in Medford, New York. “That is a good starting point in retirement planning.”
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