Annuities Income Tax Planning Retirement Income Planning Roth IRA Social Security

Increase Your After-Tax Social Security Benefits – Part 1 of 4

The last two posts, Say Goodbye to Up to 30% of Your Social Security Benefits – Parts 1 and 2 discussed taxation of Social Security benefits. As explained in both posts, up to 50% or 85% of Social Security benefits can be taxable depending upon the amount of one’s “combined income” (50% of Social Security benefits plus adjusted gross income increased by tax-exempt income) compared to specified thresholds that are dependent upon one’s tax filing status (i.e., single, head of household, married filing separate, or married filing joint) and one’s tax rates.

Although, as pointed out in last week’s post, taxation of Social Security benefits has been a thorn in Congress’ side ever since it came into being in 1984, it appears that it’s here to stay. Income taxation of Social Security benefits can be reduced or, in some cases, eliminated, in one or more years with proper planning. While much of the planning is ongoing throughout the years that one is collecting benefits, there are several opportunities that should be analyzed and potentially implemented beginning in one’s 40’s, many years before the receipt of one’s first Social Security check. This post focuses on pre-benefit receipt planning and Parts 2, 3, and 4 address planning strategies during the Social Security benefit receipt years.

Before discussing strategies that can be implemented to reduce taxation of Social Security benefits, let me make clear one strategy that generally isn’t effective. Although it hasn’t been given as much attention the last several years in our low-interest rate environment, income tax and investment planning strategies often include an analysis of after-tax return returns from taxable vs. tax-exempt investments. As mentioned in the previous two posts as well as the beginning of this one, “combined income,” which is the starting point for calculating taxable Social Security benefits, is increased by tax-exempt income. As a result, assuming that your goal is to reduce taxable Social Security benefits, other than the fact that the amount of income from a tax-exempt investment is generally less than the income from a similar taxable investment, inclusion of tax-exempt investments as part of your investment portfolio won’t be of much benefit to you.

Perhaps one of the greatest opportunities for reducing taxable Social Security benefits and ongoing associated taxation of same that can be implemented beginning 20 or more years before the receipt of one’s first Social Security check is a Roth IRA conversion or series of conversions over several years. This strategy was featured in the March 15, 2010 post, Want to Reduce Taxable Social Security Benefits? Consider a Roth IRA Conversion as part of Retirement Income Visions™ extensive Roth IRA conversion series.

As discussed in that post, to the extent that a Roth IRA conversion reduces the amount remaining in your traditional IRA, your required minimum distributions (“RMD’s”) that you must take from your traditional IRA’s beginning when you turn 70-1/2 will be reduced. Reduced RMD’s result in less “combined income” which can reduce the amount of taxable Social Security benefits and can also reduce the marginal tax rate that is applied to the taxable portion of your benefits, resulting in less taxes. It’s important to keep in mind that this strategy, in order to be effective, needs to be implemented before receipt of Social Security benefits. To the extent that it is executed while one is receiving benefits, it will generally increase taxable income and taxation of benefits.

Another strategy than can be implemented well before receipt of Social Security is investment in one or more non-qualified (i.e., not within an IRA or other retirement plan) deferred income annuities, or “DIAs”. For an introduction to this powerful retirement income planning investment strategy, please refer to the November 23, 2009 post, Deferred Income Annuities: The Sizzle in a Retirement Income Plan. When structured as a nonqualified annuity, there are two potential ways that DIAs can be used to reduce taxation of Social Security benefits. First, the payout start and end dates from one or more DIAs can be selected to plan for the amount of income that will be paid out to reduce taxation of Social Security benefits. Secondly, a portion, sometimes very sizeable, of DIA payouts from nonqualified investments are tax-favored since they aren’t subject to income taxation by virtue of an “exclusion ratio.” Furthermore, unlike tax-exempt investment income, the portion that is excluded isn’t added back to “combined income” when calculating taxable Social Security benefits.

Permanent life insurance is another strategy that can be implemented many years before receipt of Social Security retirement benefits to reduce taxation of those benefits. To the extent that there is build-up of cash value within whole life, universal life, or variable universal life insurance policies, this cash value, when not subject to modified endowment contract, or “MEC,” taxation rules, can be distributed either through loans and/or withdrawals during one’s retirement years, often with little or no associated income taxation. To the extent that this is achieved, this will favorably affect taxation of Social Security benefits.

When you get into your later 50’s and get closer to the earliest potential start date for receipt of your Social Security benefits, i.e., age 62, a key Social Security tax-reduction strategy that has been discussed extensively in several of the Social Security posts beginning with the October 4, 2010 post, Plan for the Frays in Your Social Security Blanket – Part 2 of 2, is the choice of benefit start date for you and your spouse if married. While a delay in start date can result in increased total benefits received during one’s lifetime, it will also result in delay of taxation of benefits as well as potential increased after-tax benefits once commencement of benefits occurs.

Retirement Income Planning

Do You Have An Income Portfolio Plan?

We’re all familiar with the concept of an investment portfolio. Wikipedia defines it as “an appropriate mix or collection of investments held by institutions or a private individual.” It explains that “holding a portfolio is part of an investment and risk-limiting strategy called diversification.”

A well-diversified, professionally-managed investment portfolio can enable you to pursue various financial goals, including financial independence, in the accumulation stage of your life. As you approach, and move into, retirement, a customized income portfolio plan is essential for enabling you to close the gap between your projected income needs and your projected income sources without worrying about, and being dependent upon, the gyrations of the stock market.

How many of us have heard of a “retirement income portfolio,” or the term that I have coined, “Financial Independence Income Portfolio™?” I would suspect that not many people are familiar with these terms. I will simply use “income portfolio” for the remainder of this post to introduce this innovative planning strategy and explain why it should be the cornerstone of every retirement income plan for all individuals beginning ten years before retirement.

You may be wondering, what is an income portfolio? Whereas an investment portfolio uses a mix of assets, including stocks, bonds, and other types of investments with the goal of minimizing investment risk, an income portfolio uses streams of income to accomplish the same objective. The income streams can be produced at different intervals, i.e., monthly, quarterly, semi-annual, or annual, based on your needs.

There are several types of investments that can be used to generate income streams, each with their own advantages and disadvantages. These include, but are not limited to, CD’s, bonds, life insurance, and annuities.

Depending upon your situation, one or more of these investment vehicles can be used to design a strategy, or plan, to close the gap between your projected income needs and your projected income sources. Similar to an investment portfolio that is used in the accumulation stage, a secondary benefit to be derived from an income portfolio is minimization of investment risk.

It’s a fact of life that, unlike our parents’ generation who could depend on a monthly pension supplemented by Social Security, most individuals retiring today don’t receive a monthly income. Consequently, although no small task, we must create, manage, and protect our own income streams. The means to accomplish this, i.e., an income portfolio plan, should be the cornerstone of every retirement plan for all individuals beginning ten years before retirement.

Retirement Asset Planning Retirement Income Planning

The Sequence of Returns – The Roulette Wheel of Retirement

So here you are, crossing the threshold from earning a living to going into retirement. You worked hard for many years. You built a sizeable, diversified investment portfolio. You hedged your bet by purchasing life insurance and long-term care insurance. Your will and other estate planning documents have been updated to reflect your current goals and financial situation. Everything’s in place, or so you think.

Welcome to the roulette wheel of retirement, otherwise known as the “sequence of returns.” If you haven’t planned for this financial phenomenon, your retirement could be quite different than you envisioned. To illustrate this important concept, let’s take a look at three hypothetical scenarios. In each one we’ll use the following five assumptions:

1. Retirement age: 65
2. Portfolio value: $500,000
3. Annual withdrawals: $25,000, or 5% of the initial portfolio value,
increasing by 3% each year
4. Life expectancy: 25 years, or until age 90
5. Average rate of return: 7%

The last assumption is the most critical one and can wreak havoc on your portfolio if you only rely on a retirement asset planning strategy during your retirement years.

Let’s start with Scenario #1 – 7% Return Each Year. While this scenario never occurs in real life, it’s often used for illustration purposes. Once you review Scenario #1 – 7% Return Each Year, you will see that even after taking out withdrawals that begin at $25,000 and more than double to $52,000 at age 90, your portfolio value increases from $500,000 at age 65 to $576,000 at age 78 and then gradually declines in value to $462,000 at age 90. You’ve taken distributions totaling $964,000 and your portfolio has earned $926,000 over 25 years. Nice result!

Scenario #2 – Good Early Years assumes that you are fortunate enough to retire at the beginning of a bull market where your investment returns exceed your inflation-adjusted withdrawal rate of 5% for several years, you experience a couple of years of negative rates of return, and a bear market kicks in your final three years, resulting in negative rates of return each year. Per Scenario #2 – Good Early Years, although it doesn’t occur in a straight line, your portfolio increases from $500,000 at age 65 to a peak of almost $1.5 million at age 87, with a final value of $921,000, or double the value of Scenario #1, at age 90. Like Scenario #1, you’ve taken distributions totaling $964,000 and your portfolio has earned $1.385 million over 25 years. Life is great!

So far, so good. To illustrate Scenario #3 – Bad Early Years, let’s simply reverse the order of investment rates of return that we assumed in Scenario #2. As in Scenario #1 and Scenario #2, over 25 years, we’re going to end up with the same average rate of return of 7%, however, the first three years are going to be bumpy, to say the least. Unlike Scenario #2, where your portfolio value increases by $208,000 the first five years, going from $500,000 at age 65 to $708,000 at age 70, per Scenario #3 – Bad Early Years, it decreases by $224,000, going from $500,000 at age 65 to $276,000 at age 70, or a swing of $432,000 during the same period.

Your portfolio continues to decrease in value each year until it is depleted at age 81. Instead of taking distributions totaling $964,000 as you did in Scenarios #1 and #2, your total distributions over 25 years are only $541,000. Furthermore, instead of realizing portfolio income totaling $926,000 in Scenario #1 and $1.385 million in Scenario #2 over 25 years, your total portfolio income is a measly $41,000. Yikes!

In both Scenario #2 and Scenario #3, there are negative rates of return in only five, or 20%, of the total of 25 years of retirement. Two years of negative rates of return out of ten years, on the average, is fairly typical for long-term historical rates of return for a diversified equity-based portfolio. As you can see, in Scenario #3, it doesn’t matter that 80% of the returns were positive, nor is it relevant that there was an average rate of return of 7%. As a result of the portfolio being depleted at age 81, the hypothetical individual in this situation wasn’t able to experience the 11.4% average rate of return during the final nine years.

The most important factor in Scenario #3, and the #1 risk to any retirement asset plan, is the sequence of returns. While you have no control over this investment phenomenon, you don’t need to play roulette with your retirement assets.

Financial Planning Retirement Asset Planning Retirement Income Planning

Is Your Retirement Plan At Risk?

Before I write about the specific risks associated with retirement asset planning and the strategies that retirement income planners use to address, and, in many cases, mitigate, these risks, let’s take a look at risks that are common to all retirement planning. While many of these are uncertain and/or uncontrollable, each of them needs to be addressed in a retirement plan.

The risks that will be discussed are as follows, with the first three common to all types of financial planning, and each one intended to be a brief introduction vs. a comprehensive discussion:

  1. Inflation
  2. Investment
  3. Income tax
  4. Longevity
  5. Health
  6. Social Security benefits reduction


Although it is unpredictable as to amount and fluctuation as it pertains to individual and overall variable expenses, a key risk that must be considered in the design and funding stages of all retirement plans is inflation. Unlike most types of financial planning where it is a factor only in the accumulation phase, inflation is equally, if not more important, during the withdrawal stage of retirement planning. The longer the time period, the more magnified are the differences between projected vs. actual inflation rates insofar as their potential influence on the ultimate success of a particular retirement plan.


Unless you are living solely off of Social Security or some other government benefit program, you are directly or indirectly exposed to investment risk. Even if you are receiving a fixed monthly benefit from a former employer, although it isn’t likely, your benefit could potentially be reduced depending upon the investment performance of your former employer’s retirement plan assets and underlying plan guarantees. Whenever possible, investment risk should be maintained at a level in your portfolio that is projected to sustain your assets over your lifetime while achieving your retirement planning goals, assuming that your goals are realistic.

Income Tax

Even if income tax rates don’t change significantly as has been the case in recent years, income tax can consume a sizeable portion of one’s income without proper planning. With the exception of seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) that have no personal income tax and two states (New Hampshire and Tennessee) that tax only interest and dividend income), the rest of us need to be concerned about, and plan for, state, as well as, federal income tax. In addition, if you have a sizeable income, it is likely that income tax legislation will be enacted that will adversely affect your retirement plan on at least one occasion during your retirement years.


Unlike other types of financial planning, the time period of retirement planning is uncertain. Although life expectancies are often used as a guide to project the duration of a retirement plan, no one knows how long someone will live. The risk associated with the possibility of outliving one’s assets is referred to as longevity risk. In addition, life expectancies, themselves, are changing from time to time. The August 19, 2009 edition of National Vital Statistic Reports announced a new high of nearly 78 years for Americans. Planning is further complicated for married individuals since you are planning for multiple lives.


An extremely important risk that is sometimes overlooked or not given enough consideration in the design of retirement plans is health. Under-, or uninsured, long-term care events as well as premature death in the case of a married couple, can deal a devastating blow to an otherwise well-designed retirement plan. It is not unusual for a prolonged long-term care situation, such as Alzheimer’s, if not properly planned for, to consume all of one’s retirement capital and other assets. Inadequate life insurance to cover the needs of a surviving spouse can result in dramatic lifestyle changes upon the first spouse’s death.

Social Security Benefits Reduction

Once considered to be unshakable, the security of the Social Security system, including the potential amount of one’s benefits, is questionable. In addition, it was announced in May that for the first time in more than three decades Social Security recipients will not receive a cost of living adjustment, or COLA, increase in their benefits next year. While beneficiaries have received an automatic increase every year since 1975, including an increase of 5.8% in 2009 and a 14.3% increase in 1980, this will not be the case in 2010.

Each of the foregoing six risks needs to be considered, and appropriate strategies developed, in the design and implementation of every retirement plan to improve the chances of success of the plan.