Tag: retirement plan

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Retirement Income Planning

Mind the Gap

If you’ve been to London and taken the Underground, you’re probably familiar with the phrase, “Mind the gap.” It’s a recorded warning to train passengers to be cautious when crossing the gap between the train door and the station platform. Having an affinity for the British and their sense of humor, this resonated with me and puts a smile on my face whenever I think of it.

When planning for retirement, you also need to “Mind the gap.” Just like with the Underground where you have an unsafe opening between the station platform and the train door, there’s often a separation between retirement expenses and income, with income not being sufficient to match expenses in a particular year. I like to refer to this as a “net expense year.”

In order to “mind the gap” in retirement income planning, you first need to identify the gaps. This is extremely complicated due to the many uncertainties and associated assumptions that must be made when doing this type of planning, a discussion of which is beyond the scope of this post.

The preparation of a cash flow projection is an essential tool for most financial planning situations. It’s indispensable when it comes to retirement income planning, including identification, analysis, and resolution of net expense years. Like any financial projection, a cash flow projection is only as useful as the information that’s used to prepare it.

Retirement income planning cash flow projections, unlike other types of cash flow projections where you typically work with a defined number of years, is complicated by the fact that you need to plan for what is generally an unplannable event, i.e., death. This becomes even more problematic when planning for couples.

It’s important to keep in mind that cash flow planning isn’t a one-time exercise. Cash flow projections need to be prepared and updated using multiple what-if scenarios on a regular basis before and throughout retirement. The use of account aggregation software is advisable, if not essential, for consolidating real-time information from multiple financial accounts in one place whenever this is done. I make the secure, online system that I use for this purpose readily available to my clients for viewing cash flow, investment, net worth, and other essential financial reports.

Projected net expense years, in and of themselves, aren’t necessarily problematic. There may be sufficient cash reserves or other liquid assets available that can be used to cover projected deficiencies in a particular year(s). Income tax liability associated with sales of nonretirement assets or withdrawals from retirement plan accounts needs to be calculated to determine the net amount available to cover projected shortfalls. When the projected net expense years are reoccurring and are projected to deplete investment assets, the sale of real estate assets, when available, including one’s house, may be required to provide funds to reduce or eliminate the gaps.

When planning for the years leading up to or during retirement, remember to “mind the gap.”

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Retirement Income Planning

Nonretirement vs. Retirement Plan Investments – What is the Right Mix?

Retirement Income Center

Last week’s post made the point that retirement plans, in and of themselves, generally aren’t sufficient for meeting most people’s retirement needs and, therefore, it’s important to include nonretirement investments in most retirement income plans. The question is, what is the right mix of retirement vs. nonretirement investments?

Like the answer to many financial planning questions, the correct response is, “It depends.” Each situation is different. It all revolves around the interaction between a host of many variables, including, but not limited to, current age, projected retirement age, retirement income goals, insurance coverage, current investments, access to and participation in employer retirement plans, availability of other types of retirement plans, other assets owned, liabilities, current disposable income, projected sources of retirement income, income tax carryover losses, and current and projected income tax rates.

Aside from obvious situations where there are inherent limitations in the ability to make nonretirement investments, e.g., minimal disposable income combined with access to an employer-matching 401(k) plan, a detailed analysis should be performed and monitored periodically by a qualified retirement income planner to determine the optimal mixture of retirement vs. nonretirement investments. In addition, the analysis should include the determination of which individual investments are best suited for inclusion in a retirement plan vs. a nonretirement investment portfolio.

As stated last week, nonretirement investments are simply the same types of investments that you find in retirement plans, i.e., stocks, bonds, mutual funds, exchanged traded funds, annuities, CD’s, etc. While this is true, different types of assets behave differently in retirement vs. nonretirement plans. The behavioral differences are attributable to differing income tax rules associated with each type of investment. Furthermore, different income tax rules apply to the accumulation vs. the distribution stage.

It’s critical to understand the accumulation and distribution income tax differences associated with placing a specific investment in your nonretirement portfolio vs. holding it in your retirement plan. An example of this is annuities. Whether held inside or outside a retirement plan, annuities grow tax-deferred. This means that so long as there are no distributions taken from the annuity, there are no current income tax reporting requirements associated with it. When it comes time to taking distributions, it’s a completely different story. Distributions from annuities held in retirement plans are generally taxable as ordinary income vs. those from nonretirement plan annuities are subject to an exclusion ratio whereby a portion of each distribution is generally nontaxable.

The allocation of investments between retirement vs. nonretirement plans as well as the inclusion of a particular investment in a retirement vs. a nonretirement investment portfolio can make or break a retirement income plan. This definitely falls under the category, “Don’t try this at home.”

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Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 4

Retirement Income Center

Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. Steps 1 and 2 of this strategy was presented two weeks ago in Part 2 and steps 3 and 4 were discussed last week in Part 3.

This week’s post presents the fifth and final step together with a hypothetical case to illustrate the use of this strategy. If you haven’t done so already, I would recommend reading Parts 2 and 3 to learn about steps 1, 2, 3, and 4.

Step 5 – Complete Your Conversion Plan No Later Than the Year Before You Turn 70-1/2

As discussed in the January 11, 2010 blog post, Year of the Conversion, there are two main benefits of a Roth IRA that aren’t available to traditional IRA owners:

  1. Nontaxable distributions
  2. No required minimum distributions (“RMD’s”)

No one I know likes to be forced to do anything. In order to realize benefit #2, it’s important to target your conversion plan completion date for no later than the year before you turn 70-1/2. Once you reach this milestone, you will be required to take minimum distributions from your traditional IRA accounts each year based on your traditional IRA account value on December 31st of the preceding year and an IRS table life expectancy factor. Assuming that you complete your Roth IRA conversion plan by the year before you turn 70-1/2, you won’t be subject to the “RMD” rules.

Hypothetical Case

Now that we have completed our discussion of the 5-step Roth IRA conversion strategy, let’s take a look at a hypothetical case. Keeping in mind that you want to (a) have your 2010 conversion amount be larger than in subsequent years, (b) skip 2011 and 2012 if you deferred the taxation of your 2010 Roth IRA conversion income, (c) convert equal amounts thereafter, and (d) complete your conversion plan no later than the year before you turn 70-1/2, let’s make the following ten assumptions:

  1. Individual age 50 in 2010
  2. Sufficient liquid nonretirement assets to pay income taxes attributable to annual conversions
  3. SEP-IRA with beginning of 2010 value of $400,000 and cost basis of $0
  4. Earnings of 5%
  5. Annual SEP-IRA contributions of $20,000 through age 65
  6. 2010 Roth IRA conversion of $160,000
  7. Taxation of 2010 Roth IRA conversion deferred to 2011 and 2012
  8. No 2011 and 2012 Roth IRA conversions
  9. 2013 and subsequent year conversions of $45,000
  10. Final conversion at age 69 after which SEP-IRA account value = $0

Per the Hypothetical Roth IRA Conversion Strategy spreadsheet, the 2010 value of $400,000, total earnings of approximately $196,000, and total SEP-IRA contributions of $320,000 results in Roth IRA conversions totaling approximately $916,000 by age 69. Not only will the Roth IRA conversions of $916,000 not be subject to additional taxation, 100% of the growth of the Roth IRA funds will escape income taxation provided that the funds remain in the Roth IRA for at least five years from the beginning of the year of each conversion and until age 59-1/2.

It’s important to keep in mind that this is a hypothetical case and actual conversion amounts in a particular situation, assuming a Roth IRA conversion makes sense, will depend on many factors that need to be carefully analyzed for each conversion year.

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IRA Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 3

Retirement Income Center

Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. Last week’s post presented steps 1 and 2 of this strategy. This week’s post discusses steps 3 and 4. Step 5 will be presented in Part 4 together with a hypothetical case to illustrate the use of this strategy. If you haven’t done so already, I would recommend reading Part 2 to learn about steps 1 and 2.

Step 3 – Convert An Equal Amount Each Year Beginning in the Year After the Year(s) in Which You Recognize Your 2010 Conversion Income

If you deferred the taxation of your 2010 Roth IRA conversion income, you should plan on converting an equal amount of your traditional IRA to a Roth IRA each year from 2013 until you complete your Roth IRA conversion strategy in order to keep things simple and increase the likelihood of sticking with your plan. Alternatively, if you recognized your 2010 Roth IRA conversion income on your 2010 income tax returns, you should begin your “equalization” phase in 2011.

Depending upon income tax rates and your particular situation, there may be years when you will want to increase or decrease your conversion amount in order to minimize your income tax liability. To the extent that you do this, you will need to adjust your annual equalization amount going forward. You will also need to adjust your future annual equalization amounts for any additional contributions or rollovers to your traditional IRA as well as for any recharacterizations (See Recharacterization – Your Roth IRA Conversion Insurance Policy).

Step 4 – Complete Your Conversion Plan by Your Social Security Benefit Commencement Date If It Makes Sense

As a general rule, if possible, you should plan on completing your Roth IRA conversions by the date when you will begin receiving Social Security benefits. This will be much easier to accomplish if you begin your conversion plan between age 45 and 50 assuming that your traditional IRA is not increased by any sizeable contributions and/or rollovers after age 50.

Given the overriding goal of reducing the taxation of Social Security benefits and the fact that Social Security benefit taxation is directly influenced by the amount of your other taxable income, the absence of Roth IRA conversion income could reduce, or potentially eliminate, otherwise taxable Social Security benefits under current income tax laws.

Assuming your other income is projected to be sufficient to cover your expenses, it may even be advisable to defer your Social Security benefit commencement date so that you may extend your conversion period and, in turn, minimize your Roth IRA conversion income tax liability.

In addition, since the Medicare Part B, or medical insurance, premium amount is determined by one’s income, the absence of Roth IRA conversion income beginning at age 65 could help keep Medicare Part B premiums in check.

Depending upon your current age, it may not be prudent to complete your Roth IRA conversions by your Social Security benefit commencement date since doing so may require you to incur a substantial amount of income tax liability in connection with your Roth IRA conversion amounts. This is especially true if you’re 60 or older when you begin your conversion plan, you have a sizeable traditional IRA, and you aren’t planning on doing any conversions in 2011 and 2012 (see Step 2 in Part 2). In addition, if it is projected that you will have a substantial amount of income from other sources that is projected to result in taxation of your Social Security benefits, it probably won’t make sense in most cases to accelerate your Roth IRA conversion plan so that it is completed by your Social Security benefit commencement date.

For the fifth and final step of the 45 to 60 Roth IRA conversion strategy, watch for Part 4 next week.

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Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 2

Retirement Income Center

Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. This post presents steps 1 and 2 of this strategy, with steps 3 and 4 to be discussed in Part 3, and step 5 to be presented in Part 4 together with a hypothetical case to illustrate the use of this strategy.

Step 1 – Begin Your Plan in 2010 Using a Larger Conversion Amount Than in Subsequent Years

I’m recommending that you begin your Roth IRA conversion strategy in 2010 to take advantage of the one-time opportunity to defer 50% of the income from your 2010 conversion to 2011 and 50% to 2012 or, alternatively, take advantage of lower income tax rates in 2010 if you elect to include the income from your 2010 conversion on your 2010 federal income tax return if this makes more sense for you (see In Which Tax Year(s) Should You include Your 2010 Roth IRA Conversion Income – Parts 1, 2, and 3).

Given this unique tax planning opportunity, it will make sense in most cases to convert a larger portion of your traditional IRA to a Roth IRA in 2010 than in future years. I generally recommend to my clients a 2010 conversion amount of approximately 2-1/2 to 4 times the size of the annual subsequent year conversion amounts per Step 3 (See Part 3 next week), depending upon their current IRA value, the cost basis of their IRA, future planned IRA contribution amounts, and the total number of years over which conversions will be made.

Furthermore, if you will be doing a larger Roth IRA conversion in 2010, per my blog post two weeks ago (Be on the Lookout for Roth IRA Conversion Opportunities), it’s prudent to execute your conversion(s) following market declines whenever possible in order to convert the largest amount of your traditional IRA with the least amount of income tax liability.

Step 2 – Skip 2011 and 2012 If You Deferred the Taxation of Your 2010 Roth IRA Conversion Income

Assuming that you converted, or will convert, a sizeable portion of your traditional IRA to a Roth IRA in 2010 and will defer the taxation of your 2010 conversion to 2011 and 2012, with some exceptions, it probably won’t make sense in most situations to do any additional Roth IRA conversions in 2011 and 2012. Unless you have some significant tax sheltering opportunity, e.g., sale of rental property resulting in a large passive activity loss with minimal capital gains, net operating loss, large charitable contribution deduction from establishment and funding of a charitable remainder trust, etc., you should plan on skipping 2011 and 2012 Roth IRA conversions in order to avoid adding yet another layer of income onto your already bloated 2011 and 2012 taxable income.

So you know what to do for the next three years. What’s the plan after 2012? Stay tuned for Steps 3 and 4 in Part 3 next week.

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Roth IRA

The 45 to 60 5-Step Roth IRA Conversion Strategy – Part 1

Retirement Income Center

Are you 45 to 60 years old and either have a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA? If so and you would like to enhance the likelihood of maximizing your retirement benefits, you should consider implementing a multi-year systematic plan to convert the vast majority, if not all, of your traditional IRA to a Roth IRA.

Ideally, you want to begin converting your traditional IRA to a Roth IRA beginning in 2010 and complete your conversion plan by the year that you will begin receiving Social Security benefits or no later than the year before you will turn 70-1/2. Your age, the value of your IRA, future contributions to your IRA, recharacterizations (See Recharacterization – Your Roth IRA Conversion Insurance Policy), income tax rates, income tax planning opportunities, and source of funds to pay the income tax liability attributable to your conversions will directly affect your actual annual conversion amounts as well as when you will complete your plan.

The last factor – source of funds to pay the income tax liability attributable to your conversions – needs to be carefully analyzed before you do a one-time conversion, let alone design a multi-year Roth IRA conversion plan. Per the January 25, 2010 post, Three Roth IRA Conversion “Show Stoppers,” if you don’t have sufficient funds in checking, savings, money market, and other nonretirement accounts outside of your IRA to pay the tax attributable to a Roth IRA conversion, you aren’t a good candidate for a Roth IRA conversion. The importance of this liquidity analysis is magnified in a multi-year plan.

Assuming that liquidity isn’t projected to be an issue and assuming there aren’t any other factors present that would negate the potential benefits to be derived from one or more Roth IRA conversions, there are five steps that should be included in a Roth IRA conversion plan for individuals who are 45 to 60 years old as follows:

  1. Begin your plan in 2010 using a larger planned conversion amount than in subsequent years.
  2. Skip 2011 and 2012 if you deferred the taxation of your 2010 Roth IRA conversion income.
  3. Convert an equal amount each year beginning in the year after the year(s) in which you recognize your 2010 conversion income.
  4. Complete your conversion plan by your Social Security benefit commencement date if it makes sense.
  5. Complete your conversion plan no later than the year before you turn 70-1/2.

Steps 1 and 2 will be addressed in Part 2 of this blog post, steps 3 and 4 will be discussed in Part 3, and step 5 will be presented in Part 4 together with a hypothetical case to illustrate the use of this strategy.

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Roth IRA

Roth IRA – Retirement Plan Holey Grail?

Retirement Income Center

With all of the buzz in the investment/retirement planning community about Roth IRA’s as a result of the January 1st elimination of the $100,000 modified adjusted gross income threshold for converting a traditional IRA to a Roth IRA, you would think that they’re the only game in town. Although the two main attractions of a Roth IRA that were introduced in last week’s blog post, Year of the Conversion, i.e., nontaxable distributions and no required minimum distributions (“RMD’s”), are two desirable benefits of any retirement plan, there is a price you must pay to obtain them.

The Ideal Retirement Plan

In order to understand the Roth IRA club entry fee, let’s take a step back and examine the eight features of an ideal retirement plan to see which ones are present or lacking in a Roth IRA:

  1. Contribution ability not subject to income test
  2. Fully deductible contributions
  3. Unlimited contribution amounts
  4. Nontaxable income
  5. Nontaxable distributions
  6. Distributions at any age without penalties
  7. No required minimum distributions
  8. No income tax liability upon conversion to the plan

Contribution Ability Not Subject to Income Test

Unlike other types of retirement plans, potential IRA owners must clear an income hurdle in order to be eligible to make contributions. If your adjusted gross income exceeds specified limits, which are different depending upon your filing status, then you won’t be allowed to make a contribution to either a traditional or Roth IRA.

Fully Deductible Contributions

Contributions to plans that are used directly and indirectly for conversion to Roth IRA’s are often, but not always, fully deductible. These include traditional IRA’s, SEP-IRA’s, 401(k) plans, profit sharing plans, and defined benefit plans. This is an extremely important benefit not to be overlooked, particularly if you’re in a high marginal income tax bracket when making contributions to these types of plans. Roth IRA contributions, on the other hand, are never deductible.

Unlimited Contribution Amounts

In addition to being fully deductible, allowable contribution amounts for certain retirement plans, such as defined benefit plans, while they aren’t unlimited, can be quite generous, particularly for highly-compensated older employees. In addition to being nondeductible, Roth IRA contributions are currently limited to $5,000 per year, or $6,000 if 50 and above.

Nontaxable Income

All retirement plan participants enjoy the benefit of nontaxable income while funds remain in the plan. This includes interest, dividends, and realized gains from securities sales that would otherwise be taxable if the same investments were held in a nonretirement plan.

Nontaxable Distributions

As pointed out in Year of the Conversion, whenever a deduction is allowed for contributions to a retirement plan, whether it be an IRA, 401(k), or some other type of pension plan, withdrawals from the plan are taxable as ordinary income just like salary. As also mentioned in last week’s post, since contributions to a Roth IRA aren’t deductible, withdrawals generally aren’t taxable provided that they remain in the plan for five years after the Roth IRA owner established and funded his or her first Roth IRA account, or, in the case of a Roth IRA conversion, five years from the date of conversion, and the owner is at least 59-1/2.

Distributions At Any Age Without Penalties

To promote the fact that retirement plans are intended to be used for retirement, distributions from retirement plans before age 59-1/2 are generally subject to a 10% federal premature distribution penalty plus potential state penalties. This includes distributions from Roth IRA conversions.

No Required Minimum Distributions

In exchange for tax-deductible contributions and nontaxable income while funds remain in a plan, IRS requires you to begin withdrawing funds, otherwise known as required minimum distributions, or “RMD’s,” from plans at a specified age, generally age 70-1/2, or be subject to a 50% penalty on RMD’s not distributed. While Roth IRA’s escape this requirement during the owner’s lifetime, Roth IRA beneficiaries are required to take minimum distributions from their inherited plans.

No Income Tax Liability Upon Conversion to the Plan

When you convert, or roll over, company pension plans, such as 401(k) plans, profit sharing plans, and defined benefit plans to a traditional IRA, there’s generally no income tax liability assessed upon conversion. Roth IRA conversions, however, are fully taxable as ordinary income with the exception of funds originating from nondeductible IRA contributions.

Depending upon facts and circumstances, assuming you have the funds available outside of your retirement plans to pay it, in many cases, the income tax liability associated with a Roth IRA conversion won’t outweigh the potential benefits one might potentially receive from a Roth. Even though Roth IRA’s share many of the eight desirable features of an ideal retirement plan, as you can see, they aren’t the holy grail of retirement plans, and, depending on your situation, may in fact, end up being the “holey” grail for you.

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Retirement Asset Planning Retirement Income Planning

Retirement Income Planning – The End Game

Retirement Income Center

If you’re a subscriber to Retirement Income Visions™, you may have noticed that, although there have been nine posts prior to this one, none of them has stayed true to the theme of this blog, i.e., Innovative strategies for creating and optimizing retirement income. This post will be no exception. As the saying goes, there’s a method to my madness. In order to understand and appreciate the strategies and apply them to your situation, it’s important to understand the origin of retirement income planning, including the limitations of the retirement asset planning approach.

As explained in The Retirement Planning Paradigm Shift – Part 2, retirement planning is undergoing a paradigm shift. Instead of relying on retirement asset planning as a solution for both the accumulation and withdrawal phases of retirement, people are beginning to recognize, understand, and appreciate the need for, and value of, employing retirement income planning strategies during the withdrawal phase. No doubt about it, per Retirement Asset Planning – The Foundation, retirement asset planning is the way to go in the accumulation stage to build a solid foundation for a successful retirement plan. However, as discussed in The Retirement Planning Shift – Part 2, as a result of the uncertainty of traditional retirement asset planning as a solution for providing a predictable income stream to match one’s financial needs in retirement, retirement income planning was born.

Is Your Retirement Plan At Risk? introduced six risks common to all retirement plans: inflation, investment, income tax, longevity, health, and Social Security benefits reduction.

Beginning with Retirement Asset Planning – The Foundation, the inadequacy of retirement asset planning during the “spend-down” phase was discussed. This begins with the process itself. Unlike most types of financial planning where you get to see the results of your plan after reaching a specified target date, this is not the case with retirement asset planning since the timeframe is undefined.

Withdrawal Drag – The Silent Killer contrasted the beauty of compound rates of return during the accumulation stage with the erosion of portfolio income and the associated benefit of compounding, otherwise known as “withdrawal drag,” in the withdrawal stage of retirement. There is yet another phenomenon that can wreak havoc on your portfolio if you only rely on a retirement asset planning strategy during your retirement years. The Sequence of Returns – The Roulette Wheel of Retirement exposed this investment phenomenon and provided an example of how “luck of the rate-of-return draw” can prematurely devastate a conservative, well-diversified portfolio.

As if all of these variables and financial phenomenon were not a wake-up call to your planning, we mustn’t forget about the “safe withdrawal rate.” Safe Withdrawal Rate – A Nice Rule of Thumb demonstrated how the widely-accepted 4% “safe” withdrawal rate doesn’t necessarily guarantee that you won’t outlive your investment portfolio. Furthermore, the withdrawal amount that is calculated using this methodology typically won’t match your retirement needs.

All of the foregoing financial risks and phenomenon contribute to the inherent uncertainty associated with the retirement asset planning process during the withdrawal phase of retirement. As pointed out in Retirement Asset Planning – The Foundation, even if you’ve done an excellent job of accumulating what appear to be sufficient assets for retirement, you generally won’t know if this is true for many years

Retirement income planning is truly the end game in financial planning. Assuming that your goal is to generate a predictable income stream to match your financial needs in retirement while minimizing your exposure to withdrawal drag, the sequence of returns, and the various risks common to all retirement plans, it generally makes sense for you to begin employing retirement income planning strategies for a portion of your assets ten years before you plan to retire. The amount of assets and the exact timing of implementation are dependent upon your particular retirement and other financial goals as well as your current and projected financial situation.

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Retirement Asset Planning

Safe Withdrawal Rate – A Nice Rule of Thumb

Retirement Income Center

Last week’s post, The Sequence of Returns – The Roulette Wheel of Retirement, showed how “luck of the rate-of-return draw” can have a dramatic affect on a retirement asset plan in determining whether you will outlive your investment portfolio. In two scenarios where the retirement age (65), portfolio beginning value ($500,000), average rate of return (7%), withdrawal rate (5%), and inflation factor applied to the withdrawal rate (3%) were identical, and the only variable was good vs. bad early years, there were quite different results. With the “Good Early Years” scenario, after 25 years, at age 90, distributions totaled $964,000, the portfolio earned $1.385 million, and the portfolio value was $921,000. Under the “Bad Early Years” scenario, the portfolio was depleted after 16 years at age 81 after taking distributions totaling $541,000 and the portfolio earning $41,000.

Many people would argue that 5% seems like a reasonable withdrawal rate, however, as we saw, under the “Bad Early Years” scenario, this proved to be too aggressive. The financial planning industry, after many years of debate, has settled on a rule of thumb of 4% as a “safe withdrawal rate.” That is to say, you can withdraw 4% of the value of your portfolio in your first year of retirement and then increase your withdrawal amount by an inflation factor in subsequent years without depleting your portfolio during your lifetime. As an example, assuming a portfolio value of $500,000 at retirement and a 3% inflation factor, you could withdraw $20,000 ($500,000 x 4%) in Year 1, $20,600 ($20,000 x 1.03) in Year 2, $21,218 ($20,600 x 1.03) in Year 3, etc.

Is a “safe withdrawal rate” something we should live by or is it simply a rule of thumb? While a 4% withdrawal rate during retirement can potentially enable you to sustain your retirement capital for the duration of your retirement, this is not always the case, particularly in “Bad Early Years” scenarios. In addition to the withdrawal rate, the interplay of the following ten variables will determine whether or not you will outlive your portfolio:

  1. Type of portfolio, i.e., nonretirement vs. retirement
  2. Income tax rates
  3. Source of income tax payments, e.g., checking account, nonretirement sales proceeds, IRA withdrawal, etc.
  4. Retirement duration
  5. Average rate of return
  6. Sequence of returns
  7. Timing of earning of income
  8. Inflation rate
  9. Frequency of withdrawals
  10. Timing of withdrawals

As an example of the interplay of several of these variables, let’s make the following assumptions:

  1. Retirement age: 65
  2. Beginning portfolio value: $500,000
  3. Average rate of return: 6%
  4. Sequence of returns: Bad early years
  5. Withdrawal rate: 4%
  6. Inflation rate: 3%
  7. Frequency of withdrawals: Annual
  8. Timing of withdrawals: Beginning of year

In this scenario, despite the fact that the withdrawal rate has been reduced from 5% per the “Bad Early Years” scenario in the last post to 4%, which is generally considered to be a “safe” withdrawal rate, by simply changing one other variable, i.e., reducing the average rate of return from 7% to 6%, per Bad Early Years Assuming 6% Average Rate of Return, the portfolio is depleted at age 85. While the frequency and timing of withdrawals in this example may not be typical, the “safe withdrawal rate” of 4% isn’t conservative enough.

There are other scenarios where the interplay of the various variables is such that a withdrawal rate of 4% can prove to be problematic. As is typically illustrated, the previous example assumed an inflation rate of 3% each and every year. What happens if inflation averages 3%, however, the sequence of inflation rates is such that it is much higher in the first five years, say 7%. This would result in larger withdrawals in years 2 through 6, and, depending upon the rate of return, sequence of returns, and duration of retirement, this could result in premature depletion of the portfolio.

Mathematics aside, there are several other issues to consider when planning to use a safe withdrawal rate. For starters, why should you base your withdrawals for the duration of your retirement on the value of your retirement portfolio on a single day, i.e., the day before you retire? Also, it does not consider the fact that a sizeable portion of your expenses may be for mortgage and/or other fixed payments that don’t increase each year, and, as such, don’t require an inflation factor to be applied to them. In addition, the safe withdrawal rate methodology doesn’t take into consideration the fact that we typically incur nonrecurring expenses, planned and unplanned, e.g., new car, home improvements, wedding, etc., in addition to our ongoing expenses.

Another factor not incorporated in safe rate withdrawal calculations is the affect of differences in sources and amounts of non-portfolio income, e.g., Social Security, pensions, part-time income, etc. on portfolio values. What about the impact of inheritances on the amount of subsequent withdrawals? Finally, who is going to be responsible for doing the accounting to ensure that the amount of withdrawals doesn’t exceed the targeted amount in a particular year?

While the amount of withdrawals calculated using safe withdrawal rate methodology may match your income needs in some years, this probably won’t be the case in most years. This is arguably its single biggest weakness. I don’t know about you, but I don’t want to live my life based on a simple calculation that doesn’t consider my changing financial needs. While a safe withdrawal rate is a nice starting point, or rule of thumb, for calculating retirement withdrawal amounts, its limitations need to be considered when applying it to one’s retirement plan.