Navigating the Retirement Risk Zone

No one wants to pay taxes.

Not before retirement
and certainly not in retirement.

Today we're going to talk about required
minimum distributions and how to minimize

the tax consequences of those RMDs.

I'm a certified financial planner

and the owner of an independent
financial planning firm.

And every year, we help retirees
identify the best tax, saving, income

and withdrawal strategies
that work towards their retirement goals.

The truth about taxes

in retirement is very different
from what we are led to believe online.

It's very easy to feel like there is
a tax bomb somewhere in your future.

And it would be reasonable
for that tax bomb to instill fear in you.

But the reality is that fear,
especially when it comes

to taxes, often leads
to decisions with consequences.

That we may not
always be clear on.

Let me illustrate this with a story.

I had a client come to me.

He was 59 years old
at the time and had accumulated

significant wealth, about $3 million
in a blend of investment accounts,

along with a nearly paid off
house valued at around $1,200,000.

Now, he had been widowed a few years back
and had phased slowly out of work

after the passing of his wife, and wanted
to formalize a plan for his retirement.

He explained to me that most of his assets
were in pretax accounts,

that he hadn't saved much

into Roth accounts, and regretted it,
and was living in fear of two things.

Large future required
minimum distributions

and the cost of private
health insurance,

now that he was no longer
insured by his employer.

But was still several years
or so from Medicare age.

As a result, he explained that he was
doing his best to minimize his income

so that he could obtain Affordable Care
Act subsidies for his health insurance.

He explained that he was trying
to calculate whether that was indeed

in his best interest, or would it
be better to perform Roth conversions

to avoid this tax bomb
that I alluded to earlier?

So I asked him

how much he had been living on
for the first full year of his retirement.

He explained that he'd been living off
about $70,000 a year in withdrawals,

which ended up being about $55,000
in spendable money.

In order to stay below

four times the federal poverty limit
to obtain those health care subsidies.

So I asked him again,
did living on that amount of money

feel like what he expected
his retirement to feel like?

He replied to me and said, absolutely not.

I feel like I haven't retired.
I feel poor.

It feels like I'm just getting punished,

no matter what I do.

That I can't spend my money

or I'm going to lose my subsidies,
or if I spend more money,

I'm going to end up paying more in taxes.

He explained that
just before a meeting with me,

he had almost impulsively pulled the
trigger on a substantial Roth conversion,

and that the only reason he didn't pull
the trigger

was because he had been worried
about losing his health care subsidies.

He said that he felt stuck
between a rock and a hard place.

Now this gentleman was blinded by
his fear.

His fear was taking him along
for a roller coaster ride.

Between being paralyzed
into spending dribbles of his assets

and not feeling retired while doing so,
versus impulsively triggering

a huge taxable event by performing
a substantial Roth conversion,

the value of which he explained
he did not really know.

And this is a really common bind
many retirees find themselves in.

So for the next few minutes,
I'm going to share the process

we walked this client through to help him
figure out a plan to minimize

his RMDs and manage his tax liabilities,
all while helping him feel retired.

The first thing we did together was
identify his tolerable withdrawal rate.

Think of the tolerable withdrawal rate
as the most dollars

he would have been able to withdraw

out of his accumulated
retirement savings that year.

Now, we weren't telling him
he should spend that amount,

but we explained that
starting by understanding

what the portfolio could tolerate
as a withdrawal amount would help him

see his situation
more clearly.

Based on his asset allocation

and using a modern guard rails
withdrawal approach,

we found that his portfolio of roughly
$3 million could tolerate

as much as $162,000 in
withdrawals this year,

or up to a 5.5% distribution rate.

So almost two and a half times
what he had withdrawn in the prior year.

His first full year of retirement.

He had no idea that a retirement
income of that amount

was even in the realm of possibility.

He explained to us

that he knew that he had a lot of money,
but he really didn't feel like

he had a lot,
because he hadn't felt comfortable

pulling money out of his accounts
and losing his subsidies.

So the next thing we did was quantify
the actual value of those Affordable

Care Act subsidies that he was receiving.

He was receiving roughly $7,000 per year
in financial benefit

from those health care subsidies.

So basically, as soon as he passes
the four times the federal poverty

level in income,
he would lose $7,000 of value

as a result of having to purchase
health insurance on the private market.

Well, the difference between his tolerable
withdrawal amount,

which is $162,000 versus the $70,000

he was actually withdrawing,
resulted in a difference of $92,000.

So clearly
he had the financial wiggle room to absorb

the additional cost of private health
insurance.

That $7,000 and then some.

So the next step in this
process was to ask.

Even if you don't feel comfortable

spending that $162,000,
the tolerable withdrawal limit,

what did you imagine yourself doing
with your wealth in retirement?

He explained that he had imagined
spending that time

with his wife, traveling around the world
3 to 4 times a year.

Now his wife was no longer with him,
and he told us that he felt

that he was young enough
to meet a new partner

and that he would like to do that
if possible.

That he felt that his fears around taxes
and spending in retirement

were holding him back
from exploring that possibility.

So we asked him how much he imagined
that it would cost him.

He said that if he had $25,000
a year as a travel budget,

he felt that he could accomplish and enjoy
all the things that he had hoped he would.

So we added up his cost of living.

About $50,000 a year,
then we added in the additional cost

to replace his subsidized health
insurance, another $7,000.

And then we added in $25,000
of travel budget and all of that

totaled about $82,000 of required
after tax dollars,

which would make him feel retired.

Now to produce that $82,000
of after tax spendable money,

it looked like it would require
about $105,000 of pretax withdrawals,

which was still an effective distribution
rate of roughly 3.5%.

And that left him with about $50,000
of what we call distribution wiggle room.

So we were now ready to address those
looming RMDs that he had mentioned earlier.

We explained that we understood
that seeing the fact that you might have

large RMDs
that push you into higher future

tax brackets can trigger this desire
to perform Roth conversions.

Pay the tax now to avoid that
tax bomb in the future

makes a lot of sense.

But we explained that there were a few
crucial things to consider here.

The first thing to consider
is the question how much stress will

bringing taxes forward
put on your portfolio today?

And therefore your ability
to spend and enjoy?

If the cost of paying the tax
for the Roth conversion

will push your withdrawal rate
above a tolerable limit

or above a psychological limit,
then it may not be wise to do that.

Now, in this client's case,

he would have about $50,000
of distributable money to allocate

towards the cost of a Roth conversion
before it would push him above

the tolerable withdrawal limit.

If he wanted to stick to a 4%
withdrawal rule, he would still have

about $15,000 of space
to perform Roth conversions.

Even with the extra spending for travel.

Now, a financial planning tool
would likely recommend doing a far

larger amount of Roth conversions
in the early years of his retirement.

But this leads to the
second thing to consider -

- the time value of money.

Basically, money
spent on current experiences and things

is worth more and brings
more joy and satisfaction,

than money spent on future
experiences and things.

The central question here would be
if the financial planning tool recommends

far larger amounts of Roth conversions
in early retirement,

how much of those current
experiences and things

will the cost of that Roth
conversion crowd out?

And then the client would need to decide,

do I accept a higher withdrawal rate

in order to absorb the cost
of the Roth conversion?

What if that withdrawal rate
is 7 or 8 or 9%?

What if I don't want to accept
the cost of the conversion

by taking on a higher withdrawal rate?

Then where do I cut my spending in order
to accommodate the Roth conversions?

Well, obviously the spending that would be
cut would be the discretionary spending.

So that would be things like travel,
gifting to kids and the like.

Then we really have to evaluate
if that's a trade that we want to make.

So ask yourself,
put yourself in this client's position.

If you're 76 years old and less
physically able to do activities,

things like play handball with your
grandkids or take a scuba diving trip.

Does paying taxes at 76
crowd out spending at that age

when you would not be able
to do those travel likely?

And would you regret
not being able to spend at that age?

Or would the inverse be more true
when paying the cost of a Roth conversion

tax today?

That would actually restrict you
from being able to take that extra trip

across country
to see your grandkids, or

restricts you from that scuba
diving trip with your partner?

Which of those scenarios
would be less desirable?

Now, ultimately, this client whose story
I've been sharing with you today

decided to forego the Roth conversions
and test out a year of higher

personal spending.

He told us that he had imagined
spending his retirement with a partner.

And that his wife's early surprise early
passing left him feeling a huge gap.

And as he progressed through the year,

he actually met a new partner
and planned three amazing trips.

He reported back to us
that he would never have felt

that that was possible,
nor would he have given himself

permission to do those things.

And he felt absolutely elated
at the prospect

that he could both meet a new partner
to spend his retirement with,

but also still do the traveling he had
imagined doing with his deceased wife.

Now the reality is
there are no gimmicks avoid taxes.

The best you can do
is balance a seesaw of trade offs.

If you pay taxes today
so that you don't pay taxes tomorrow,

you have to give up something in return,
which is current day spending.

If you pay taxes later
so that you don't pay taxes today,

you have to give up future spending

and take on the risk that
tax rates may be higher in the future.

And knowing that there are still ways to manage
the taxes that large future RMDs could incur.

A couple of those ways
are to sequence withdrawals

from pretax accounts in the years
leading up to RMD age,

so that you can smooth out
future shifts to higher tax brackets.

This would look like strategically
withdrawing from pretax accounts,

such that you would distribute enough
from those pretax accounts before RMD age,

so that you're not kicked into higher
marginal brackets once RMDs kick in.

You could also perform
qualified charitable distributions

if you're charitably inclined,
and have the luxury to a foreign them.

Qualified charitable distributions

allow your RMDs to be satisfied
or partially satisfied tax free

to both you and the end receiver,
as long as the receiver meets

specific requirements.

And a third strategy
might be to tax locate specific parts

of your asset
allocation into pretax accounts.

For instance, income from interest bearing
investments like bonds are going to be

taxed at income tax rates no matter
what type of account you hold them in.

Bonds also tend to grow
more slowly than stocks,

and so holding bonds in a pretax accounts
can end up being net neutral

from the perspective
of the income generated.

But also the gains on underlying
bonds are likely to be smaller.

Therefore,
holding those in pretax accounts

can limit
the eventual size of that account.

And therefore the RMD.

The trick here

is to know what you're optimizing for
and live in accordance with those values.

Now, philosophically, at Peak
Financial Planning, we support people's desires

to maximize their present day
joy from their wealth.

And this looks like helping

people understand the spending tolerances
of their wealth first,

and then encouraging them to explore
how that spending can bring them joy.

We believe that as long
as there are good,

predetermined contingency
plans in place,

then clients will know how and when to
rein spending back if that is warranted.

As a result, we often explain that
paying taxes in the future is basically

a bargain that purchases present day
flexibility or optionality.

So I hope you found
this exploration helpful.

If you'd like to learn more about

how we help our clients build
and prioritize their retirement plans,

you can visit our website at

www.thepeakfp.com

And as always, thank you for your time and
attention and see you in the next video.