When I speak to groups about retirement planning and the risks we face in retirement, the usual topics that come up are: inflation, longevity, health, rising health care costs, long term care, market volatility, low yields on savings, general economic uncertainty and government insolvency. The list goes on and on. However, one risk that is consistently overlooked is taxes.
Yes, the biggest risk you face in retirement is taxes.
The essence of retirement income planning is to create an income stream, which rises at least as fast as the cost of living, and that will last through retirement. Traditional rules for investment management based on average annual returns will not work, as they deal in probabilistic expectations. What is needed is a definite outcome, that is the required amount of income, adjusted for inflation, each year.
Recent political events and current discussions in Washington have highlighted the very real possibility that current tax rates will rise. Any rise is taxes effects retirees doubly.
First, the actual tax dollars due is more money to Uncle Sam, less money for all the things we want and need. You don’t need to be a retirement guru to figure that one out.
More importantly, however, is the second, and often overlooked consequence of higher taxes that dramatically impacts retirees. Additional, unsustainable pressures are placed on the retirement portfolio.
Higher taxes means higher withdrawals are needed from those tax-deferred, qualified plans. Lets say you have a qualified plan (IRA, 401(k), 403(b), etc.) with $1 million. Let’s assume you need $60,000 a year to live on. However, because the entire amount you take from the plan is fully taxable, you need to take $100,000 from the account every year, in order to be left with that 60,000 spendable after-tax dollars.
No portfolio, no investment strategy, no mix of assets, can survive a withdrawal rate of 10 percent. So the high tax rates, and lack of deductions puts unrealistic pressure on that retirement portfolio, and in effect assures that the $1 million portfolio is exhausted long before the income need is over.
Remember, you are also likely enjoying the fact the house is paid off and the kids are gone, leaving you with no write offs! So virtually all income is fully taxed. Given the tsunami of debt our federal and state governments find themselves battling against, it seems a combined federal and state tax rate of 40 percent, is not unrealistic.
Yes, there are strategies that can be employed both before and after retirement to minimize the catastrophic effects of taxes on retirement lifestyle. Tax favored investments, and other non-qualified investment strategies can help long before the first retirement dollar is spent. Additionally, there are techniques that can be utilized to shift money out of those tax-trap qualified plans into other more advantaged alternatives, even after retirement. Different isn’t always better, but better is always different
Finally, there is one more tragic insult. We can’t forget the income and estate taxes that beneficiaries may be forced to pay on the transfer of those same retirement assets. It is not unreasonable to assume that heirs may only receive 30 to 40 percent of the value of those accounts.
It’s imperative, you take into consideration not only the risk/return trade-off when evaluating an investment, but how the results are ultimately impacted by the effects of tax policy coming out of our nation’s capital.
The reality is, having the best mutual fund or stock investment strategy does little if you own the investment in a manner that subjects that investment to undue taxation.
Darren Vilardo is an independent financial advisor specializing in retirement income planning, and the owner of Inland Retirement Advisors in Rancho Cucamonga. Vilardo can be heard weekdays at 9 a.m. on AM-1510. Vilardo can be reached at (888) 944-6266.