As you climb the retirement mountain, you are trying to accumulate as much wealth as possible. Each of you will get there at your own pace, but everyone is looking forward to the view from the top of the mountain. You cannot wait to get to the top and reach “retirement” and the financial independence that affords you the opportunity to never work again if you so choose.
While climbing the retirement mountain, we have all faced various obstacles we must overcome in order to reach the top. Your banker, investment manager, financial advisors, Wall Street, TV, books, and many other resources have guided you past these potential pitfalls. Everyone was talking about the challenges of climbing the retirement mountain and you felt informed and educated. You may have even fallen victim to a few pitfalls, but you are staying the course.
When do you think most climbers struggle the most on Mount Everest? Surprisingly, it’s on the way down, and your retirement mountain is no different. What most people don’t realize is once we get to the top of the mountain, we must successfully get down. We call this “distributing your wealth” or “spending your money in retirement.”
As you begin to spend your money in retirement, the threats you will face will change. Unlike the climb up the retirement mountain, you will probably get very little advice and perhaps even misconceptions or falsehoods. Much of this advice is not on purpose, but mostly because financial professionals, the media, and our friends spend most of their time talking about saving for retirement rather how to enjoy it. The focus of this book is to help you get down the mountain safely by sharing with you the threats that no one is talking about.
There are 4 core retirement threats that you should be aware of and, more importantly, plan to address. Inside each threat are key concepts and risks you should understand:
Four Key Threats:
- Market volatility
- Timing and accessibility of money
- Cost of care
The Volatility Threat
- Average return versus actual return
- Market loss
- Sequence of return
What would you think if we told you that your “average” return in the stock market is not the “actual” return on your money? The stock market, stock, mutual fund, or ETF average return is one of the biggest lies in the financial industry. As a matter of fact, the concept of average return versus actual return is something most financial planners and investment managers either do not understand or simply ignore. But what could be worse than not getting the return you thought you were? Market Loss!
One thing we know for sure about the stock market is that it goes up and down; we call this market volatility. Many will tell you that if you just stay in the market long enough, your money will grow.
While it is true that the overall trend of the stock market over extended periods is one of growth, the problem is during these extended periods of growth there are also down markets, market pullbacks, and major market corrections. Can you be sure that your need for retirement dollars will not correlate to the periods of market loss? As you near retirement or have already begun, the down years are much more painful; you have less time to recover and market loss is a big threat in retirement.
If you were retired in 2008, you could potentially have 40% less money than you hoped. Let’s say before you lost 40%, you had $1,000,000 in your 401(k). After 2008, you had just $600,000. Ouch! Even worse, you would need a 66% return from the stock market to just get back to $1,000,000. As you can see, protecting your capital in retirement from loss is important. It takes much more time to gain 66% then it does to lose 40%, and this is all occurring when you don’t have time on your side and are no longer working. Combine this with taxes, inflation, and other factors and your wealth can erode very quickly.
What is worse than market loss? Needing to draw money from your account when the market is down. When you combine market loss or depressed values with needing to draw money from the account, it is called “sequence of returns risk.” We know that there will be down years in the market – no one will argue that – but what many do not know is when those down years occur, they can have a dramatic impact on your retirement dollars. If the down years are early in retirement, your account will be depleted much faster than in the same down years later. Do you know when those down years will be? Neither do we!
Please understand that we are not saying the stock market is a bad place to have some of your money. We are simply ensuring that you understand the various risks that come with seeking the growth of the market. The word “diversification” is used a lot in the financial industry, especially by investment managers referring to the diversification of asset classes (i.e. stocks, bonds, growth, value, etc.). Although that is important, we feel diversification is much broader than just your traditional asset allocation, and tax diversification too often neglected or misunderstood, which can be very costly.
The Tax Threat
- Qualified plan trap
- Taxed at death
- Tax diversification
Most Americans who are saving for retirement are including a “partner” they may be unaware of; in many ways, these are no different than other business partnerships. This business partner is in debt, needs money, and gets a percentage of whatever you withdraw from your retirement plan and can also change that percentage at any time since this business partner gets the only vote. This does not sound like a good and fair partnership, and no one would willingly enter this business arrangement. Unfortunately, however, this is the business arrangement everyone has with Uncle Sam with their 401(k), various IRAs, deferred compensation plans, and any other tax-qualified plans which provide a “tax deduction.”
This tax deduction we commonly refer to is not actually a deduction, but specifically a tax deferral. You will pay the tax on your contribution eventually, but also on all the growth. Your business partner is giving you a break on paying tax on your contribution, the “seed,” and then will charge you tax on the distribution, the “harvest.” This sure does not seem like a fair deal, either.
Let’s look at an example and some math. If you saved $20,000 per year for 30 years and got 7% compounded growth, you would have just over $2,000,000 in your 401(k) or IRA. If you were paying 35% in federal and state tax, you would have gotten $210,000 in tax deductions from the $600,000 you contributed over the 30 years of contributions. Let’s assume the tax rate in retirement is the same 35%: that means 35% of your $2 million belongs to Uncle Sam. How much is that? $700,000! Your tax liability on YOUR MONEY has grown over three times as large. Hence, we call this the “harvest.” Simply put, you get a deduction on the smaller amount and pay taxes on the larger amount!
You may be told not to worry about that because you’ll be in a lower tax bracket when you are older and retire. While this may be the case for some, beware of blindly following this advice because it is often not the case. The income we have in retirement may or may not be less, but most often our tax deductions are less or gone, and the loss of your deductions means your marginal tax rate will increase.
Let’s look at this a little closer. While in our working years, we can usually earn more than we may in retirement. This is the premise that most use to discuss a lower tax bracket in retirement. What most don’t consider, however, is that we can also lose our biggest tax deductions. In retirement, we hope the kids are moved out, the house is paid off, and we are no longer contributing to retirement accounts, but that means mortgage interest, children deductions, and retirement plan deductions – some of our largest deductions – are GONE! This often leaves clients unable to itemize their deductions, and all that remains are the standard deduction and personal exemption.
Let’s just say you moved down one tax bracket in retirement because you have less income. Being in a lower bracket doesn’t mean paying less in taxes since the lower bracket could be a higher tax rate if Uncle Sam raises the rates. (Need visual showing this). In this business partnership, you do not control the tax rates; your partner does.
So with limited or no deductions in retirement, no guarantees that you are in a lower tax bracket, and your business partner controlling the rates for each bracket and leaving your loved ones with a possible tax bill, it is wise to have good tax diversification in your overall plan.
The Qualified Plan tax trap is something that most Americans face when they have the majority of their money in a qualified plan or “tax later” bucket. The balance between the “tax-free,” “taxed later,” and “taxed now” buckets is very important. The only thing more valuable than tax-free money is free money; this is money we get from our employers in a match of our contributions to our plan. The reason for the qualified tax trap is not the free money from the match, but the rest of the contribution after the match amount. Taking the free money (match) is great, but most skip the “tax-free” bucket with the remainder of the contribution and create a big problem down the line in the “taxed later” bucket.
What happens to my retirement account at death?
A qualified plan is a terrible way to pass money to the next generation, as it carries a large tax bill with it. If your 401(k), IRA, or other qualified plan is passed on, it is 100% taxable for the next generation. This can increase the tax brackets of your heirs, forcing more money to go to Uncle Same than your loved ones. Regardless of who it is from, your business partner will get their taxes from your harvest.
The Timing Threat
- Required Minimum Distribution (RMD) trap
- Government and control
It’s clear that the threats of losing money in the market or paying too much in taxes are quite real. Let’s assume that, with proper planning, you limited your market risk and have great tax diversification, meaning you’ve avoided excessive taxes. Congratulations! These are two major steps to a successful retirement.
What if I told you that, despite all the saving and proper planning, if you need your money early, you still cannot access it? Or that if you never needed the money you saved, you would be forced to move it from one account to another and pay taxes on it annually. Yes, the timing of when you need or don’t need your own money can also be a threat to your retirement.
As we explained in the tax trap section, most of America has their money in qualified plans such as 401(k)s, IRAs, Deferred Compensation, 403(b)s, and much more. These are the plans that provide a tax break today on the smaller amount, and you pay tax when you need it on the larger amount (contribution + growth).
What is another common trait these plans have? There are very few ways to access your money without a 10% penalty until age 59 ½. So, if you retire early or just need the money to pay for your children’s college, grow your business, make a down payment on a home, or buy a car, you can’t access your money without a penalty.
Do you really want your money held hostage or have to meet a government-set eligibility age to spend your hard-earned money? If you could access your money at any age and any time, would you take a year or two off traveling the world before returning to work? Would you retire earlier? Would you work part-time for five years before retiring age 60? Why should 59 ½ for retirement accounts and 62 for Social Security determine when you stop working? Access to your money provides you with many more options.
On the other end of the spectrum is when we don’t need our savings; this is where we learn about how the Required Minimum Distribution (RMD) trap comes into play. This is one that surprises many retirees: when you reach the age of 70 ½, you are forced to take distributions from your qualified retirement accounts even if you don’t want or need the money. Even if you only need a small amount or nothing at all, you are forced to take out what the government calculates for you. Remember that deal you made with them for the so-called “tax deduction?” They knew they would get the tax dollars on the harvest one way or another. Either you take it out because you need it, or they force it out at 70 ½. And what if you don’t take the RMD? A 50% penalty on the amount not taken! Ouch! So, this RMD trap can certainly force a retiree into the previously-discussed tax trap.
You are starting to notice your business partners (IRS and the government) are very savvy. They give you what seems like a break upfront while they control the rules, tax brackets, and much more. Not only do they control the rules, these rules can change as the political parties change in the House, Senate, and Presidency. These changes and a lack of retirement plan flexibility can become real threats to your retirement dollars. Did you know that Social Security used to be 100% tax-free? Now, for the average income in retirement, it is 85% taxable! Having all your money in one system or savings device is never a good idea, and having the only place you saved for retirement mostly controlled by someone else’s rules is even worse.
Cost of Care Threat
We can plan for market volatility and tax diversification and even be sure our money is accessible when we need it. Unfortunately, however, we cannot guarantee that we will stay healthy while climbing the retirement mountain or descending down it. What would happen if a serious illness or injury occurred to you, your loved one, or your business partner? Would you have enough funds available without damaging your retirement or your spouse’s? Which bucket of money would you turn to first, and are there penalties, taxes, or other hidden costs for accessing that money?
Uncovered medical expenses by your health insurance or Medicare as well as long-term care in your home or a facility can devastate your retirement money and the legacy you hoped to leave to your heirs or charity. Currently, 7 out of 10 people will need some form of care. Who will take care of you? What will it cost? Many have no idea and no plan.
This care that 70% of us will need can vary. It will not just be nursing home care; it can also include assisted living, in-home nursing, convalescent hospital, or custodial care. Again, these are not covered by Medicare or a Medicare supplement, and the costs for this type of care can range from $3,000 to $10,000 per month depending on where you live and the level of care or assistance you require. The national average for a private room in 2016 is $93,000, a 19% increase from 2011. So, what will your cost of care be in 10, 20, or 30 years? Will you be prepared to cover it?
Historically, how are people paying for care?
- Government plans
- Traditional long-term care insurance
Most people heading into their later years are familiar with traditional long-term care insurance that can help with these costs. However, this sort of insurance can be expensive depending on when you purchase it, the premium amounts are rarely guaranteed, and if we never use the insurance, we lose all the money we paid for it. If you don’t buy the insurance, we must pay for the care with our savings and possibly pay taxes on our money to use it. If you end up without enough money in your savings, it can leave your spouse with little to live on. This large expense may also force families to help with the costs or bring you into their home. This can be a big financial and emotional burden on them and lack of privacy for you. If this is not an option, then the final stop is government programs.
So, as we climb down the retirement mountain or up the mountain (saving), not only is our health not predictable or even guaranteed, it can be a devastating blow to your retirement savings and legacy.
Now that we’ve covered some key threats you may face as you head down the retirement mountain, The next step is to speak to a Camas Wealth Advisor and learn about one of the best-kept secrets of planning tools in the financial industry.