Retirement Planning Tip of the Month

June, 2005

June Retirement Planning Tip Of The Month

How "Phantom Income" Creates "Tax Erosion" During Your Retirement

It is amazing how many retirees don't recognize they are jeopardizing their level of financial security by creating their own form of "phantom retirement income."

Let's take the example of a recent 72 year old widow, Jane, who only needs Social Security ($15,000 per year) and her small pension ($15,000 per year) to live comfortably during retirement. If Jane only reported these 2 sources of income ($30,000) on her tax return she would pay $5551 of federal income tax each year (a manageable amount).

However, when Jane's husband passed away, she inherited his IRA and received the proceeds from his life insurance policy. She does not need to use either of these investments to supplement her income. Because she is over 70½, she is forced to take $16,250 from her IRA. The life insurance proceeds are invested in CD's and an investment portfolio that produces $5,000 of dividends and interest. Jane has to report these amounts on her tax return. At first glance it would appear that Jane would now pay income tax on $36,250 (her $15,000 pension plus $21,250 of unneeded income). Unfortunately the additional income forces Jane to report $12,750 of her Social Security as taxable income. This adds up to $44,000 per year that Jane reports and creates an income tax burden of $6,553! (a yearly problem)

In summary, Jane is paying income taxes of $6,553 while living on $30,000 per year. Each year Jane pays the extra taxes out of her IRA distribution, and adds the balance to her investment portfolio. What is the long-term consequence of Jane continuing this behavior? If Jane lives to her normal life expectancy (15.5 years) she will pay over $101,000 of income taxes versus taxes of slightly over $8,500 on just her pension and Social Security income! To make matters worse, Jane's tax woes are further compounded because her reportable dividends and interest will increase every year since she is investing the ever-increasing IRA minimum required distributions.

Jane is a living example of how "Phantom Income" creates "Tax Erosion" that can hurt an investor over their retirement. What Jane does not know is that she has the ability to take control of her cash flow and eliminate tax erosion.

Next month: How did we help Jane eliminate her Tax Erosion?

1Tax figures are based on the 2005 IRA Tax Tables.

May, 2005

Filling Your Retirement Income Gaps

In our February retirement planning tip, we suggested you find a way to visually map out how your retirement cash flow might look in a chart. This tool would give you insight to effectively design when and how much to take from your retirement nest egg. Here is one visual example of how you can build a simple cash flow strategy chart. The sample chart is designed for a person age 55. First put in all income streams you have no control over, such as your Social Security and company defined benefit pension. This may be done monthly or annually. Then put in your total retirement income need. Your income sources can reflect any cost of living adjustments as you see fit. As you might already note from the example chart, there are two gaps of cash flow you would need to fill from other retirement asset sources. The first gap represents an additional need over a 7 year period until that person reaches Social Security age. The second gap is reduced at age 62, but the length of time needed is longer (life expectancy), and the ultimate amount needed could be a lot greater.

The example could be further complicated by adding your spouse's benefits at the appropriate times, along with retirement distributions you are forced to take whether you need them or not, such as IRA Minimum Required Distributions at age 70& ½. This offers a very important question. Do your retirement investments and IRS regulations offer the flexibility to adjust your cash flow needs to fill you gaps? It is unlikely you know the answer to this question, and if you did, you will find out you might have very limited flexibility (at present) to adjust to your specific cash flow needs.

Many of our clients have found that these inflexibilities create shortages in some gaps they cannot replace, or excess cash in gaps. This almost always reduces the level of financial security in retirement. Most retirees create what we call "Phantom" income; a method of taking income during retirement that results in paying excessive income taxes during retirement. Through the use of effective financial planning software and expertise many clients find ways to overcome many of these pitfalls.

Up next: How "Phantom Income" creates "Tax Erosion" during your retirement.

April, 2005

Can We Count On Our Pension Plan Benefits?

A major source of retirement income for many Americans is their employer's defined benefit program. Based upon events over the last few years, it can no longer be assumed these pension payments are written in stone. Many of our advisors clients are questioning the ability of their pension plan to continue making benefit payments over their lifetimes. And, what once was considered the layer of protection for employer sponsored defined benefit plans, The Pension Benefit Guaranty Corporation (PBGC), is also under scrutiny.

What is the PBGC? How does it work? Where does it stand financially?

Mission and Background: The PBGC was created by the Employee Retirement Income Security Act of 1974 to encourage the growth of defined benefit pension plans, to provide timely and uninterrupted payment of pension benefits, and to keep pension insurance premiums at a minimum. Defined benefit pension plans promise to pay a specified monthly benefit at retirement, commonly based on salary and years on the job.

Money PBGC Takes In and Pays Out: The PBGC is not funded by general tax revenues. PBGC collects insurance premiums from employers that sponsor insured pension plans, earns money from investments, and receives funds from pension plans it takes over. PBGC pays monthly retirement benefits, up to a guaranteed maximum, to about 518,000 retirees in 3,479 pension plans that ended. PBGC is responsible for the current and future pensions of about 1,061,000 people, including those who have not yet retired, and participants in multi-employer plans receiving financial assistance.

PBGC's Two Pension Insurance Programs: The single-employer program protects 34.6 million workers and retirees in 29,651 pension plans. The multi-employer program protects 9.8 million workers and retirees in 1,587 pension plans. Multi-employer plans are set up by collective bargaining agreements involving more than one unrelated employer, generally in one industry.

PBGC's Financial Status: The combined programs' underwriting and financial activities resulted in a net loss for the fiscal year of $12.042 billion, and a deficit of $23.541 billion. The single-employer program posted a net loss of $12.067 billion, the largest loss in the history of the single-employer program, and a deficit of $23.305 billion. The multi-employer program reported net income of $25 million, and a deficit of $236 million. This is not a good long-term trend!

In summary: A thorough investigation of your company's pension plan should be one of your top priorities. Most plans are funded adequately, but you need to stay ahead of any potentially negative changes to your plan. For more information you are welcome to talk to one of our professional advisors, or go to www.sfgweb.com to find a link to the PBGC website.

March, 2005

Will Social Security Retire Before I Do?

People have traditionally seen Social Security benefits as the foundation of their retirement planning programs. The Social Security contributions deducted from your paycheck have, in effect, served as a government-enforced retirement savings plan. However, the Social Security system is under increasing strain.

Better health care and longer life spans have resulted in an increasing number of people drawing Social Security benefits. And as the baby boom generation (those born between 1946 and 1964) approaches retirement, even greater demands will be placed on the system. In 1945, there were 41.9 active workers to support each person receiving Social Security benefits. In 2000, there were only 3.4 workers supporting each Social Security pensioner. And it is projected that by 2030, there will be only 2.1 active workers to support each Social Security pensioner.¹

It used to be that you could receive full benefits only after you reached age 65. But in 2003, the age to qualify for full benefits began to increase on a graduated scale. By 2027, the age to qualify for full Social Security benefits will have increased to age 67, where it is scheduled to remain. Also keep in mind that as your income gets higher, Social Security benefits replace a proportionally smaller percentage of your income. That means in the future, you will probably have to wait longer to qualify for full Social Security benefits to start replacing a smaller percentage of your pre-retirement income.

Your long-term retirement planning program should recognize Social Security benefits as playing a more limited role when calculating required retirement income. Indeed, some financial professionals suggest ignoring Social Security altogether when developing a retirement income plan.

¹ Social Security Administration

Note: The Social Security Administration will now assist you in calculating your projected retirement benefits. You can call 1-800-772-1213 and ask for Form SSA-7004, the “Personal Earnings and Benefit Estimate Statement,” or you can access the form on the Internet at www.ssa.gov. Complete the form; return it to the Social Security Administration, and you will receive an estimate of your benefits.

Februrary, 2005

"The ABC's of Designing My Retirement Income Sources"

Now that you know how much money you need per month (or year) to live on in retirement all you need to do is decide where you are going to draw enough income to cover these expenses. Sounds simple, right? Many of our clients say that picking the right retirement income stream increases the stress they face in making the transition into retirement.

While there are many sources of income in retirement, most retirees receive the bulk of their income from three main sources: Social Security, employer pension plans, and qualified retirement plans. Below are some factors you should consider when designing your retirement income stream from the top three sources.

Social Security: One big decision is choosing when to receive the benefits since that decision changes the amount of benefits you will receive. Age 62 is still the earliest age to receive benefits, but the benefit amount is reduced by several factors including your "normal retirement age." "Normal retirement age" is a moving target for all aspiring retirees. If you were born in 1940 "normal retirement age" is age 65 and 6 months to receive full benefits. If you were born between 1943 and 1954 "normal retirement age" is age 66. "Normal retirement age" continues to increase for younger workers. If you are married, you have an additional decision. If your spouse worked, he/she needs to decide whether to take his/her own benefit calculated on his/her age and salary history, or to take the spousal benefit.

Pension Options: Do you have a lump sum option on your pension? In most cases, the lump sum offers the greatest opportunity to design flexible cash flow streams (for you and your spouse) along with a great opportunity to control taxes during retirement. If you do not have the lump sum option, you have a range of choices between retiring at a normal retirement age with full benefits versus earlier retirement at a reduced benefit. By law pension plans have a built in survivor benefit, but usually you may "purchase" additional survivor benefits by taking a reduction in your benefit. Refer to your employer's pension plan document to see what options you have available. Also, some employers can provide specific illustrations that compare your benefit options.

Qualified Plan Distributions: The government has standardized rules for taking distributions from your 401(k) plan, IRA's, and other retirement. Employer sponsored plans, such as 401(k) plans, can limit your choices based upon the rules in the retirement plan document. However, one distinct advantage in your employer plan is you can often take distributions before age 59 1/2 without restrictions or IRS penalties. On the other hand, rolling your employer plan to an IRA allows you to convert part or all of these funds to a Roth IRA. (See future e-mail tips on the benefits and costs of this strategy.)

Many retirees experience long-term cash flow problems because of the inflexibility of these income sources, and they don't understand the best way to take income from these top three sources. It is not unusual to see periods of time during retirement where retirees receive more money than they need (invariably wasted, and other periods of time where retirees receive less income than is needed (tight budget). It is critical to your financial security in retirement to see all of your income options from all sources illustrated in a comparative diagram or chart that can give you a clearer vision of the impact of your choices. To find out more about how you can receive this type of illustration contact us at RetirementPlanning@unitedplanners.com

January, 2005

How Much Is Enough?

"Financial security in retirement" is a moving target among those individuals who are approaching retirement or who are already retired. How in the world can you know if you will be "financially secure" if you have no idea how much income you will need in retirement to meet the lifestyle you desire? What kind of lifestyle do you want to lead during retirement? How will this desired lifestyle impact your need for income? How will your lifestyle change during retirement?

We can offer some helpful tips on how to arrive at a reasonable income goal in retirement:

Create a list of all the things you and your spouse wish to do during retirement. Now add to your list all the things you want to stop doing during retirement. You might be surprised by your list.

Fill out an annual/monthly expense worksheet that reflects a fair estimate of how you spend your money today.

Now, fill out a brand new worksheet adjusting each estimated expense item from your current worksheet to reflect the changes in lifestyle you foresee. For example, if you want to play golf everyday during retirement, your greens fees category may increase from your current level. Also, let's say you won't need to commute to work everyday, so the expense estimate for gas and auto expenses may decrease substantially. The new total should reflect a reasonable estimate of your retirement income needs.

Many of our clients have told us that their desired lifestyle often changes throughout their retirement. Many clients have found it helpful to regularly revisit the worksheet analysis to make adjustments on how they take income from their investments.

If you would like us to send you a Cash Flow Analysis Worksheet please e-mail us at RetirementPlanning@unitedplanners.com