Retirement Income Visions

Ladder Your Retirement Income

2013-06-17T01:00:00-07:00

"Don't put all of your eggs in one basket." This is a saying that's often tossed around when it comes to retirement income planning. Usually it's brought into the conversation to address different types of investments one should consider to generate retirement income.

While diversification is a fundamental principle when it comes to both pre- and post-retirement investment planning, income timing is just as important in retirement. The first thing that needs to be recognized is that retirement isn't a single financial event. It's a process that includes multiple stages, each with its own financial demands.

There are unique types of expenses associated with each stage. For example, there may be an emphasis on travel in the initial stage of retirement, potentially requiring a large initial budget for this item that may decline, and ultimately be eliminated, in later stages. Another example may be a mortgage that gets paid off during retirement. Finally, health and long-term care expenses tend to dominate the final stage. Nonrecurring, or infrequently recurring, expenses, such as car purchases and home improvements, need to also be considered.

Given the fact that income needs to cover expenses and there will be various types and amounts of expenses with different durations associated with each of the various stages, different streams, or ladders, of income need to be planned for to match one's needs. Several types of income need to be analyzed to determine which ones will be best suited to match the projected expense needs of each stage.

When considering income types, it must always be kept in mind that after-tax income is used to pay for expenses. If the income source to be used to pay for a particular expense is a retirement account such as a 401(k) plan, a larger distribution will generally need to be taken from the plan than would be required from a nonretirement money market fund or from a Roth IRA account. Income tax planning is essential when it comes to income ladder design.

Complicating the income ladder design process is the decision regarding when to begin receiving Social Security. While Social Security can provide a solid base, or floor, to meet income needs for the duration of retirement, the amount of income that you will receive is dependent upon the age when you begin to receive your income. Given the fact that the amount will increase by 8% per year plus cost of living adjustments between full retirement age and age 70, it may make sense to defer the start date depending upon one's retirement age, marital status, health condition, and other potential sources of income. The types, timing, and amounts of income ladders are directly affected by the Social Security start date decision.

Keeping in mind that successful retirement income planning includes planning, managing, and protecting income, an analysis of one's income protection plan is also essential to the income ladder design process. As an example, to the extent that long-term care insurance has been purchased, a large income stream won't be needed to pay for long-term care expenses. Funds will generally be needed, however, to pay for long-term care insurance premiums throughout retirement unless a claim arises.

As you can see, retirement isn't a smooth ride whereby you can plan for the same amount of expenses each year increased by an inflation factor. Given this fact, an analysis of different types of projected expenses, including amounts and timing of each, is critical, followed by the design of an after-tax income ladder plan to match your expense needs.

Delayed Gratification is the Key to Maximizing Income with Fixed Index Annuities

2013-06-03T01:00:00-07:00

When you're planning for retirement, income is the name of the game. The more sustainable income that you can generate, the less you need to worry about things like sequence of returns and major stock market downturns – before and during retirement.

The idea is to build a base, or floor, of predictable income that will cover your day-to-day expenses. For most people doing retirement income planning, Social Security is the core element of an income floor. Although pre-retirees today can plan to receive a full Social Security benefit beginning somewhere between age 66 and 67 depending upon their year of birth, the benefit that they, and potentially their spouse, will receive will increase by 8% per year for each year that they defer their start date up until age 70. This equates to as much as a 24% - 32% greater benefit depending upon your year of birth and how long you defer your start date.

Assuming that your goal is to build a solid base of sustainable income with the ability to increase your lifetime income amount similar to Social Security, one of the best ways to do this is to invest in a flexible fixed index annuity ("FIA") with an income rider. The reason that you want to use a flexible, vs. a single, premium FIA is to provide you with the ability to add to your investment should you choose to do so. In addition, you need to purchase an income rider, which is optional with most FIA's, in order to receive guaranteed (subject to the claims-paying ability of individual insurance companies) income.

Like Social Security, the longer you wait to begin receiving your income, the greater it will be. Unlike Social Security benefits which are increased by cost of living adjustments ("COLA's"), the lifetime income from the majority of FIA's available today will remain unchanged once it's started.

To demonstrate the benefit of deferring the start date of FIA income withdrawals, let's use one of the contracts purchased by my wife and me two years ago when we were 55 and 48, respectively. I will use my wife's age as a point of reference for the remainder of this post since income withdrawal amounts are always calculated using the younger spouse's age.

Per our annuity contract, my wife and I are eligible to begin income withdrawals at least 12 months after our contract was issued provided that both of us are at least age 50. It generally doesn't make sense to take withdrawals from a FIA income rider before age 60 since the formula used to calculate the withdrawal amount is less favorable and the withdrawals will be subject to a 10% IRS premature distribution penalty and potentially a state penalty. Assuming that we plan on retiring after my wife is 60, there would be no need to begin income withdrawals before this age.

I have prepared a spreadsheet with various starting ages in increments of five years beginning at 55 through 75. The spreadsheet shows the projected percentage increase in our annual income withdrawal amount that we will realize by deferring our income start age compared to ages that are 5, 10, 15, 20, and 25 years younger, depending upon the starting age chosen.

Using an example that's comparable to the Social Security starting age decision, suppose that we decide to defer our income start age from 65 to 70. This would result in a 31.2% annual increase in lifetime income. We will receive 120.3% more income if we begin our income withdrawals at age 70 instead of at 60. The percentage increases are significant in many cases depending upon the chosen withdrawal starting age compared to another potential starting age.

Similar to the Social Security starting age decision, there are numerous factors that need to be considered when determining the optimal age to begin income withdrawals from a FIA with an income rider, a discussion of which is beyond the scope of this post. Like Social Security, when possible and it makes sense, delayed gratification is the key to maximizing lifetime income.

Insure Your Longevity

2013-05-20T01:00:00-07:00

When people hear the term, "longevity insurance," they immediately conjure up images of insurance agents trying to sell them an insurance policy. Longevity insurance isn't a product in and of itself. It is instead one application of a couple of different types of fixed income annuity products offered by life insurance companies.

The Need for Longevity Insurance

It's been my personal and professional experience that people generally underestimate how long they will live. Not only is it common to live to age 80, it isn't unusual to survive to age 90 and even to 100. According to a March, 2012 report, The 2011 Risks and Process of Retirement Survey, prepared for the Society of Actuaries, when a couple reaches 65, there's a 10% chance that at least one of the individuals will live to 100. There's a 1% chance that one spouse will reach 107. More than half of retirees and pre-retirees underestimate the age to which a person of his or her age and gender can expect to live.

Given the foregoing facts, combined with the uncertainty of the sustainability of a traditional investment portfolio as a source of retirement income, there's a need for a guaranteed lifetime income solution for the latter stage of one's life. The income amount, when combined with other sources of sustainable income, needs to be sufficient to meet projected known and unforeseen expenses for an indefinite period of time.

Products Providing Longevity Insurance

There are two types of fixed income annuities that can be used for the purpose of longevity insurance: deferred income annuities ("DIA's") and fixed index annuities ("FIA's") with income riders. Both provide the ability to (a) receive income beginning in a future year, and (b) have the income be paid for the remainder of one's life and a spouse's life if married.

Deferred Income Annuities

Although DIA's are currently offered by only a handful of life insurance companies, they're the solution that's typically been touted for longevity insurance up until now. Like single premium immediate annuities, or "SPIA's," DIA's pay periodic income for a specified period of time or over one's lifetime or joint lifetimes as applicable. Unlike SPIA's which begin payments one month after date of purchase, the start date of DIA payments is contractually defined and is deferred for at least 13 months. The longer the income start date is delayed, the lower the premium, or investment, required to provide a specified amount of income.

Although DIA's can be purchased for a specified term, e.g., ten years, when used as longevity insurance, the payout on DIA's often starts in one's 80's and is for life. Depending upon the age at which a DIA is purchased, the premium can be a relatively small amount compared to the potential lifetime income that may be received.

Fixed Index Annuities With Income Riders

For those individuals who don't want to be locked into a fixed starting date, in addition to providing an accumulation value, FIA's with income riders offer greater flexibility than DIA's. With FIA's, which are more readily available than DIA's, there's no contractual income start date. Income withdrawals can generally begin any time at least one year after the initial investment is made. The longer the start date is deferred, the greater the amount of lifetime income. The start date can be targeted when the investment is purchased based on the amount and timing of initial and projected ongoing investments and desired amount of income. A flexible, vs. single, premium FIA is required in order to invest additional funds.

Depending upon one's needs and marketplace availability, it may make sense to use a combination of DIA's and FIA's with income riders. and potentially multiple products within each category, to meet deferred lifetime income needs. As with all things of this nature, a thorough analysis should be prepared by a professional retirement income planner to determine the solution that will best meet your needs.

Are You Depending on Medicare for Long-Term Care Coverage?

2013-05-06T01:00:00-07:00

I've wanted to write this post for a long time, however, I just haven't gotten around to it. Over the years, clients and others I've talked to have been reluctant in initial conversations about long-term care planning to consider the purchase of long-term care insurance (LTCI) because they thought that Medicare will take care of them.

Let's put it this way, if you're part of this school of thought, you experience a long-term care event, and you don't have LTCI, you're in for a big surprise. A large part of the problem is that most people don't know what constitutes a "long-term care event," let alone how this compares to what Medicare will cover.

Long-Term Care Event

In order to qualify for benefits under a tax qualified LTCI policy, which represents 95% of policies sold today, you're required to be certified by a qualified health professional as having a chronic illness that will last for at least 90 days whereby the illness must result in you:

Being unable to perform at least two out of six activities of daily living ("ADL's"), or
Having a severe cognitive impairment that requires substantial supervision

The six ADL's include bathing, dressing, eating, continence, toileting, and transferring.

Will Medicare provide benefits for either of these two situations? It's not likely, and, if there's coverage, it will be limited as far as number of days, dollar amount, and type of coverage.

Custodial Care

The majority of long-term care expenses are for custodial, or personal, care, none of which is covered by Medicare. Custodial care is designed to assist a person who has limited ability to perform daily activities due to deficiencies in physical and/or cognitive functions. It's provided to help someone with his or her ADL's or instrumental activities of daily living ("IADL's"). IADL's are the cognitive functions pertaining to comprehension, judgment, memory, and reasoning. Activities include shopping for personal items, managing money, using the telephone, preparing meals, managing medication, and doing housework.

Medicare Event

Medicare wasn't designed to handle significant long-term care expenses. Medicare only covers medically necessary care with the focus on medical acute care, such as doctor visits, drugs, and hospital stays. There are three qualifications that you must meet in order to receive Medicare benefits:

Have had a recent prior hospital stay of at least three days
Admitted to a Medicare-certified nursing facility within 30 days of your prior hospital stay
Need skilled care, such as skilled nursing services, physical therapy, or other types of therapy

Medicare Benefit Period and Benefit Amount

If you meet these strict requirements, none of which are necessary to qualify for LTCI benefits, Medicare will pay for some of your costs for up to 100 days. Medicare will pay for 100% of your costs for the first 20 days, with the cost being shared for the next 80 days. In 2013, you're required to pay the first $140 per day and Medicare pays any balance for days 21 - 100.

Home and Other Care Services

In addition to skilled nursing facility services, Medicare will pay for various services when your doctor says they are medically necessary to treat an illness or injury. If you're unable to perform ADL's and/or IADL's that's unrelated to the treatment of an illness or injury, Medicare won't provide any coverage for home and other care services.

The home and other care services that Medicare covers, some of which are for a limited number of days, include part-time or intermittent skilled nursing care, physical and occupational therapy, speech-language pathology, medical social services, and medical supplies and durable medical equipment. Once again, custodial services aren't covered.

Are you depending on Medicare to be your long-term care plan? If so, you may want to revisit your plan.

With a Fixed Index Annuity, You Can Have Your Cake and Eat It Too

2013-04-22T01:00:00-07:00

Beginning with the August 1, 2011 post, Do You Want to Limit Your Potential Gains? through the November 5, 2012 post, Invest in DIA to Fund LTCI Premiums When Retired – Part 4 of 4, there were a total of 58 posts about fixed index annuities ("FIA's"). Not to state the obvious, however, that's a lot of information about one subject!

The impetus for the volume of material on FIA's was, and continues to be, the fact that a FIA with an income rider is a unique and underutilized strategy that can provide a meaningful lifetime income floor for many retirement income plans while protecting against downside risk. As evidence of this fact, fixed index annuity sales have been increasing at a rapid pace the last two years while sales of variable annuities have been on the decline. Furthermore, their use as a retirement income planning tool is affirmed by the fact that the majority of sales have included an optional income rider.

What's so special about a FIA? In one word – flexibility. A FIA is the only fixed annuity where you can receive a stream of income and also enjoy an investment value -- that comes with downside protection. The other two types of fixed annuities, i.e., single premium immediate annuities ("SPIA's") and deferred income annuities ("DIA's") fulfill the income role (immediate in the case of SPIA's and deferred with DIA's), however, neither one of these two vehicles has an investment value. In addition, the lifetime income stream from a DIA often isn't as competitive as lifetime payments from a FIA income rider with the same deferral period.

Another example of the flexibility associated with FIA's is the income start date. Unlike a DIA where there's a contractual fixed start date, the commencement of lifetime income from a FIA is totally flexible. It can typically be turned on at any time beginning one year after the contract date. Furthermore, while the lifetime income amount generally increases the longer you defer the start date, there's no requirement to ever begin taking income withdrawals.

While SPIA's and lifetime DIA's (there are also period certain, or fixed term, DIA's), are both designed to protect against the risk of longevity, the fact of the matter is that premature death can reduce their value, in some cases significantly. Some DIA's can be purchased with a death benefit to protect against the possibility of death prior to their deferred annuitization date, however, the added insurance protection often increases the required investment amount, all else being equal.

When FIA's are purchased with an optional income rider, it's usually done in conjunction with some type of retirement income planning. As such, the emphasis is on deferred lifetime income, with the investment, or accumulation, value playing a secondary role. The fact of the matter is that the investment value is the anchor that provides the following four important benefits in addition to the sustainable lifetime income from the income rider:

Principal protection
Minimum guarantees
Upside interest potential
Death benefit

Assuming that no withdrawals are taken from the accumulation value in addition to income rider distributions, the accumulation value will only decrease by the income rider charge prior to turning on the income stream. Given this fact, unlike SPIA's and lifetime DIA's, FIA's will have a death benefit available from day 1 that continues for much of the life of the FIA.

Once income begins, the accumulation value, i.e., death benefit, will decrease by the amount of income withdrawals in addition to the income rider charge. An optional death benefit rider can be added to the contract at the time of purchase to provide a guaranteed death benefit that will be paid even if there's no accumulation value.

A fixed index annuity with an income rider is truly a unique retirement income planning tool. Unlike other types of fixed annuities where income begins immediately, i.e., SPIA's, or at a contractually fixed date in the future, i.e., DIA's, a FIA income start date is totally flexible. In addition, unlike SPIA's and DIA's which are only about lifetime income, FIA's include an investment value. Furthermore, the investment value has built-in downside protection. Who said you can't have your cake and eat it too?

Plan for a Range of Retirement Ages

2013-04-08T01:00:00-07:00

It's widely agreed that age 65 is no longer the magic retirement age. According to the U.S. Bureau of the Census Current Population Survey, 65 or 66 was the average retirement age for men from the early 60's through the mid 70's. It dropped to age 64 in the late 70's, 63 in the 80's, and 62 from 1989 until 1995. It then increased to 63 from 1997 through 2007 before it returned to age 64 in 2009.

The average retirement age for women has historically been younger than for men. There was a 6 to 13-year age difference from the early 60's through the mid 80's when the average age for women ranged from 53 to 57. It wasn't until 1989 that the average retirement age for women climbed to 59, then 60 in 1995, 61 in 2003, and 62 in 2007. Since 1989, the spread between men and women's average retirement age has held steady between two and three years.

You may be thinking, that's pretty good – men are retiring at age 64 and women at 62. There are several things to keep in mind, however, when digesting these statistics:

These are average ages, with 50% of individuals retiring at a later age.
When someone retires, it isn't always by choice and instead is often dictated by layoffs or health issues.
Most people who retire don't have a retirement income plan with multiple potential sources of sustainable income.
Many people who retire do so with minimal income with a reduced lifestyle compared to what they previously enjoyed.
The absence of a retirement income protection plan, including long-term care protection, is common.
With longer life expectancies, it's becoming more challenging to not outlive your financial resources.

With traditional pension plans becoming rarer in the private sector, increasing starting age for collecting full Social Security benefits as well as other anticipated unfavorable changes to the Social Security system, the average retirement age for men and women is likely to continue its climb. Given this situation, planning to retire at age 65 isn't realistic for most people.

Assuming that you want to do retirement income planning, what is the retirement age for which you should plan? I'm a firm believer, for many reasons which are beyond the scope of this post, that retirement income planning, more so than any other type of financial planning, needs to be dynamic and flexible. It's important that you don't pigeon hole yourself into one specific age and instead plan for a range of possible retirement ages. A five-year range is generally appropriate, e.g., 64 to 68. In addition, this isn't a one-time exercise. It should be reviewed and adjusted on a regular basis, preferably annually.

Don't be guided and mislead by statistics. There's no magic age at which you should retire. If you haven't done so already, you need to hire a professional retirement income planner to assist you with the analysis and recommendations. You don't want to make a mistake when it comes to calculating your ability to retire at a certain age since you probably won't get a second chance once you retire.

The Retirement Income Planning Sweet Spot

2013-03-25T01:00:00-07:00

If you know me professionally, you know that I'm big on distinguishing between retirement income, vs. retirement asset, planning. This isn't about semantics. It's about being practical. Unless your lifestyle allows you to survive solely on Social Security or a comparable monthly benefit if you don't qualify for Social Security, you need to create your own pension. This is, after all, the theme of this blog: Innovative strategies for creating and optimizing retirement income.

In order to create your own pension, you need assets. The question is, when should you transition from a retirement asset planning to a retirement income planning approach? Tied into this question is a related question: Is your current financial advisor trained, experienced, and equipped to offer solutions to assist you with making this change? If not, it may be time to look for a new adviser who specializes in retirement income planning. See What Tools Does Your Financial Advisor Have in His or Her Toolbox?

So when should you begin creating your own pension? This is a daunting task since the primary goal is to ensure that you won't outlive your income while surrounded by many unknowns, including, how long you will live, potential health issues and timing and cost of same, as well as changing inflation and tax rates, to name a few. Given this situation, there ideally needs to be a significant amount of lead time to do the necessary planning.

As with all financial planning goals, you need to work backwards from your target date. By definition, the applicable date for retirement income planning would be the age at which you would like to retire. Given the complexity of the process together with the many unknowns, a 20-year lead time is generally advised. Assuming that you would like to retire at age 70, you should have an initial retirement income plan prepared at age 50.

This doesn't mean that you need to transfer all of your nonretirement and retirement investment assets into income-producing assets on your 50th birthday. This is simply when the transition from a retirement asset planning to a retirement income planning process should begin. Strategies will generally be implemented gradually over the course of the years leading up to, as well as after, retirement as your situation changes and different opportunities present themselves. Your retirement income plan needs to be vibrant, proactive, and responsive to change since you will experience many of them at an increasing rate as you approach, and move into, your retirement years.

In addition to retirement income planning strategies, your plan should include income protection strategies for yourself and for your spouse if married. An unprotected, or under protected, life event such as disability, long-term care, or death can severely reduce the longevity of, and potentially prematurely deplete, your, or your survivor's, investment assets. Income protection strategies should be included and implemented as part of an initial retirement income plan due to the fact that they become increasingly expensive and potentially cost prohibitive with age, not to mention the risk of being uninsurable as you get older.

So what if you're within 20 years of retirement and you haven't begun retirement income planning? No need to panic. While your strategies and potential opportunities may be more limited depending upon how close to retirement you are, it's never too late to start a retirement income plan. As previously stated, retirement income planning strategies are generally implemented both before and during retirement as your situation changes and different opportunities present themselves.

Consider the Future Purchase Option When Buying Long-Term Care Insurance

2013-03-11T01:00:00-07:00

Long-term care planning, and, in particular, long-term care insurance (LTCI) is getting a lot of attention recently with gender-based pricing just around the corner. If you haven't heard by now, Genworth, the leader in the LTCI industry, will be changing the rules of the game beginning in April when it charges higher premiums for single women on new policies.

Window of Opportunity

This development, together with Genworth's announcement last Wednesday that it's suspending sales of LTCI in California effective March 21st, has the industry abuzz and the public scrambling to find and implement solutions to quickly meet their needs. Genworth's latest announcement came in response to the company's introduction of a new product with higher premiums and reduced benefits.

When Genworth's new product is approved in California, which could take several months, consumers in the state will see premiums on new policies jump substantially compared to what's available today. It's anticipated that the increases will be in the range of 20% - 40% or higher in some cases. This will apply to men and women, although single women will be hit the hardest as a result of gender-based pricing.

Potential Alternative to Inflation Protection

The purchase of LTCI, unlike life insurance which is generally straight forward, is complicated by the a la carte approach that's prevalent in the industry. The details of this approach, which are beyond the scope of this post, allow you to pick and choose a combination of variables, including, but not limited to, benefit amount and length of coverage, in order to customize a policy to meet projected needs. One of the important options is inflation protection, with 3% or 5% simple or compound and cost of living being common choices.

Inflation protection, especially 5% compound, significantly increases the cost of LTCI. If you're 50 years old today applying for a policy with a daily benefit of $150 and 5% compound inflation and you experience a qualifying long-term care event when you're 80, your insurance company is on the hook for a daily benefit of $650 after you satisfy the policy's elimination period, or deductible. An alternative to this approach to reduce your premium is to increase the amount of your daily or monthly benefit and include a future purchase option (FPO) when you apply for LTCI.

What is a Future Purchase Option?

A future purchase option gives you the right to purchase additional coverage without evidence of insurability at specified intervals in the future at an additional cost based on your attained age. The amount of coverage is typically calculated using a compound inflation factor based on your original benefit amount. The number of available options, date of availability to exercise your first option, and number of years between exercise dates are dependent upon the terms of each policy.

A FPO, like many things, has its pluses and minuses. On the positive side, it allows you to start out with lower premiums compared to a comparable policy with built-in inflation and grow into a richer benefit with higher premiums later. Offsetting this are three disadvantages:

Due to the limitation on number of available options and the fact that they're generally front-loaded in the early years of a policy, you generally won't be able to match the benefit that you would receive with built-in inflation many years down the road when coverage is more likely to be needed.
If you could match the coverage of a policy with inflation coverage, the cumulative premiums that you will pay will be significantly greater than a comparable inflation-based policy without a FPO.
Assuming that you purchase a LTCI policy with a FPO when you're in your 40's – 60's and won't need the coverage until you're in your later 70's or 80's, you will need to purchase one or more additional policies in the future when you may not be insurable and the premiums will be more expensive or plan to potentially pay a sizeable amount of out-of-pocket expenses compared to a policy that includes inflation protection.

The inclusion of a future purchase option vs. inflation protection in a LTCI policy is in most cases a short-term cost decision. While benefits will generally be much less when claim time rolls around, so will one's annual premium. It allows individuals who otherwise wouldn't purchase LTCI to get some basic coverage and, as such, can be a reasonable practical alternative. Buyers beware – you get what you pay for.

Insure Your Longevity Risk With Social Security

2013-03-04T01:00:00-08:00

When planning for retirement, you need to plan for all of your retirement years. Sounds obvious, however, too often there's a focus on living it up in the early years without fully considering the potential for longevity and financial risks associated with the later years. As stated in previous posts, the consequences of the financial decisions that you make before you retire can have a profound effect on your ability to meet your financial needs throughout your later retirement years.

How do you plan for all of your retirement years if you don't know how long you're going to live? The answer is longevity insurance, otherwise known as a lifetime income annuity. This type of investment will pay you a specified amount of income beginning at a specified date at specified intervals, e.g., monthly or quarterly, with potential annual payment increases for the duration of your life.

If you're married, the payments can continue to be paid to your spouse upon your death at the same or a reduced amount, depending upon the contractual terms of the particular annuity. Unlike equity-based investments, the payments will be made regardless of market performance.

One of the best longevity insurance planning tools that most of us have at our disposal is Social Security. With its lifetime income payments, not to mention flexible starting date, i.e., age 62 through 70, and associated 7% - 8% increase in benefits each year that the starting date is deferred, excluding cost-of-living adjustments ("COLA's"), we can use it to insure our, and, if married, our spouse's, longevity risk.

The amount of retirement income that we choose to insure with Social Security is a personal decision. It's dependent upon several factors, including, but not limited to, projected investment assets and liabilities, other projected sources of income and expenses and projected timing and duration of same, as well as income tax laws and projected income tax rates.

Delayed claiming of Social Security benefits, in addition to providing increased annual lifetime benefits, results in greater longevity insurance since there will be more guaranteed income available in the latter years of retirement when it may be needed the most. The ability to delay one's Social Security benefit start date needs to be determined within the context of an overall retirement income planning analysis that includes an analysis of various potential retirement dates.

How to Reduce Your Spouse and Your Social Security Benefits

2013-02-25T01:00:00-08:00

As discussed in the two-part series, Approaching 62? – Stop Before You Leap, there are financial and non-financial consequences that will be dictated by your choice of a Social Security retirement benefit starting age. It's a decision that shouldn't be taken lightly since it may possibly be the most significant factor in your ability to sustain financial security throughout retirement.

If you're married, sustainability of financial security continues after the passing of the first spouse to die and often lasts for many years. If you decide to begin receiving your Social Security benefits before your full retirement age ("FRA"), you will also be turning on your spousal benefit. This is due to the deemed filing provision.

Under the deemed filing provision, when you apply for Social Security benefits before your FRA, you are deemed to also apply for your spousal benefit and vice versa. This is automatic. As a result, not only will you receive a reduced benefit compared to what you would receive if you wait until your FRA, your spousal benefit will also be reduced. In addition, your spouse must be 62 in order to receive a spousal benefit. Furthermore, a spousal benefit is only payable if you have been married for at least one year before filing for your benefit.

The spousal benefit is 50% of your benefit if your spouse has reached FRA. If you file an application to receive your benefits before your FRA, both you and your spouse will receive reduced benefits. Your benefit will be reduced by virtue of the fact that you're applying for benefits before your FRA. At best, your spouse will receive 50% of your reduced benefit. If your spouse hasn't reached FRA, his/her spousal benefit will be further reduced.

Spousal benefits are reduced from age 62 to FRA, which can vary from age 65 to 67 depending upon when your spouse was born. If your spouse is 62 when you claim your benefit and you claim your benefit before your FRA, he/she will receive 70% of 50% of your benefit, or 35% of your reduced benefit.

As an example, let's suppose that you were born in 1952 and your FRA is 66. Let's further assume that your monthly benefit at FRA is $1,000, however, when both you are your wife are 62, you decide to apply for your retirement benefits. Your benefit will be reduced by 25% to $750 and your spousal benefit, which would be $500 at your FRA, will be reduced to $262.50 (70% of 50% of your reduced benefit of $750). As a result of starting your benefits at age 62, you and your spouse will receive monthly benefits totaling $1,012.50 (your benefit of $750 plus a spousal benefit of $262.50), or $487.50, or 32.5%, less than the amount of $1,500 (your benefit of $1,000 plus a spousal benefit of $500) that you would have received had you waited until FRA to start your benefit.

If you haven't reached your FRA and you're married, beware of the deemed filing provision. That is, unless you don't mind receiving reduced Social Security benefits for you and your spouse.

Working? Social Security Benefits Don’t Stop, They’re Suspended

2013-02-18T01:00:00-08:00

Last week's post discussed the fact that, with two exceptions, the choice of your Social Security start date is an irrevocable decision. The two exceptions allow you to suspend payment of your monthly retirement benefit in order to take advantage of Social Security's annual 7% - 8% benefit increase between age 62 and 70 that's available to individuals who haven't yet begun receiving benefits.

Both of the benefit payment suspension exceptions require you to file an application with Social Security Administration in order to implement them, and, as such are voluntary. There's another way to suspend payment of your benefits that's automatic and doesn't require you to complete a form.

Social Security has an earnings test that only applies to individuals who are younger than their full retirement age ("FRA"). FRA varies between age 65 and 67 and is determined by your year of birth. Once you reach your FRA, your benefit amount will be unaffected by the amount of your earnings.

There are actually two earnings tests:

Under full retirement age
The year an individual reaches full retirement age

Under Full Retirement Age

If (a) you're less than your FRA and (b) you're not in the year that you will reach your FRA, you can earn up to $15,120 a year without any reduction in your Social Security benefits. Once you exceed this amount, your benefits will be reduced by one dollar for every two dollars in earnings above this limit.

The Year an Individual Reaches Full Retirement Age

In the year than you reach your FRA, you can earn up to 1/12 of $40,080, or $3,340 a month, during each month preceding the month that you reach your FRA without any reduction in benefits. Once you exceed this amount, your benefits will be reduced by one dollar for every three dollars in earnings above this limit.

Benefit Suspension

It's common for individuals who may be affected by Social Security's earnings test to use it to target the amount of earnings they will receive in order to avoid a reduction in benefits in a particular year. What many people fail to understand is that to the extent their benefits are reduced as a result of the earnings test, they aren't lost, they're simply suspended. Furthermore, there will be an increase in benefits to the extent that they were reduced once FRA is reached and the earnings test is no longer an issue.

My recommendation is don't let the earnings test drive your decision regarding the amount of your earnings in a particular year for two reasons. First of all, you won't lose Social Security benefits if your earnings exceed the threshold amount. Your benefits will simply be deferred. Second, the employment income that you're foregoing may require you to tap into other sources of retirement income prematurely, resulting in a potential accelerated depletion of valuable retirement assets that wouldn't have otherwise been necessary.

The Almost Irrevocable Retirement Income Planning Decision

2013-02-11T01:00:00-08:00

I don't know about you, however, I appreciate and enjoy flexibility in my life. When I hear the word "irrevocable," other than in the phrase "irrevocable life insurance trust," which I know from many years of experience is a wonderful estate planning tool in the right situation, I get a little squeamish. As Duke Frederick says to Celia in Scene 3 of Act 1 of Shakespeare's As You Like It, "Firm and irrevocable is my doom."

As pointed out in the December 17, 2012 post, Approaching 62? – Stop Before You Leap – Part 2 of 2, with two exceptions, the choice of your Social Security start date is an irrevocable decision. This wasn't always the case. Although it wasn't well-publicized and wasn't used very often, the "do-over," or "pay-to-play" strategy as I liked to refer to it, enabled individuals who claimed Social Security at age 62 to repay 100% of their benefits received to date without interest and receive a higher benefit going forward based on their current age. Ironically, Social Security Administration ended the ability to use this strategy on December 10, 2010, four days after the third of a three-part series on this topic was published by Retirement Income Visions™ (see Pay-to-Play Social Security – Part 3 of 3).

Once you start receiving your Social Security retirement benefits, why would you want to stop receiving them? As pointed out in last week's post, benefit amounts will increase by 7% - 8% each year that the start date is deferred between age 62 and 70, excluding cost-of-living adjustments ("COLA's"). You may have started your benefits at age 62 or some other age before your full retirement age ("FRA") since you thought this made sense at the time and later realized this wasn't the right choice in your situation. Another possibility is that you learned about a strategy to suspend and restart your benefits at a later date in order to receive a larger monthly payment.

Stopping Social Security Before Your Full Retirement Age

Unlike the now defunct "do-over" strategy where you could repay 100% of your benefits received to date without interest at any time after you began receiving them, there's a limited exception that enables you to employ a scaled-down version of this strategy. If you claimed benefits before your FRA and you're within 12 months of when your benefits started, you can withdraw your application and stop your benefits by repaying 100% of what you received so far.

Stopping Social Security After Your Full Retirement Age

Between FRA and age 70, Social Security Administration allows you to suspend retirement benefit payments. This can be done either when you're approaching your FRA and haven't started receiving benefits yet or after you have reached FRA and are already receiving benefits. There are different reasons why you would want to do this that's beyond the scope of this post.

While there are two exceptions when it comes to the irrevocability of the Social Security start date that may or may not be beneficial in a particular situation, these are limited exceptions. As emphasized in the last post, the age at which you begin receiving Social Security retirement benefits may possibly be the most significant factor in your ability to sustain financial security throughout retirement. As Billy Joel says in his song, Get it Right the First Time, "Get it right the first time, that's the main thing. I can't afford to let it pass. Get it right the next time, that's not the same thing."

New Tax Law – Don’t Let the Tax Tail Wag the Dog – Part 2 of 2

2013-02-04T01:00:00-08:00

Part 1 of this post focused on the two investment-related tax areas of the new tax law that went into effect on January 1st – (a) the Medicare investment income tax and (b) long-term capital gains and qualified dividends. It made the point that while the amount of potential income tax liability resulting from exposure to one or both of these changes may be significant, neither one in and of itself, or in combination for that matter, should cause you to overhaul an otherwise appropriate retirement income planning investment strategy.

After preparing income tax projections using current vs. prior tax law, your CPA or other income tax professional will be able to determine two things: (a) the total amount of your additional projected income tax liability attributable to various changes in the law, and (b) the amount of your additional projected income tax liability attributable to specific changes in the law, including the Medicare investment income tax and 20% long-term capital gains and qualified dividends tax.

Once you determine the amount of your projected income tax liability attributable to specific changes in the law, the next step is to determine (a) the applicable income threshold type and amount that you have exceeded, and (b) the projected amount of excess income over the applicable threshold amount. In the case of the Medicare investment income tax, the threshold type is modified adjusted gross income ("MAGI") and the amount is $200,000 if single or $250,000 if married filing joint. If your additional projected income tax liability is attributable to long-term capital gains and/or qualified dividends, the threshold type is taxable income and the amount is $400,000 if single or $450,000 if married filing joint.

Whether you're affected by the Medicare investment income tax or the 20% (vs. 15%) tax on long-term capital gains and dividends, the next step is to determine the various components of income that comprise your gross income. Once you do this, you need to determine which specific non-investment related components can be reduced, as well as the amount of reductions for each component, in order to reduce the amount of your projected income tax liability attributable to changes in the tax law.

It's important to keep in mind that some types of income can be reduced indirectly. An example of this is taxable salary which can be reduced significantly by various types of pre-tax deductions as available, including, but not limited to, 401(k) plan and cafeteria plan contributions. Another example is self-employment income which can be reduced by self-employment expenses.

In addition to determining which specific non-investment related components can be reduced, it's also important to determine if any losses can be created or freed up as another means of reducing gross income. This can include capital losses to offset capital gains, net operating losses, as well as passive activity loss carryovers that can be freed up as a result of the sale of a rental property. The latter strategy can be a double-edged sword since this may also result in a capital gain that may increase exposure to the Medicare investment income tax and/or the 20% capital gains tax.

Since the starting point for determining exposure to both the Medicare investment income tax and 20% capital gains tax calculations is adjusted gross income ("AGI"), the next step is to determine potential deductions for AGI, or "above-the-line" deductions, that you may not be currently taking advantage of. This includes self-employed retirement plan contributions, self-employed health insurance premiums, and health savings account ("HSA") contributions, to name a few.

If your issue is the 20% capital gains tax, in addition to reducing your AGI, there's another way that you can potentially reduce your exposure to this tax and retain the 15% favorable capital gains tax. Keeping in mind that the threshold type in the case of the 20% capital gains tax is taxable income which is calculated by subtracting itemized deductions and personal exemptions from AGI, you may be able to increase your itemized deductions in order to reduce your taxable income.

As you can see, there are things you can do to reduce your exposure to the Medicare investment income tax and 20% capital gains tax without changing your investment strategy. If you have an otherwise appropriate retirement income planning investment strategy, don't let the tax tail wag the dog.

Is It Time to Take Some Chips Off the Table?

2013-01-28T01:00:00-08:00

For those of you looking forward to reading Part 2 of the New Tax Law – Don't Let the Tax Tail Wag the Dog post, my apologies to you. It will be published next week. After the recent surge in stock prices with the notable exception of Apple, which has lost 265 points, or 38% of its value, in just four months from its September 21st high of 705.07 to its close of 439.88 this past Friday, I feel compelled to write and publish this post first.

I was in Las Vegas attending a professional conference last week which may have been the impetus for the title of this post. As an investment advisor, when I see the Dow Jones Industrial Average increase by 792 points, or 6%, from its December 31st close of 13,104.14 to Friday's close of 13,895.98 in less than one month, including 13 out of 17 sessions when the closing price has exceeded that of the previous day with 7 consecutive daily increases through Friday, on top of a 7.3% increase in 2012, I take notice. The phrase "reversion to the mean" comes to mind.

As a retirement income planner, I look for windows of opportunity for my clients to transfer, what amounts to slivers of their investment portfolio in many cases, from the unpredictable fluctuations of the stock market to conservative investments that are designed to provide guaranteed income* payable over a specified period of time that they can depend on throughout retirement. This includes single premium immediate annuities ("SPIA's"), deferred income annuities ("DIA's"), and fixed index annuities ("FIA's") with income riders. Since my crystal ball shattered years ago, I don't try to time the market to determine when it has peaked in order to recommend and perform this heroic service for my clients.

While my clients are unanimously very happy with the recent increased value of their portfolios, I know from many years of experience that this state of euphoria is often short-lived. The reality is that their equity allocation is more than what is targeted for their portfolio in several cases. As a result, the risk associated with their portfolio is greater than what is appropriate for their risk tolerance level. This is inevitably a ticking time bomb unless corrective action is taken in a timely manner.

Shifting a portion of a managed investment portfolio to guaranteed income* at opportune moments has proven to be a winning strategy for my clients within 20 years of, or in, retirement. They have everything to gain and nothing to lose. Each time that a client implements this recommendation, he/she accomplishes two important goals shared by all individuals doing retirement income planning: (a) portfolio risk reduction and (b) decreased likelihood of running out of money in retirement.

Although I haven't done any formal large-scale studies, I can confidently state from personal and client experience that this generally results in reduced short- and long-term stress levels, fewer cases of insomnia, and less health issues in general for those individuals who implement this strategy compared to those who don't. This unequivocally trumps the short-term euphoria associated with increased portfolio values in a bull market.

Let Apple's recent experience be a lesson for us all. Don't be afraid to take some chips off the table, especially when your retirement, health, and happiness are at stake.

*Subject to the claims-paying ability of individual insurance carriers

New Tax Law – Don’t Let the Tax Tail Wag the Dog – Part 1 of 2

2013-01-21T01:00:00-08:00

The new tax law which went into effect on January 1st, which is actually a combination of provisions from two different tax bills – the American Taxpayer Relief Act of 2012 (ATRA) and the Health Care and Education Reconciliation Act of 2010 – penalizes individuals with certain types and amounts of income. See parts 1 and 2 of The 2013 Tax Law Schizophrenic Definition of Income published on January 7th and January 14th for a discussion of the affected income types and threshold amounts, including a summary table of same.

As pointed out in the two posts, there are now five different definitions of income affecting seven different tax areas as a result of the new legislation. What I have found interesting as a CPA retirement income planner is the fact that while only two of the seven affected tax areas are directly related to investments, these two areas have commanded the vast majority of the media's attention to date.

The two investment-related tax areas, both of which were discussed in detail in the two posts, are (a) the Medicare investment income tax and (b) long-term capital gains and qualified dividends. The Medicare investment income tax affects those with modified adjusted gross income ("MAGI") in excess of $200,000 if single or $250,000 if married filing joint while long-term capital gains and qualified dividends are problematic if taxable income exceeds $400,000 if single or $450,000 if married filing joint.

The penalty for crossing these thresholds is 3.8% of the lesser of net investment income or MAGI in excess of the specified threshold amounts in the case of the new Medicare investment income tax and a 20% vs. 15% tax rate on long-term capital gains and qualified dividends. While the amount of potential additional income tax liability resulting from exposure to one or both of these changes may be significant, neither one in and of itself, or in combination for that matter, should cause you to overhaul an otherwise appropriate retirement income planning investment strategy.

As with all major tax law changes, and I've been through many, including the Economic Recovery Tax Act of 1981 (ERTA), the Tax Reform Act of 1986 (TRA), and the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRA), to name a few of the biggies, the first step in evaluating how the legislation will affect you is to prepare an income tax projection for the current and future tax years. The number of years that you choose to include in your projection depends upon a number of factors that are beyond the scope of this post. Needless to say, preparation of your projection by a CPA specializing in income taxation or by another income tax professional is recommended.

In order to determine how specific tax law changes will affect you, a baseline tax projection using prior law before the various changes took effect should be prepared. The next step is to prepare a projection under the new tax law. This will enable you to determine the total amount of your additional projected income tax liability attributable to various changes in the law. Once you know this, you can fine tune your analysis to determine the amount of additional projected income tax liability attributable to specific individual changes in the law. Your analysis should include types of income, affected tax areas, and additional income tax liability resulting from exceeding specified threshold amounts.

Assuming that your income tax projection reveals that you're projected to incur more than a nominal amount of additional income tax liability that's attributable to various types and amounts of investment income, you need to read Part 2 of this post in order to learn what to do next.

The 2013 Tax Law Schizophrenic Definition of Income – Part 2 of 2

2013-01-14T01:00:00-08:00

Per last week's blog, as a result of President Obama's signing on January 2nd of the American Taxpayer Relief Act of 2012 following changes legislated by the 2010 Health Care Reform Act effective beginning in 2013, there are now five different definitions of income affecting seven different tax areas. Exhibit 1, which was also included in last week's post, summarizes 2013 individual federal income-based tax law changes, comparing each one with the law in effect in 2012.

Please see last week's post for a discussion of the first three definitions of income. This week's post examines the last two.

Adjusted Gross Income Exceeding $250,000 or $300,000

Once your adjusted gross income (AGI) exceeds $250,000 if single or $300,000 if married filing jointly, your income tax liability will increase as a result of two affected tax areas: (1) Itemized deductions limitation and (2) Personal exemption phaseout. Although neither of these provisions was effective in 2012, both have been part of prior years' tax law.

Itemized Deductions Limitation

The limitation on itemized deductions, known as Pease after the congressman who helped create it, was originally part of the Economic Growth and Tax Relief Reconciliation Act of 2001, was phased out beginning in 2006, and was repealed in 2010.

Back in 2013, the itemized deductions limitation reduces most otherwise allowable itemized deductions by 3% of the amount by which AGI exceeds the specified threshold of $250,000 or $300,000, depending upon whether you're filing as a single or married filing joint taxpayer. Itemized deductions can't be reduced by more than 80%. In addition, the reduction doesn't apply to deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses.

Personal Exemption Phaseout

The personal exemption phaseout is another reincarnation of prior tax legislation. Since 1990, the personal exemption has been phased out at higher income levels. The 2001 tax act phased out the phaseout beginning in 2006 with repeal in 2010.

Back in 2013, 2% of the personal exemption amount, projected to be $3,900, is eliminated for each $2,500 of AGI in excess of $250,000 for single filers and $300,000 for those using married filing joint tax filing status.

Taxable Income Exceeding $400,000 or $450,000

Welcome to 2013 tax law income definition #5 affecting two more income tax areas. If your taxable income exceeds $400,000 if single or $450,000 if married filing jointly, your income tax liability will be further increased by two different tax provisions: (1) Income tax bracket and (2) Long-term capital gains and qualified dividends.

Income Tax Bracket

The top tax bracket of 35%, which was in effect from 2003 through 2012, jumps by 4.6% to 39.6% beginning in 2013 for those individuals whose taxable income exceeds the single and married filing joint thresholds of $400,000 or $450,000, respectively. The last time that the 39.6% rate was part of the tax law and was also the top tax rate was in 2000.

Long-Term Capital Gains and Qualified Dividends

Beginning in 1982, tax rate reductions reduced the tax rate on long-term capital gains, i.e., capital gain income from assets held longer than one year, from 28% to a maximum of 20%. The rate was further reduced from 20% to 15% beginning in 2003 and also began applying to qualified dividends.

The 20% maximum rate on long-term capital gains and qualified dividends has returned in 2013 for those individuals whose taxable income exceeds the $400,000 or $450,000 threshold depending upon filing status.

Summary

With the exception of the Medicare Earned Income Tax and Medicare Investment Income Tax discussed in last week's post, the other five affected tax areas resulting in higher federal income taxes in 2013 are reincarnations of prior tax law. Everyone with employment or self-employment income of any amount with limited exception will pay more tax in 2013 than they did in 2012, all else being equal. In addition, income tax liability will increase for anyone with certain types of income exceeding specified thresholds starting at $200,000 or $250,000 depending upon filing status. The cumulative effect of the various changes and associated increase in federal income tax liability will be significant for many people.

The 2013 Tax Law Schizophrenic Definition of Income - Part 1 of 2

2013-01-07T01:00:00-08:00

QUOTED AND LINKED IN JANUARY 11, 2013 WALL STREET JOURNAL
And you thought that the tax law was already too complex. As a result of President Obama's signing on January 2nd of the American Taxpayer Relief Act of 2012 following changes legislated by the 2010 Health Care Reform Act effective beginning in 2013, there are now five different definitions of income affecting seven different tax areas. With a schizophrenic name ("Taxpayer Relief Act"), this comes as no surprise.

Although the most publicized affected income level is individuals with taxable income exceeding $400,000 for single tax filers and $450,000 for married filing joint tax filers, everyone with employment or self-employment income of any amount with limited exceptions will pay more tax in 2013 than they did in 2012, all else being equal.

Exhibit 1 summarizes 2013 individual federal income-based tax law changes, comparing each one with the law in effect in 2012. The five different definitions of income are as follows, with dollars amounts depending upon single vs. married filing joint tax status with the exception of #1 which applies to everyone with earned income with limited exceptions:

Earned income of between $0 and $113,700
Earned income and modified adjusted gross income exceeding $200,000 or $250,000
Modified adjusted gross income exceeding $200,000 or $250,000
Adjusted gross income exceeding $250,000 or $300,000
Taxable income exceeding $400,000 or $450,000

The first three definitions of income will be discussed in the remainder of this post, with the last two deferred to next week's post.

Earned Income Between $0 and $113,700

The employee Social Security tax rate which was reduced from 6.2% to 4.2% for 2011 and 2012 is back to 6.2% beginning in 2013. In addition, the Social Security wage base, which was $106,800 in 2010 and 2011 and $110,100 in 2012 is $113,700 in 2013. This translates to a Social Security tax increase of $2,425.20 in 2013 vs. 2012 for individuals with Social Security wages of at least $113,700, with the tax going from $4,624.20 (110,100 x 4.2%) in 2012 to $7,049.40 ($113,700 x 6.2%) in 2013.

Earned Income and Modified Adjusted Gross Income Exceeding $200,000 or $250,000

In recent years, everyone with earned income has been subject to Medicare tax at a rate of 1.45% on all earned income with limited exceptions. Beginning in 2013, the rate is increased by 0.9% to 2.35% on earned income exceeding $200,000 if single or $250,000 if married filing joint if modified adjusted gross income ("MAGI") also exceeds the specified threshold amounts. MAGI is adjusted gross income ("AGI") with certain adjustments, the details of which are beyond the scope of this post.

Modified Adjusted Gross Income Exceeding $200,000 or $250,000

The first two definitions of income are dependent upon the presence of earned income. It doesn't matter if you have any earned income for purposes of meeting the next three definitions of income. If your MAGI exceeds $200,000 if single or $250,000 if married filing joint, and you have investment income, you will be subject to the new Medicare investment income tax. The tax is assessed at a rate of 3.8% on the lesser of net investment income or MAGI in excess of the specified threshold amounts. Net investment income includes taxable interest, dividends, and capital gains.

If you have income of at least $100,000 and you haven't retired TurboTax and rehired your CPA yet, I'll guarantee you will do so after reading part 2 of this post.

Happy Holidays!

2012-12-24T01:00:00-08:00

Retirement Income Visions™ is taking a well-deserved rest for the holidays. I wish you and your family a Happy New Year. I look forward to continuing to bring you innovative strategies for creating and optimizing retirement income beginning on January 7^th.

If you miss our weekly posts, please visit Retirement Income Center (www.RetirementIncomeCtr.com) to learn more about how to plan, manage, and protect your retirement income.

Thank you for your continued support. It is much appreciated.

All the Best Always,

Bob Klein

Approaching 62? - Stop Before You Leap - Part 2 of 2

2012-12-17T01:00:00-08:00

Last week's post began a discussion regarding the far-reaching and long-term consequences of the Social Security claiming decision. It concluded by stating that the choice of a Social Security starting age will differ depending upon each person's unique circumstances.

Why is the choice of a Social Security start date so important? There are several reasons, all of which can be divided into two categories: (a) Those dictated by Social Security rules and regulations and (b) Other fianncial reasons.

Reasons Dictated by Social Security Rules and Regulations

Social Security rules and regulations affecting the choice of a start date include the following:

Benefit amounts will increase by 7% - 8% each year that the start date is deferred between age 62 and 70, excluding cost-of-living adjustments ("COLA's").
Social Security COLA amounts will be greater for those who defer their start date.
If married, it will affect the amount of one's spousal Social Security benefit.
If married, it will affect the amount of one's survivor's Social Security benefit.
With two exceptions, it's an irrevocable decision.

Other Financial Reasons

Other financial reasons why the choice of a Social Security start date is so important include the following:

It can affect the choice of one's retirement age as well as that of one's spouse if married.
It may impact sustainability of retirement income and assets for 30 to 40 years.
It will influence the amount and timing of withdrawals from retirement and nonretirement investment assets.
It can affect the amount of Social Security benefits that are taxable each year.
It will directly affect one's overall income tax liability and tax planning.

As you can see, there are many things riding on the choice of one's Social Security starting age, most of which won't become apparent until several years, or even decades, after the claiming age decision has been made. The age at which you begin receiving Social Security retirement benefits may possibly be the most significant factor in your ability to sustain financial security throughout retirement. Given the importance of this decision, sit down with your retirement income planner before going to the "Boldly Go Online to Retire - It's So Easy!" section of the Social Security Administration website and clicking the "Apply for Retirement" link.

Approaching 62? – Stop Before You Leap - Part 1 of 2

2012-12-10T01:00:00-08:00

As I've dealt with clients and nonclients alike over the last three decades, one of my ongoing observations is the lack of formal and informal financial education we receive as a society when it comes to how to recognize and plan for critical life-changing financial events in our lives. This is especially true as it pertains to one of the most, if not the most, important financial decisions most of us will make during our lifetime, i.e., when to begin receiving Social Security retirement benefits.

By way of background, although you may apply to begin receiving Social Security retirement benefits at age 62, your benefit will increase each month that you defer your start date until age 70. While it's tempting to turn on the faucet at age 62, this may not be the best age to begin receiving benefits if you're concerned about maximizing and prolonging your retirement income stream and that of your spouse if you're married.

The timing of the Social Security claiming age decision occurs at the crossroads of most peoples lives when many decisions need to be made that will affect the financial and emotional success of one're retirement years. It comes at a time when:

The financial and psychological security of full-time employment will be ending in the near future for most people.
The sequence of investment returns can make or break one's retirement if not properly planned for.
There will be a prolonged period of financial uncertainty without the associated safety of a paycheck, including unknown investment performance, inflation, and income tax rates.
Health begins to decline for many people with escalating health insurance premiums, potential higher out-of-pocket medical costs, and potential uncovered long-term care expense.

Given the far-reaching and long-term consequences of the Social Security claiming decision, it should be a high priority for anyone approaching age 62 to have a professional retirement income planner prepare an analysis as part of a retirement income plan to determine the optimal age to begin receiving Social Security retirement benefits.

The choice of a Social Security starting age will differ depending upon each person's unique circumstances. This will become more evident when you read the reasons why the choice of your Social Security claiming age is so important in Part 2 of this post next week.

Social Security – The Ultimate Deferred Income Annuity

2012-12-03T01:00:00-08:00

Last week's post made the point that Social Security isn't simply an entitlement program and is instead a deferred income annuity ("DIA") payable for life. As discussed, the primary difference between Social Security and a commercial DIA is the organization from which the investment is purchased and payments are guaranteed. In the case of Social Security, it's the federal government while DIA's are purchased from, and payments guaranteed by, individual life insurance companies.

It turns out that in today's low-interest rate environment, Social Security is inarguably the ultimate DIA. To illustrate this, I will use my current Social Security benefits statement that includes the following information about my projected monthly retirement benefit beginning at various ages:

    Age 62                                                        $1,870
    Age 66 and 2 months (full retirement)        $2,559
    Age 70                                                        $3,385

In addition to projected monthly retirement benefits, my statement also shows that through 2011, I have paid Social Security taxes totaling approximately $149,000 and my employers (including myself and my two corporations for the last 23 years) have paid approximately $94,000, for a total of approximately $243,000.These taxes have been paid over the last 40 years beginning with part-time employment when I was in high school, with the vast majority paid over the last 25 years.

In addition to my Social Security retirement benefit, my wife is entitled to receive a monthly benefit equal to one-half of my full retirement benefit, or $1,280 (50% x $2,559) if she starts receiving benefits at her full retirement age. This is referred to as a spousal benefit and is independent of any benefit to which she may be entitled based on her earnings record. Assuming my wife has no significant earnings and further assuming that I predecease her, she will receive her spousal benefit for the rest of my life at which time she will receive my higher monthly benefit for the remainder of her life.

Ignoring my wife's spousal benefit in order to minimize complications, let's demonstrate the value of my Social Security retirement benefit by calculating the single premium required today at my age 57 to purchase a DIA that will pay my projected monthly retirement benefit beginning at various ages with a 2% annual increase for the remainder of my wife and my lives. Per the November 12, 2012 The Smooth COLA post, Social Security cost-of-living adjustments ("COLA's") have averaged 2.6% over the last ten years; therefore, an assumed 2% annual increase is probably conservative.

The following is the range of DIA single premiums required to pay various joint lifetime income amounts assuming an annual 2% increase beginning at various ages using illustrations from three highly-rated life insurance carriers:

While it's obvious that the above single premium amounts are significantly greater than the total Social Security taxes of $243,000 paid through 2011 by my employers and myself, it's important to keep in mind the following facts when doing a cost/benefit analysis of Social Security compared to commercial DIA's:

In order to receive the projected Social Security monthly income beginning at various ages, it's assumed that my current earnings will continue until my full retirement age.
In order to receive the projected Social Security monthly income beginning at various ages, Social Security taxes paid by my employers and myself are projected to total $314,000 - $381,000 or greater depending upon my annual earnings, actual taxable Social Security wage bases, and when I retire.
Although my Social Security tax payments haven't been segregated and invested in an account in my name and they have been used to fund Social Security benefits for other individuals, my employers and I have been paying into the Social Security Trust Fund for 40 years.
My projected Social Security monthly income beginning at various ages doesn't include COLA's between now and my Social Security starting age.
The DIA assumed annual increase of 2% may be greater or less than the actual Social Security COLA's for the remainder of my wife and my lifetime.
Although it isn't likely, it's possible that my projected Social Security benefit amounts may change if Social Security law changes.
As previously stated, my projected Social Security benefits and the single premium DIA calculation both exclude my wife's Social Security spousal benefits.
While it's possible that less than 50% of my Social Security benefits will be taxable, under current law, it's likely that 50% - 85% of my benefits will be taxable, depending upon the amount of my other income.
Depending upon when I would start receiving payments from a DIA, approximately 40% - 60% of my payments would be taxable as a result of favorable tax treatment associated with nonqualified annuity payments.
The required DIA single premium amounts are on the high side since they were calculated assuming that I'm a California resident when I receive my payments and, as such, take into consideration California's nonqualified annuity premium tax of 2.35% which isn't applicable in most states.

As you can see, a number of factors must be considered when comparing Social Security as a DIA to purchasing a commercial DIA. Despite these various factors, in today's low-interest rate environment, it's clear that Social Security is the ultimate DIA.

Social Security – A Lifetime Deferred Income Annuity

2012-11-26T01:00:00-08:00

Do you have an investment that will pay you guaranteed lifetime income totaling $870,000 to $1.87 million? This is the projected range of income that my wife and I expect to receive from Social Security during our lifetime based solely on my earnings record depending upon when I choose to start my benefits and how long both of us live. Granted that my earnings have exceeded the taxable Social Security wage base for most of my working years, however, this isn't unusual.

Our projected benefits assume that (a) my current earnings level continues until I begin receiving Social Security, (b) either my wife or I live until at least my age 90, (c) my wife potentially lives until age 95, and (d) Social Security cost-of-living adjustments ("COLA's") are 2% each year which is less than the average increase of 2.6% over the last ten years. If all of these assumptions are realized, our actual benefits will likely be greater than the projected amounts since the projections don't include COLA's between now and retirement.

In order to truly appreciate the value of Social Security retirement benefits, it's important to understand that it isn't simply an entitlement program. Social Security is instead an investment; in particular, it's a deferred income annuity ("DIA") payable for life.

Let's review a couple of definitions in order to put things in perspective. Per Retirement Income Visions™ Glossary, a Deferred Income Annuity is an annuity for which annuitization begins at least 13 months after the date of purchase in exchange for a lump sum or series of periodic payments. Per the Glossary, Annuitization is the irrevocable structured payout of income with a specified payment beginning at a specified date, paid at specified intervals over a stated period of months or years or for the duration of the annuitant's and potentially his/her spouse's and/or other individuals' lifetime(s) depending upon the payout option selected.

Relating these two definitions to Social Security, in exchange for a series of payments, i.e., Social Security taxes paid by you and your employer, over your working years, you will receive an irrevocable structured payout of income with a specified payment beginning at a specified date paid for the duration of your, and potentially your spouse's, lifetime, depending upon the payout option selected.

The primary difference between Social Security and a commercial DIA is the organization from which the investment is purchased and payments are guaranteed. In the case of Social Security, it is the federal government while DIA's are purchased from, and payments guaranteed by, individual life insurance companies.

A second difference is the methodology used to calculate one's lifetime benefit. Simply stated, Social Security benefits are calculated using a series of formulas based on one's historical earnings relative to the taxable Social Security wage base in effect during each year of employment. Lifetime DIA payouts, on the other hand, are actuarially calculated using the amount and timing of lump sum and/or series of periodic payments, life expectancy factors, as well as current and projected interest rates.

A third potential difference between Social Security and a commercial DIA is the calculation of the payment amount after the initial year. Although a specified payment beginning at a specified date is calculated by the Social Security Administration based on various assumptions, the payment is the amount payable during the first year of benefits. Subsequent years' payments can increase depending upon annual COLA's. DIA payouts can increase as well if contractually provided. In some cases it's also based on COLA's, however, most of the time it's determined by a predefined inflation factor.

Approximately 96% of working-age Americans are covered by the Social Security system. Social Security provides 90% of retirement income for one in three retirees and more than 50% for two in three retirees. Given these facts, Social Security is the most prevalent type of investment in the United States. Furthermore, it is, by far, the most popular DIA available in the marketplace.

Black Friday – Think Roth IRA Conversion

2012-11-19T01:00:00-08:00

This Friday is Black Friday. It's the day after Thanksgiving when major retailers open early promoting significant price reductions on lots of items. It has routinely been the busiest shopping day of the year since 2005.

There's another major sale taking place as I write this post that's not being publicized. It's happening in the investment world. It's one of those perfect storm moments when a confluence of seemingly unrelated factors occurs that results in a short-lived opportunity for those who act on it.

With the recent 1,000 point, or 8%, drop in the Dow Jones Industrial Average (DJIA), closing at 13,593 on September 14^th and finishing at 12,588 on Friday, combined with a distinct possibility of higher income tax rates in 2013, with one notable exception, this is one of those moments for individuals considering a Roth IRA conversion.

Let's start with the exception which is the result of the last major Roth IRA conversion opportunity. In 2010, individuals who did Roth IRA conversions were given the choice of including income from their conversion on their 2010 income tax returns or deferring it. If they chose the latter, they were required to report 50% of the income on their 2011 income tax returns and 50% on their 2012 returns.

Several of my clients did sizeable conversions in 2010, choosing to defer 50% of their Roth IRA conversion income to 2011 and 50% to 2012. While these individuals have enjoyed 30% increases in the equity portion of their Roth IRA accounts since 2010 as a result of the increase in the DJIA from the 10,000 level that will never be taxed, they will also be including large amounts of income from their 2010 conversions on their 2012 income tax returns. Without offsetting losses or deductions, most of these individuals won't be good candidates for a 2012 Roth IRA conversion.

If your 2012 taxable income is being inflated by a large amount of deferred income from a 2010 Roth IRA conversion without offsetting losses or deductions, you may not be a good candidate for a 2012 Roth IRA conversion. Assuming that you don't fall under this exception and you haven't already done a sizeable Roth IRA conversion in 2012, you should be evaluating this strategy as part of your 2012 year-end income tax planning. Once again, there isn't one, but two, events that make this a potentially timely transaction depending upon your tax situation, either one of which qualifies as a potential trigger.

While it's possible that the stock market may decline further and income tax rates may not increase in 2013, the recent significant stock market decline in and of itself presents a Roth IRA conversion opportunity. In addition to avoiding taxation on future appreciation of conversion amounts, Roth IRA conversions result in reduction of taxable IRA accounts which in turn offers two other potential benefits.

Smaller taxable IRA accounts translate to smaller required minimum distributions ("RMD's") and reduced taxable income beginning at age 70-1/2. In addition, to the extent that you have less taxable income, you may be able to reduce the amount of your taxable Social Security benefits, providing for a second tax reduction opportunity as well as enhanced retirement income longevity.

While you're setting your alarm clock to take advantage of all of those Black Friday sales, don't forget about the Roth IRA conversion sale. It may be one of those short-lived investment opportunities that you won't see for a long time.

The Smooth COLA

2012-11-12T01:00:00-08:00

Remember the old Dr Pepper commercials promoting the fact that this famous soft drink, which was created in the 1880s and was first nationally marketed in the United States in 1904, was "so misunderstood." I'm a firm believer that this saying also applies to a non-soft drink COLA brought to you by the Social Security Administration.

Every year since 1975, the Social Security Administration calculates a cost-of-living adjustment, or COLA. The 1975 – 1982 COLAs were effective with benefits payable for June in each of those years. Since 1982, COLAs have been effective with benefits payable for December.

The COLA has always been based on an annual increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Since 1983, COLAs have been calculated using increases in the CPI-W from the third quarter of the prior year to the corresponding quarter of the current year in which the COLA became effective. The 2012 COLA of 1.7% was announced in October and will apply to benefits payable beginning in December.

Per the Social Security Cost-of-Living Adjustments table below, there were sizeable annual increases the first eight years from 1975 to 1982. The increases ranged from a low of 5.9% in 1977 to a high of 14.3% in 1980, averaging 8.7% during this period. The COLA decreased to 3.5% in 1983 and further declined to 1.3% in 1986 before climbing to over 4% for four straight years beginning in 1987. There have been only two years since 1982 when the COLA exceeded 5% (1990 – 5.4% and 2008 – 5.8%). There were also two consecutive years recently in 2009 and 2010 that saw no increases.

Since its roaring start the first eight years, average COLA increases have declined dramatically and have remained consistent over extended periods of time. They have averaged 2.6%, 2.5%, and 2.9% for the last 10-, 20-, and 30-year periods, respectively. As a result of their initial jump start, COLA's have averaged 4.1% over their 38 years of existence.

Although average annual increases have remained below 3% for extended periods of time over the last 30 years, Social Security recipients have kept up with inflation as measured by the CPI-W. Someone still alive today who started receiving benefits in 1975 has seen a 354% increase in benefits, with 108% of the increase attributable to COLA's during the first 10 years. For the individual who began receiving benefits in 1982, her benefits have increased by 134% over the last 30 years. Benefits have doubled over the last 25 years as a result of COLA's.

With only two COLA's exceeding 4% in the last 20 years (4.1% in 2005 and 5.8% in 2008), the pace of the total increase in Social Security benefits has declined significantly. If you began receiving benefits 20 years ago in 1992, you have seen an increase of 63%. If your start year was 2002, your benefits have increased by 29%. Finally, the total increase over the last five years has been only 11%.

Despite the fact that Social Security recipients have enjoyed sizeable cumulative increases in their benefits over the past 20+ years, another reason why COLAs are often misunderstood is due to their accounting treatment. Social Security benefits are reduced by the Medicare Part B premium that helps pay for doctors' services and outpatient care. The monthly premium for most individuals in 2012 is $99.90. Although Medicare premium increases cannot be greater than the COLA, Social Security benefit increases are diluted to the extent of any increase in Medicare premium.

Enjoy your COLA's!

Invest in DIA to Fund LTCI Premiums When Retired – Part 4 of 4

2012-11-05T01:00:00-08:00

The first three posts in this series discussed five differences between fixed index annuities ("FIA's") with income riders and deferred income annuities ("DIA's") that will influence which retirement income planning strategy is preferable for funding long-term care insurance ("LTCI") premiums in a given situation. If you haven't done so already, I would recommend that you read each of these posts.

This week's post presents a sample case to illustrate the use of a FIA with an income rider vs. a DIA to fund LTCI premiums during retirement.

Assumptions

As with all financial illustrations, assumptions are key. A change in any single assumption will affect the results. The following is a list of assumptions used in the sample case:

55-year old, single individual
Planned retirement start age of 68
Life expectancy to age 90
Current annual LTCI premium of $4,000 payable for life
Need to plan for infrequent, although potentially double-digit percentage increases in LTCI premium at unknown points in time
Given assumptions #4 and #5, plan for annual pre-tax income withdrawals of approximately $6,000 beginning at retirement age
Solve for single lump sum investment at age 55 that will provide needed income
Investment will come from a nonqualified, i.e., nonretirement, investment account
One investment option is a fixed index annuity ("FIA") with an income rider with lifetime income withdrawals beginning at age 68.
Second investment option is a deferred income annuity ("DIA") with no death benefit and lifetime income payout beginning at age 68.
FIA premium bonus of 10%
FIA annual return of 3%
FIA income rider charge of 0.95% of income rider value otherwise known as the guaranteed minimum withdrawal benefit ("GMWB")
No withdrawals are taken from the FIA other than the income withdrawals.
All investments are purchased from highly-rated life insurance companies known for providing innovative and competitive retirement income planning solutions.

Investment Amount

The first thing that needs to be solved for is the amount of investment that must be made at the individual's age 55 in order to produce lifetime annual income of approximately $6,000 beginning at age 68. The goal is to minimize the amount of funds needed for the investment while choosing a strategy from a highly-rated insurance company that's known for providing innovative and competitive retirement income planning solutions.

It turns out that an investment of $50,000 to $65,000 is needed to produce lifetime annual income of approximately $6,000 beginning at age 68. Given the fact that my goal as a retirement income planner is to use the smallest amount of investment for a fixed income annuity to produce a targeted income stream in order to preserve the remainder of a client's investment portfolio for my client's other financial goals, the amount of the investment needed is $50,000.

Results

There are three items we will examine to compare the results between investing $50,000 in a FIA with an income rider vs. a DIA to fund LTCI premiums during retirement. They are as follows:

Annual gross income
Annual taxable income
Value/death benefit

Annual Gross Income

Per the Exhibit, the annual payout, or gross income, from the FIA is $5,764, or $236 less than the annual gross income of $6,000 from the DIA. This equates to a total of $5,428 for the 23 years of payouts from age 68 through age 90.

Annual Taxable Income

If the investment was made in a retirement account like a traditional IRA and assuming there have been no nondeductible contributions made to the IRA, 100% of the income would be taxable. This would be the case for both the FIA or DIA.

As stated in assumption #8, the investment will come from a nonqualified, i.e., nonretirement, investment account. Per Part 2 of this series, this makes a difference when it comes to taxation of the withdrawals. Per the Exhibit, 100% of the annual FIA income of $5,764 is fully taxable vs. $3,066 of the DIA income. This is because the DIA, unlike the FIA, is being annuitized and approximately 50% of each income payment is nontaxable as a return of principal. Over the course of 23 years of payouts, this results in $62,054 of additional taxable income for the FIA vs. the DIA.

The amount of income tax liability resulting from the additional taxable income from the FIA will be dependent upon several factors that will vary each year, including (a) types, and amounts, of other income, (b) amount of Social Security income, (c) potential losses, (d) adjusted gross income, (e) itemized deductions, (f) marginal tax bracket, and (g) applicable state income tax law.

Value/Death Benefit

While the present value of the future income stream of a DIA represents an asset, you generally won't receive an annual statement from the life insurance company showing you the value of your investment. In addition, while some DIA's will pay a death benefit in the event that the annuitant dies prior to receiving income, per assumption #10, this isn't the case in this situation. Consequently, the DIA column of the "Value/Death Benefit" section of the Exhibit is $0 for each year of the analysis.

On the other hand, there's a projected value for the FIA from age 55 through age 79. This value is also the amount that would be paid to the FIA's beneficiaries in the event of death. There's a projected increase in value each year during the accumulation stage between age 55 and 67 equal to the net difference between the assumed annual return of 3% and the income rider charge of 0.95% of the income rider value.

Per the Exhibit, the projected value/death benefit increases from $56,278 at age 55 to $68,510 at age 67. Although the assumed premium bonus of 10% is on the high side these days, this is reasonable given the fact that FIA values never decrease as a result of negative performance of underlying indexes, the assumed rate of return of 3% is reasonable in today's low index cap rate environment, and the assumed income rider charge of 0.95% of the income rider value is on the upper end of what's prevalent in the industry. The projected value/death benefit decreases each year from age 68 to age 79 until it reaches $0 beginning at age 80 as a result of the annual income withdrawals of $5,764.

Conclusion

As discussed in Parts 1 – 3 of this series, there are five important differences between FIA's with income riders and DIA's that will influence which retirement income planning strategy is preferable for funding LTCI premiums during retirement in a given situation. Two of the differences, income start date flexibility and income increase provision, haven't been addressed in this post.

In addition to the five differences, the amount of the investment required to produce a targeted lifetime annual income amount to pay LTCI premiums, including potential increases, will differ depending upon the particular FIA or DIA strategy used. In the illustrated case, which isn't uncommon today, an investment of $50,000 resulted in an almost identical lifetime income payout whether a FIA with an income rider or a DIA is used.

As illustrated, the taxable income associated with a DIA in a nonqualified environment is much less compared to a FIA. As previously discussed, the amount of tax savings resulting from the reduced taxable income will depend upon an analysis of several factors and will vary each year. Ignoring the potential income tax savings resulting from the tax-favored DIA payouts, the FIA with income rider would be the preferred investment choice for many individuals in this case given the presence, duration, and projected amount of, the investment value/death benefit.

The FIA edge is reinforced by the fact that, unlike most traditional DIA's, the income start date and associated annual lifetime income payout amount for FIA's is flexible. This would be an important consideration in the event that the year of retirement changes. Furthermore, this is quite possible given the fact that the individual is 13 years away from her projected retirement year.

As emphasized throughout this series, the purchase of LTCI needs to be a lifetime commitment. Planning for the potential purchase of a LTCI policy should be included as part of the retirement income planning process to determine the sources of income that will be used to pay for LTCI throughout retirement. Whether it's a FIA with an income rider, a DIA, or some other planning strategy that's used for this purpose will depend on the particular situation.