As a recovering CFO, I find it particularly interesting to help people with their financial planning. I recently organized a retirement income class here locally, where I was fortunate enough to sit down with one of the students to answer some of the questions she had a little deeper. We quickly discovered that our conversation had much more merit in becoming a formal meeting, so we set aside a time to visit us at her home where she would feel more comfortable and have access to all of the documents including she would need. Our friend, let's call her Mildred, is a 70-year-old lady who, like most workers her age, has all her strengths in ARI. She has social security and a small pension on which she lives and, like most people who grew up with parents of the depression era, lives fairly comfortably within the limits of her "fixed income". Mildred came to our class because one of our efforts is to minimize taxes throughout retirement and since she now has minimum distributions required, she wanted to learn everything she could about way to reduce his annual income tax bill.
Our conversation was fruitful in that we learned that she was replacing her windows at around $ 14,000. It was important to her because she plans to give her daughter home after she dies. Mildred doesn't like to owe money, so she called her chartered financial planner in Maryland and told her to liquidate enough money for her RMD and a little more so that she can pay the windows in cash. So, Bob, the financial advisor suggested that she liquidate and distribute about $ 26,000 from her IRA where they would withhold about 30% for taxes to the federal and state governments.
Now, that sounds like it doesn't matter, right? Well, my CFO training told me to try to mitigate the costs of doing business, especially as slippery as taxes. We have projected his taxes for next year by completing this transaction Mildred would be on the hook for more than $ 11,000. Tax laws have become quite complex, especially with regard to social security income. Any income from the IRA will be counted at 100% when you calculate "provisional income" or the portion of your benefit that will be taxable. So not only does the effective rate increase because you have received more income, but more of your social security income is taxed. There are three levels, 0%, 50% and 85% and once you reach these thresholds, your tax bill increases at a rate of 46%. By paying income from her IRA, she went from an effective tax rate of 14% to a rate above 20%.
My first thought was to split the payment to the windows business using this year's RMD and then again using next year's RMD. This would keep her effective tax rate closer to 14% than she would incur anyway. Mildred had two options, one was to use her home equity line of credit which she had at 4% and, as she detailed, the real cost to her would be closer to 3 % per year and consider that she would pay it back in less than 6 months it would only have cost her about $ 600 in interest. Her other option was of course to use the window company's interest-free financing which she could repay in a year. Either way, it would save him $ 6,000 in taxes.
But our story doesn't end there … during our conversation, we discovered that it gives a little to charity, about $ 13,000 a year. So we talked about a tax law called "Tax Increase Prevention Act" which allows people who need to distribute income from their qualified accounts to donate directly to their charity while being counted as their distribution minimum required. Mildred is required to distribute $ 11,000 this year, which would add to her income and at an effective tax rate of 14%, or approximately $ 1,500 in taxes, instead she can transfer $ 13,000 directly to his charity, satisfy his RMD and bring his full tax bill. from $ 5,000 to just over $ 1,100. In other words, by understanding the tax laws, Mildred is able to increase her "take home pay" from $ 3,200 to over $ 3,600. Who could not appreciate an increase of $ 400 per month, especially on a “fixed income”?
Now the last piece of the puzzle, his current portfolio. An allocation consisting of 75% equity mutual funds and 25% bond mutual funds. No matter how expensive mutual funds are or whether a 70-year-old fixed income person with minimal assets is so heavily affected in the stock market, let's talk about distribution. If we follow the RMD schedule, there will be a time each year when Mildred will have to sell its mutual funds in order to get its distribution. Now, the state of mind is to make sure that the whole portfolio brings in enough money to live on interest and capital appreciation. It's great in theory, but when you factor in the integrated fees of around 3%, the market should do a pretty good job of staying the course and we all know that the markets don't always go up (except of course the last 6 years, but I get lost). Historically, there is a bear market 3 out of 10 years and if Mildred lives another 30 years, she will have to sell her assets when they are in decline at least 10 times during her retirement. I have been helping individuals and businesses for over 20 years and nothing brings a wallet to its knees faster than having to withdraw money as the value of assets declines. Simple math tells us that if I start with $ 1000 and the market takes $ 100 and I have to withdraw $ 100, I have $ 800 left and if the market finds what it lost, I now own 880 $ and if we do this calculation again? In 4 years, it would be $ 750.
Our student therefore becomes a client when we discover that it would be in her interest to implement and manage two strategies. The foreground is called "Sequence of Returns" where essentially we cut Mildred's portfolio into 3 parts; short term (3 years), medium term (5 years) and long term (more than 5 years, built forever). Basic financial planning is fundamental: you never distribute assets from a volatile account. By placing 3 years of distribution in a non-volatile account (does not lose money), Mildred can be assured that the income will be there if necessary. The expected rate of return is something small, about 1 to 3%, but it is guaranteed and will never lose its capital. Its average allocation would carry a percentage of its assets with a minimum of 5 years but on average around 25% of its assets. This account would carry very minimal volatile assets which should collect between 4 and 7%, we use 6% as a reference. Long-term allocation can be committed to the market if necessary or can simply be placed in a guaranteed investment so that there is no loss of capital (why take the risk if you don't Don't have to?). In fact, we predicted that its standard deviation (amount of volatility) would decrease from its original level by 17% to 3.5% for its overall portfolio, while we increased its average rate of return by 3 , 58% to more than 10.5%. The second plan was to convert half of its Qualified Assets (IRAs) into tax-free savings investments. By implementing this tax conversion plan, Mildred is able to save at least $ 30,000 in taxes throughout her retirement and increase her assets by $ 143,000 at no cost to her.
Good financial planning involves being careful in your financial decisions and not just "staying the course" when markets go south, rebalancing when things get too good or diversifying your portfolio allocation to mitigate risks while capturing upside potential. This is about identifying the costs of doing business, the risks associated with financial decisions and the unknowns that can strip away any gains like a financial manager for your household.
If you want a hassle-free 10 minute private conversation about your tax situation or your wallet, send an email to firstname.lastname@example.org and we will work for you. Take the next step, it's time.