Rarity of Pension Plans Shifts Retirement Planning Burden

Proactive Steps to Increase Retirement Confidence – With or Without a Pension

Retirement used to be “easy.”

It was once commonplace to start and end a career with one company, collect a pension, and ride off into the proverbial sunset. When defined benefit plans were the status quo, the employer carried more of the burden than the employee.

With a shift in recent years from defined benefit plans to defined contribution plans, the onus is now on the employee and many Americans are unprepared to self-fund their retirement.

Less than a quarter of retirees today will collect a pension, yet the average American’s 401(k) balance at retirement age is currently only $200,000.

Employees now find themselves in search of education and practical strategies to enhance their retirement planning, and determining where to begin can prove challenging.

Defining Retirement Savings and Income Needs

The specific amount of savings that each household requires to retire comfortably varies greatly based on a myriad of factors including fixed expenses, debt, discretionary spending, Social Security and pension income, survivorship income, and tax liabilities.

Although the focus is often on the dollar amount that should be saved for retirement, the foundation for measuring the probability of success in retirement starts with quantifying desired retirement income.

Approximately 65% of Americans are unable to quantify how much they spend on a monthly basis, and less than 42% of Americans have ever calculated what they will need to live on in retirement. Defining a future budget can be challenging, particularly when there is no history of budgeting.

Although spending in retirement will likely look different than pre-retirement spending, it is often helpful to start with a good understanding of current spending habits and average annual expenses. Many individuals find themselves budgeting for the first time once they are already retired, and this can be a difficult transition for those who are accustomed to spending freely.

Once an income goal is determined, making a pre-retirement spending adjustment can ease the transition into retirement. For example, if the goal is to reduce total income needed by 30% in retirement, then an early adjustment to this standard of living is prudent to determine if this is a feasible goal.

Some expenses may actually increase in retirement, such as travel and various leisure items like golf and shopping. Establishing a specific, realistic annual budget for travel and leisure is an important aspect of determining the savings that should be accumulated prior to retirement.

Tax Planning

Investment tax designations also play an important role in efficiently defining retirement income needs. When income is distributed from a tax-deferred account such as an IRA or 401(k), tax withholding must be accounted for to avoid a savings shortfall. If the net investment income needed is $2,000 per month, an individual with a 20% effective income tax bracket must account for an additional $500 per month of distributions. With a 25-year retirement time horizon, this is an additional $150,000 of distributions that must be considered just to cover taxes.

Post-tax savings can play an important role in retirement income planning. When income can be distributed from non-taxable sources, such as a Roth IRA, less needs to be accumulated for retirement.

Taxes also must be assessed when projecting Social Security income. As much as 85% of Social Security income can be taxable, and even if retirement income does not meet the threshold for this level of taxation at the beginning of retirement, SS taxation can quickly become a factor when Required Minimum Distributions (RMDs) come into play.

Required Minimum Distributions

Currently, distributions from qualified accounts must begin by April 1 the year after turning 72. The first RMD is the only one that can be distributed the following income tax year, which means that waiting to initiate that first distribution will result in two RMDs being required in the same income tax year. Although some RMDs can be aggregated between retirement accounts, this is not the case for all account types, so caution should be exercised if distributions do not come directly from each retirement account.

The penalty for failing to take an RMD is currently 50%, and many retirees are forced to take taxable distributions that they do not need in order to avoid a penalty.

For those who are charitably inclined, there is a little-known tax loophole that may remedy this tax burden. The IRS currently allows qualified charitable distributions (QCDs) after age 70 ½, which allows funds to be transferred directly from a qualified retirement account to a qualified charity of choice. This satisfies the RMD (currently up to $100,000 per person, per calendar year) and no taxes have to be paid by the account owner in the process.

For those who are already making charitable donations, this strategy can allow the donor to keep more money in their pocket since pre-tax dollars are being utilized instead of post-tax dollars.

Maximizing Your Tax Bracket

There is a window of opportunity between retirement and RMDs that is often overlooked by retirees. While it is innate to pay as little in taxes as possible in any given year, this approach can be short-sighted if the objective is to construct a holistic retirement plan.

As Ben Franklin put it, only two things in life are certain: death and taxes. With qualified retirement plans, taxes are deferred into the future with the assumption that the tax bracket should be lower during the retirement years when the funds are distributed. This assumption will not hold true under all circumstances, and with the uncertainty of future income tax rates, the implementation of advanced tax planning strategies can provide control over the tax rates that will be paid in retirement.

Working with a CPA to determine how much margin there may be within an existing tax bracket can be one prudent strategy to control the income tax rate to be paid on distributions. If there is margin for additional income without a meaningful increase to the marginal income tax rate, then an annual Roth conversion may be one opportunity to consider. While a conversion triggers taxation in the year of the conversion, the Roth earnings and distributions are not taxable, and there are no RMDs currently required for Roths. This strategy can be beneficial for those who do not wish to take RMDs in future years, particularly if RMDs are slated to cause an increase in Social Security or other overall taxes.

Survivorship Income

A certain level of prudent assumptions must be made along with any retirement planning strategy, and the rationale behind the assumptions utilized is likely to vary from one household to the next. One of the most important sets of assumptions involves survivorship income planning. Both Social Security and Pension elections have survivorship implications, and there are many strategies that can be utilized to compensate for survivorship deficits.

Life insurance is not only designed for covering debts when the insured dies; income tax-free death benefits can also be a tool to help transition the surviving spouse and offset the reduction of Social Security and pension income sources. Since income tax brackets are unfavorable for single individuals, tax-free income can also be instrumental in alleviating taxes.

Rules, tax laws and guidelines change, and it may even feel as though the goalposts keep moving. The first steps are often the most difficult. Following a well-defined process for financial decision-making, building a team of tax and financial experts, and maintaining discipline can significantly improve retirement outlook – both financially and emotionally.

One of the most common questions related to retirement planning is when to start, and the answer is now. It is never too early to begin evaluating spending habits, savings habits, and diversification of investment tax strategies. It also isn’t too late, even for those who may be on the cusp of retirement or who are already retired. There may still be strategies to employ both now and in the future to maximize retirement efficiency and improve peace of mind.