Withdrawal Rates

At this point it is important that you understand both the concept and the importance of the withdrawal rate (sometimes referred to as the withdrawal factor) as it relates to your portfolio.

Your withdrawal rate is equal to the percentage of dollars you are taking from your portfolio on an annual basis. For example, if you have $1 million in your investment portfolio and you take out $50,000 in a given year, your withdrawal rate is 5 percent ($50,000 ÷ $1,000,000). If your withdrawal rate is too high, you run the risk of depleting your investment account. Based on our experience, an appropriate withdrawal rate scale is as follows:

• Conservative: 4 percent or less
• Moderate: 5 percent
• Aggressive: 6 percent or more

This scale is sometimes adjusted for age and health factors. For example, a 9 percent withdrawal rate might not be considered aggressive for someone who is 95 years old and in ill health. But for our purposes, we'll use the scale described above. How you determine the appropriate withdrawal rate for you will be based on your particular circumstances and risk tolerance.

Retirement Plans

The power of retirement plans is created through one or more of the following:

• Tax deductibility of contributions
• Tax-deferred growth
• Tax-free growth (Roth IRA)

If your employer provides a contributory retirement plan such as a 401(k) plan, funding it should be your first priority, especially if the employer provides a matching contribution. If you are self-employed, you should consider starting your own retirement plan. You have numerous options available to you, including the Simplified Employee Pension Plan (SEP), single-person 401(k), profit-sharing plan, Savings Incentive Match Plan for Employees (SIMPLE), or defined benefit plan, as well as a number of variations. If you have employees, they must be included in your plan. Which one is best for you will depend on your specific circumstances. You'll need the help of a professional adviser to assist you in setting up one of these plans to make certain you maximize the benefits to you and that you follow the complex plan regulations.

Roth IRAs also require special consideration. With a Roth IRA, you don't receive an income tax deduction for your contribution, but your withdrawals are tax free. Typically, a Roth IRA is the best choice if your income tax bracket is relatively low. Note that certain restrictions apply to tax-free withdrawals for Roth IRAs. Although contributions are not tax deductible, earnings are tax-deferred, and withdrawals are tax-free under the following circumstances:

• Withdrawals are made at least five years after the Roth IRA was established and you are at least age 59¹/₂.
• Withdrawals are made because of death or disability.
• Tax-free withdrawals of up to $10,000 are allowed to cover the expenses of purchasing your first home.

Don't forget that the spouse of an employee who participates in a company retirement plan is eligible to contribute to a Roth IRA or a traditional IRA even if that spouse has no earned income. The rules regarding the phase-out of deductibility of contributions are shown in Table 4.5.

Although you can contribute to both a traditional IRA and a Roth IRA, your total combined contribution cannot exceed $5,500 (plus an additional $1,000 if you are age 50 or older).

Although you can contribute to both a traditional IRA and a Roth IRA, your total combined contribution cannot exceed $5,000 (plus an additional $1,000 if you are age 50 or older).

If you are eligible for an IRA, you should invest in one. Are you better off with the deductible traditional IRA or the nondeductible Roth IRA? For many people, the Roth IRA will produce better results. However, it is not the hands-down winner. Again, you will need to do your homework or seek the aid of a financial adviser. Contributing to a Roth IRA is definitely better than contributing to a nondeductible traditional IRA, because neither contribution is deductible, but future distributions from the Roth IRA will be tax free if you follow the qualifying rules. Also, the Roth IRA is not subject to the required minimum distribution rules, which require that you to begin systematic withdrawals from retirement plans beginning after you turn age 70¹/₂.

Magnify the Power of Your Retirement Plan Tenfold

Receiving an immediate tax deduction and tax-deferred growth are two powerful reasons for using retirement plans in your investment program. Is there a way to magnify these results? Under certain circumstances, the answer is most definitely yes. The determining factor is who you designate as your beneficiary. For many reasons, your primary beneficiary should usually be your spouse. However, we often find that people either leave their contingent beneficiary blank or they name their estate. This can be a big mistake. Let's assume that you have named your spouse as your primary beneficiary and you leave your contingent beneficiary blank. If your wife dies before you do, your retirement plan assets will automatically go to your estate and be distributed according to the terms specified in your will. Let's assume your will leaves everything to your children. Because your estate is the beneficiary, the income taxes on your retirement plan assets must be paid by December 31 of the fifth year following the year of your death. In other words, the advantage of tax deferral ends five years after you die. We'll refer to this as Option 1. If, however, you had named your children as the contingent beneficiary, they would have the option to continue deferring the majority of the retirement plan assets over their own lifetime. This is Option 2. Under these circumstances, to receive the maximum tax benefit, the law requires that your children begin mandatory distributions prior to December 31 of the calendar year following the year of death. However, the mandatory distributions are based on their life expectancy. This results in a reduced mandatory (taxable) distribution, thus allowing for a substantial continuation of tax deferral. There are two very important points here that you and your beneficiaries should be aware of. First, Option 2 is by far the best income tax strategy for the beneficiaries since it will allow them to stretch the income taxes over their respective lifetimes. In order to qualify for Option 2, the beneficiaries must begin taking the mandatory distributions by the deadline. Second, if there is more than one beneficiary, they must elect to “separate” the inherited IRA in order to use their own life expectancy for the calculation of the mandatory distribution. If they fail to do this, the life expectancy of the oldest beneficiary will be used. This is clearly a disadvantage for younger beneficiaries. It is also important to note that if you do not name an individual or individuals as your beneficiary, Option 1 is the only option your heirs will have. Let's look at two examples.

For our first example, assume that you are age 45 and you are the named beneficiary under your father's IRA in the amount of $200,000. He dies and you elect to receive only the minimum required distributions. Based on IRS life expectancy tables, your life expectancy is 38.8 more years (see Appendix C for IRS Life Expectancy Table). By dividing 38.8 into $200,000 you determine that your mandatory withdrawal for the first year is $5,155 or about 2.6 percent. If you actually earned, say, 6 percent, this means that you were able to continue to defer all of your $200,000 plus a portion of your earnings. Note that you must recalculate your required minimum distribution each year since your life expectancy changes each year. Over 38.8 years (your life expectancy according to the IRS), the combination of your mandatory withdrawals plus the remaining portfolio value exceeds $1 million!

For our second example, let's assume your father uses this strategy, naming your 25-year-old son (instead of you) as the beneficiary. Your son's life expectancy is 58.2 years. Your father dies and your son now elects to take minimum distributions (first year = $3,436) while deferring any additional growth. If the account earns an average of 7 percent per year, the account value would have grown to almost $1 million by the time he reaches age 65. This is in addition to the $737,000 in mandatory distributions that he took out over that time period! This strategy allows you to leverage a modest retirement account into a million-dollar financial asset.

Personal Investment Accounts

By now you know that you should invest the maximum amount allowable into your retirement plan(s) before you invest any money personally for your retirement. The main advantage of a personal investment program is that you have access to your money without penalties if you should need it. Doing so may trigger income taxes, but for investments held for more than 12 months, you will be taxed at the more favorable long-term capital gains rate (for most taxpayers, taxed at 15 percent federal rate; for high income taxpayers, taxed at 20 percent). Dividends paid on stocks of public corporations are also typically taxed at a favorable federal tax rate of 15 percent (20 percent for taxpayers subject to the highest marginal tax rate). This more favorable tax treatment of corporate dividends provides an incentive for investors to invest in dividend-paying stocks.

Still, the primary disadvantage of investing personally is the imposition of current taxation. For equities, the use of dividend-paying stocks or holding appreciated securities for long-term capital gains tax treatment will help reduce your tax bite. For fixed-income investments, you can invest in municipal bonds. The interest income from these bonds is not subject to federal income taxes, including the 3.8 percent surtax on investment income, and in certain cases is not subject to state, city, or county taxes, either. However, you should use some caution here. We often find that people who have bought municipal securities are in a relatively low tax bracket. They would have been better off, after taxes, having bought taxable securities. Remember, it's the net jingle in your pocket that counts. The formula for comparing taxable versus tax-free investments is as follows:

For example, if you are in the 28 percent federal tax bracket and you want to compare a tax-free bond yielding 3.0 percent to a taxable bond of similar quality and maturity yielding 4.5 percent, your calculation would be as follows:

From this example, obviously the taxable bond yielding 4.5 percent is preferable. Go to the Resource Center at www.welchgroup.com; click on “Links,” then “Tax Equivalent Yield Converter” for a financial calculator that can help you compare the net return on municipal versus taxable bonds.

It should be noted that all tax-free bonds are not entirely tax-free. Certain types of municipal bonds are subject to the alternative minimum tax. The Internal Revenue Service rules require you to first calculate your income taxes the usual way and then recalculate them the alternate way, which includes the interest income from certain municipal bonds. If the alternate method creates a larger tax, then that is the tax you must pay. To avoid this potential problem you must either buy municipal bonds that are not subject to the alternative minimum tax or make certain that you will not be subject to the tax. Your tax adviser can help you determine the best course for you.

Tax-Deferred Investment Programs

Tax-deferred investment programs fall into two main categories: tax-deferred annuities and cash value life insurance. The obvious advantage to these programs is having your money grow without being subjected to current income taxes. However, the disadvantages are also significant. Let's start by looking at annuities. Annuities have four main disadvantages:

1. High expenses. Many annuities have relatively high expenses associated with their purchase. Annual expenses for annuities can exceed 2 percent. Portions of these premiums are used to cover mortality charges in the event you choose to have your account converted into a life income. Almost no one does, so this is a waste of money. Other expenses include commissions, policy fees, and a variety of other one-time and annual charges.
2. Potentially higher taxes on withdrawals. An annuity converts what may have been long-term capital gains, which are taxed at a maximum federal tax rate of 20 percent, into ordinary income, for which federal tax rates can be as high as 39.6 percent. For example, if you bought a stock index fund, held it for 20 years, and then took your money out, your gains could be taxed at a maximum federal rate of 20 percent assuming your modified adjusted gross income in 2014 is equal to or more than $406,750 if single or $457,600 if married filing jointly (15 percent for taxpayers below these thresholds). If, however, you bought a variable annuity and through the annuity invested in a similar stock index fund, when you take your money out 20 years later the gain will be subject to ordinary income tax rates. Table 4.6 illustrates in dollar terms the disadvantages of annuities outlined here. Even worse, when you begin withdrawing money from your annuity after age 59¹/₂, you will be taxed on a last-in, first-out basis unless you annuitize your payments. This means that you will pay ordinary income taxes on all distributions until you have withdrawn all of your profits. Once all profits have been withdrawn, all future withdrawals would be a return to cost basis and be tax free.
3. Limited investment choices. Another major disadvantage of annuities is limited investment choices. Many have two dozen or fewer choices. Some have many more, but that's still limiting compared to being able to choose among the entire universe of over 10,000 mutual funds. By way of analogy, let's assume that you and I each have $100 million to buy a baseball team (never mind that this amount wouldn't even buy us a minor league team!). There are 20 teams in the league, and I give you first choice. Once you choose your team, you are stuck with it for the season. Now it's my turn. But instead of choosing a team, I get to choose individual players! Which option would you rather have?
4. Potential tax penalties. The final disadvantage of annuities is that if you had to take your money out before age 59¹/₂, you would incur a 10 percent penalty in addition to ordinary income taxes. There are cases in which annuities make sense, but they are rare. If someone is trying to sell you one, consult your financial adviser (one who doesn't sell products!) before signing on the dotted line.

For retirees, annuities can provide a guaranteed income stream. You'll want to pay close attention to the credit quality of the insurance company you invest with since you'll be counting on them to make payments to you (and perhaps your spouse) as long as you live. Consider “spreading your risks” by investing with multiple insurance companies.

Life Insurance

Life insurance is a complex product and therefore is often confusing to the buying public. Let's see if we can demystify it a bit. All financial products, including life insurance, are a matter of mathematics. When you buy a cash value life insurance policy, your money (called premiums) goes to the insurance company. A portion of your premium is used to cover the risk of your dying prematurely. This is known as the mortality charge. You can think of it as the term insurance charge. Another portion goes to cover the insurance company's overhead, including agents' commissions. The remaining portion is invested by the insurance company for your benefit. The insurance companies have managed to secure some preferential tax treatment. First, the earnings in a cash value policy are tax-deferred until withdrawn. If you do withdraw part of your money, it is taxed on a first-in, first-out (FIFO) basis. This means that you pay no taxes until you have withdrawn all the money you contributed. If you never take your money out and die while the insurance is in force, your investment gains are never subject to income taxes. While dying is not our idea of a good investment strategy, we are always happy to avoid taxes.

As an investment, the disadvantages of cash value life insurance center around two issues: potentially high expenses and limited investment choices. Commissions and expenses can easily consume your first year's entire premium. Many contracts take 10 years or longer to break even (meaning your cash value is equal to what you've paid in premiums). Some policies are more competitive than this, but all contain high expenses when compared with direct investments into mutual funds, stocks, or bonds.

As with annuities, your investment options are extremely limited. We should add that cash value life insurance does have an important and appropriate place in estate planning, which we will discuss in Chapter 10. But if you are using it primarily as an investment vehicle, you can likely find better alternatives.

To summarize, if you have only a limited amount of money to invest, you will increase the power of your retirement investment program by prioritizing how those dollars are used. First, you want to invest through retirement plans to the maximum amount that the law allows before you invest any money in personal investment accounts. Additionally, you should consider your alternatives carefully before investing in tax-deferred vehicles such as annuities or cash value life insurance.