Planning for retirement

[rafapark]

Hello:
This is the first time I post in this forum so please be patient with me. I am no expert at all. This forum is helping me a great deal as well as all the books I’ve been reading. I have a question for the experts here. I will be retiring in the next 3 years. I have estimated that by the time I retire, I’ll need to withdraw about 2.1% of my investments to meet my needs ( Fire confirms this will work). Based on my calculations, a 70% bond/cash, 30 stock portfolio split would meet this need with a low level of risk. As per my estimates the tax sheltered portion of my portfolio would be 43% and the non sheltered one would be 57%. I know the rule about allocating your tax inefficient investments in sheltered accounts and the tax efficient stock investments in non sheltered accounts. But if you are retired and want to live off your dividends, wouldn’t the other way be better? I can hopefully get a 3.7% yield from my non sheltered account (to get the equivalent 2.1% of the total portfolio) by investing in bonds, REITs and dividend MFs and invest the sheltered account on stocks and other investments ( as appropiate to keep the above mentioned allocation) so they can grow tax deferred. In other words, live from dividends from the non sheltered investments without touching the principal as much as possible and let the sheltered portion grow untouched for as long as possible. It seems to me that in my situation, this would be the preferred approach. Any thoughts on this?

 

[GrayHare]

Welcome to the board. Bond interest is taxed at ordinary income rates, while qualified dividends from stocks are taxed at a lower rate. Thus even if you do not sell the bonds or stocks, your tax bill will be lower if you generally shift bonds into tax-favored accounts like an IRA.

 

[braumeister]

To expand a bit on GrayHare's comment, consider this:
Living on the dividends from the stocks in your taxable account will give you the lower tax rate for dividends, whereas if your dividend-paying stocks were in your sheltered account, you would have to pay ordinary income rates on the money you took from that account.

In other words, your current plan may be just fine for you, but look at all aspects of it from the viewpoint of someone already retired.

 

[rafapark]

yes but

Thank you for the responses . I understand what you are saying and I understand those basics. If you look at my numbers and my potential asset allocation of 70% bonds and 30% stocks, and taking into account that I will not be able to put all bonds in a sheltered account, if I want to live from dividends, my assumption is that I will need to get most of those dividends from bonds, not stocks. My preferrence will be to live from dividends coming from my non sheltered account and let the sheltered investments grow tax deferred until I have to take mandatory distributions. Therefore since stocks should be the growth portion of a portfolio, why would a retiree in my situation won't choose to have all stocks in the sheltered account for growth and live off the yield from bonds (even with the higher taxation and assuming that bonds provide a higher yield than stocks). Other than the tax consideration (really important of course), what am I missing?

 

[rafapark]

Also, is there a tool somewhere where I can include all my portfolio that shows me tax implications for different location scenarios (sheltered, non sheltered)?

 

[jIMOh]

Also, is there a tool somewhere where I can include all my portfolio that shows me tax implications for different location scenarios (sheltered, non sheltered)?

Try this
Flexible Retirement Planner

Been a while since I plugged numbers in, but I always liked that calculator.

I might suggest considering munis for the taxable portion of the bond portfolio to possibly lower your tax burden.

I might also suggest considering Roth conversions before age 70.5 to minimize required distributions. Only convert to top of current tax bracket each year, do not try to lump sum convert qualified accounts.

 

[rafapark]

thank you

yes. I am considering munis as well but since I will have a significant portion of my portfolio on a non sheltered account, I'd be forced to consider other tax inefficient investments for that as well.

Thank you for your suggestion for the Roth. I don't qualify for it now but I did not know you could do it when retired. I guess I need to study more

 

[jIMOh]

yes. I am considering munis as well but since I will have a significant portion of my portfolio on a non sheltered account, I'd be forced to consider other tax inefficient investments for that as well.

Thank you for your suggestion for the Roth. I don't qualify for it now but I did not know you could do it when retired. I guess I need to study more

I like this site for tax information

Reference Room

If you know a little about taxes, look on back of form 1040 and check your TAXABLE INCOME and compare it to the table for your filing status.

For example if line 43 (taxable income) is $66,000 and you are married filing jointly the 15% bracket caps at $70,700 (I used the reference room to get this information). This means you could convert $4,700 from traditional to a Roth that year without increasing your marginal bracket (whether working or retired this conversion is currently allowed at these levels).

Based on your comments in this thread, I am guessing your taxable income is much higher (now), so don't do any conversions until you might be in a lower tax bracket (like in retirement).

You need to be aware of 3 specific Roth rules

1) when you are eligible to CONTRIBUTE. This is based on AGI, and you have indicated you do not qualify right now. You need at least $5000 of EARNED INCOME to meet this criteria as well.

2) when you are eligible to CONVERT. This is based on AGI and changes each year. There is not any earned income requirement to convert that I am aware of.

3) When you are eligible for a distributions (withdraw). If you convert money, there is a 5 year rule you want to get familiar with. Depending on how the money was put into Roth (conversion vs distribution) the rules for taking it out will be different.

 

[GrayHare]

2) when you are eligible to CONVERT. This is based on AGI and changes each year. There is not any earned income requirement to convert that I am aware of.

AFAIK, currently everyone qualifies to convert their own Traditional IRA to a Roth. Are such conversions already scheduled to be prohibited/limited in a future year?

 

[jIMOh]

AFAIK, currently everyone qualifies to convert their own Traditional IRA to a Roth. Are such conversions already scheduled to be prohibited/limited in a future year?

It changes each year, around 2007 the AGI limit was 100k.

Just because the conversion is in the tax code for 2011 does not mean same provisions will be there in 2012. There is usually an AGI to limit who converts, in 2010 that limit was removed temporarily.

AFAIK there is no limit in 2011 for conversions, and the entire tax must be paid the year of the conversion.

In 2010 the conversion tax could be spread over 2010 and 2011.

The rules change each year. This is why "constant education" is important if you choose to DIY.

Another tidbit
Conversions are calendar year. Jan 1-Dec 31. A conversion made Jan 2 2012 shows up on the tax return you file in 2013 for example. If you convert too much, you can undo the conversion between Jan 1 and April 15 and have it effect the prior year's tax return. I speak from experience on this, twice.

 

[rafapark]

Great input

I guess that is the biggest use of a financial or tax advisor. Not so much for asset allocation but for providing specific tax and money location as per the example above. I am sure the debate about using or not using a financial advisor has been done before in this forum. I personally believe I can do the asset allocation part properly w/o a financial advisor or using a low fee one like the services than vanguard offers ( once I retire and can transfer all my 401K and other retirement plans to vanguard to qualify for a low fee), but I am concerned about missing on the ideal asset location for best tax advantages. Any thoughts on this?

 

[teejayevans]

There is no AGI limit on traditional IRA conversions to Roth, anybody can do it, however,
the IRS treats all IRAs as 1, so if you use nondeductable IRA -> Roth trick, you can't have any deductable IRAs. This was part of the Bush tax cuts...
TJ

 

[jIMOh]

I guess that is the biggest use of a financial or tax advisor. Not so much for asset allocation but for providing specific tax and money location as per the example above. I am sure the debate about using or not using a financial advisor has been done before in this forum. I personally believe I can do the asset allocation part properly w/o a financial advisor or using a low fee one like the services than vanguard offers ( once I retire and can transfer all my 401K and other retirement plans to vanguard to qualify for a low fee), but I am concerned about missing on the ideal asset location for best tax advantages. Any thoughts on this?

My point was more that you need to stay on top of things. If you read the Roth conversion rules in 2007, then tried to do a conversion in 2011, you would come across tax law changes. Same thing now- if you read up on the rules for 2011, then try to do it on Jan 2 2012, you might come across tax law changes you were not aware of.

Make sure as you make decisions you have enough context to know why you made them... very few financial decisions are "one and done". If you choose to allocation 30% stocks and 70% bonds, with 30% stocks and 25% munis in a taxable account, then put 45% bonds in a traditional IRA and start converting that to a Roth in 2011, that conversion might take you 5-10 years to complete (while converting between $5000-$50,000 per year to minimize tax bill). By the time you are all converted, you might decide you want all the stocks in the Roth (highest growth asset=tax free) and more bonds in the taxable account (because you are living off that income).

If you have a Roth, there is some wisdom to suggest you want the asset which will grow the most inside the Roth (small cap stocks, large cap stocks) and you want the low growth assets (cash, bonds) in other account types.

There is also a school of thought which suggests that if you sell stocks in a taxable account and buy them in a Roth, then sell bonds in the Roth and buy them in a taxable account, that the transactions "wash" out because the allocation did not change.

Most of managing money is making sure you connect all the dots right... there is an asset allocation dot, an expenses dot, a withdraw rate dot, a tax planning dot etc... the goal is to connect the dots in the right order, knowing how the decision at one point affects the other decisions which come after it.