My Comments: This comes from the staff at Financial Planning, a well known magazine that appears monthly and is subscribed to by financial professionals. It contains valuable information for anyone soon to be retired or even already retired. These are summaries and if you want to read the full article, reach out to me and I’ll help.
Financial Planning Staff / SEP 17, 2014
Clients worried about longevity, unknown health care costs and a persistent low-yield environment are increasingly turning to their advisors for solutions. As they near retirement, many are eager to address their future cash-flow needs. Based on our reporting, here are some of the best ways advisors can help clients generate income in retirement.
Delaying Benefits to Avoid ‘Tax Torpedo’ on Social Security
Many people who need retirement income in their 60s claim Social Security then, supplementing those benefits with IRA withdrawals if necessary, according to Mark Lumia, CEO of True Wealth Group in Lady Lake, Fla.
A double tax on Social Security benefits and IRA withdrawals has been called the tax torpedo; to reverse the process, seniors can delay Social Security until age 70 while using IRA funds for spending money until then. The later a client starts Social Security the larger the benefit will be, so smaller IRA withdrawals can generate the total required for retirement income.
“The formula for determining the tax on Social Security benefits includes IRA distributions in full but only half of Social Security benefits,” says Lumia. Thus, increasing Social Security by waiting until age 70 and consequently reducing the desired IRA withdrawals can dramatically lower the tax on Social Security benefits.
Lumia calculates that a retired couple with $97,000 of income ($70,411 in Social Security after delaying benefits to age 70 plus $26,589 from their IRA) would owe $6,492 less in federal income tax than a retired couple with the same $97,000 income receiving $40,006 in Social Security benefits after starting early plus $56,994 in IRA distributions. Over an extended retirement, such tax savings can be substantial.
When It Pays to Recharacterize a Roth Conversion
Tax-free Roth IRA distributions can be a valued source of retirement income; withdrawals are completely untaxed after age 59-1/2, assuming the account is at least five years old. However, building up a Roth IRA recently hit a snag thanks to the Affordable Care Act. “For some clients, dealing with the Affordable Care Act (ACA) exchanges adds another dimension to Roth IRA conversions,” says Marty James, a CPA/PFS who heads an investment and tax management firm in Mooresville, Ind. “Lost health insurance tax credits can increase the effective cost of the conversion.”
A Roth IRA conversion creates more taxable income. Higher income, in turn, might cost certain clients health insurance discounts, adding sharply to the premiums they’ll have to pay. One possibility is recharacterizing the Roth IRA conversion back to a traditional IRA which will wipe out the associated increase in health insurance costs.
“We’ll also look at investing in an oil and gas program that provides first-year deductions, to offset some of the increased income,” says James. In any case, it’s likely that this couple will postpone or sharply reduce Roth IRA conversions until they reach age 65 and become eligible for Medicare.
Rethinking the 4% Rule
By now, most advisors have gotten the memo: the long-held conventional wisdom about 4% annual withdrawals from retirement accounts no longer reigns supreme in the face of longevity projections and predicted long-term stock market returns.
“I have got 25 years of experience” and “my average client is nearly 60 years old,” says Roger Kruse, who owns FFP Wealth Management, a Minneapolis-based firm. With that kind of time helping clients, many of whom who have lived out most of their retirement years, he has come to recognize that –and “this is incredibly obvious,” Kruse says, “People spend less money as they age.” Why? “You travel less, you drive less and your out-of-pocket spending decreases,” Kruse says.
Looking to Dividend Stocks
When trying to help clients generate income in retirement, advisors may want to shift their focus from domestic stocks.
“We believe that that the lion’s share of a client’s equity holdings should be in large, cash-rich multinational companies,” says Greg Sarian of the Sarian Group at HighTower Advisors, a wealth management firm in Wayne, Pa. “We are in the mature stage of the economic cycle, so large-cap stocks may have better prospects now than small- or mid-caps.”
The tax tail shouldn’t wag the investment dog, as the saying goes, and Sarian sees much more than low tax taxes to like about dividend-paying stocks these days. “Dividends are increasing at many companies,” he says, and that may continue to be the case.
Writing Covered Calls
Does implementing a covered call strategy make sense as a way to provide some income for retired clients?
“Absolutely,” says Nick Defenthaler, a planner at the Southfield, Mich.-based Center for Financial Planning, “But it’s important to point out that although writing covered calls for income is certainly one of the most conservative option strategies, it still contains risk. The premiums received are guaranteed upon writing the call but the underlying stock could plummet and lose substantial value during the contract period.”
Defenthaler favors writing calls on a stock that has appreciated in value and the client is willing to sell. “Why not write some options for additional income?” he asks. “If the stock gets called away, profit was still realized and income was also generated. The client, however, must be aware of and comfortable with the possibility of the underlying stock losing value during the option’s contract period.”
Partly because of continued growth in the U.S. economy coupled with the winding down of the Federal Reserve’s bond-buying program, the risks of continued low inflation are diminishing.
Widely followed Rick Kahler, president of the Kahler Financial Group in Rapid City, S.D., is telling clients it’s necessary to maintain exposure to asset classes that can outpace inflation in the long-term when interest rates rise –including equities.
“Retirement isn’t a time to pull back and load up on fixed-income investments and immediate annuities,” says Kahler. “Our clients’ investment portfolios need to recognize that inflation is built into our flat monetary system.”
Boosting Revenue With Real Estate Income?
Warning signs flash in most advisors’ eyes when retired clients enter their office with visions of creating extra income streams from real estate ventures.However, not all advisors feel that way.
Rich Arzaga, the founder and CEO of Cornerstone Wealth Management in San Ramon, Calif., embraces real estate investments for his retired clients.
“I think there is real opportunity to help these people out,” says Arzaga who teaches a course in real estate and financial planning at University of California, Santa Cruz. Other advisors say “no” to clients’ proposed real estate investments because the advisors “don’t know that asset class.” But, he says, “It’s a real disservice to clients.”
He does warn his retired clients to treat real estate investments, “like a business.” What does that mean? “Don’t fall in love with the property or the tenant,” he says.
Seeking Alternatives to Energy MLPs
For retirees, distributions from master limited partnerships have obvious appeal.
Thanks to rules set by Congress intending to attract long-term investors — rather than speculators — to pay for finding new sources of energy exploration and production, MLPs have the advantage that they don’t pay corporate income tax. As such, they act as “pass-through” entities, passing profits to investors in quarterly distributions.
But Judith McGee, who serves as chairwoman and chief executive of McGee Wealth Management, in Portland, Ore., an affiliate of Raymond James Financial Services, and other financial advisors dislike energy MLPs because of their illiquidity. “I’ve seen people really get stuck with these,” says McGee.
To have the investments perform at their highest rate of possible return and tax advantages, clients typically have to commit to keeping their stake in the MLPs for decades.
If her clients want a piece of the booming gas and oil discovery market, McGee prefers other energy investments, if those don’t pay the quarterly dividends. “There is a better way to play this. There are so many other options,” McGee says. She suggests some of the mutual funds that focus on natural gas pipeline investments or publicly traded energy companies. “Anytime one of my retired clients gets into something they can’t get out of quickly, I get worried,” she says.
Refining Bucket Strategies
If there’s a common denominator among bucket strategies in retirement planning, it’s the use of a sizable cash bucket. “We like to see retired clients with at least a year’s worth of needed funds in cash equivalents such as money market funds,” says Eric Meermann, client service manager with Palisades Hudson Financial Group in Scarsdale, N.Y.
Often, this mode of retirement planning groups a client’s other assets into fixed income and equity buckets. As the cash bucket is depleted, it might be replenished from the fixed income bucket, which in turn will be refilled from the equities bucket.
Other tactics could include using bond redemptions, interest income, stock dividends, or proceeds from capital losses to keep the cash bucket topped up. In any case, a bucket strategy for drawing down retirees’ investment assets needs a plan for refilling the cash bucket.
“In the drawdown phase, we use a client’s asset allocation to determine how to move money into cash,” says Meerman. “In 2008-2009,” he says, “when stocks fell sharply, our allocations became tilted towards fixed income. At that point, we wouldn’t use money from equities to restore a retiree’s cash position.” Instead, the firm rebalanced clients’ allocations, moving money from fixed income into equities, and retirees’ cash positions were refilled from fixed income rather than from equities.
And while clients’ asset allocations don’t typically vary as they go through retirement, there is still “some flexibility with these plans,” Meerman says. “If there’s a significant decline in a client’s wealth, perhaps in a bear market, we might suggest spending less, which would mean taking less from the portfolio.”