Category: Physician Retirement Planning

A bear market is defined as a prolonged decline in the stock market and generally refers to a 20% fall in stock market value. A bear market is a great opportunity to rebalance your retirement portfolio in order to give you the highest returns when you ultimately retire.

 

Last month, I outlined why a bear market is the perfect time to convert a traditional IRA into a Roth IRA in order to reduce the total amount of investment taxes you pay over your lifetime. Although a bear market Roth IRA conversion will reduce your taxes, it will not improve your overall investment returns when you eventually take the money out in retirement. But rebalancing your investments during a bear market can improve those long-term retirement portfolio returns.

What is rebalancing?

Traditional investment wisdom calls for the wise investor to “buy low and sell high”. In the short-term, it is nearly impossible for any investor to know whether the value of an investment is going to go up or going to go down. However, in the long-term, the value of broad stock and bond indices always goes up. When a broad stock market index falls into bear market territory, then you know that you have an opportunity to ‘buy low’.

My own investment philosophy has been to buy some shares of a stock index fund whenever the S&P 500 index drops in value by 10%. When the S&P 500 drops by 20%, I buy as much as I can. When the stock market drops that much, I consider stocks to be on sale. This strategy has served me very well over the past 30 years. There are two ways to buy stocks – either purchase them using your cash savings or purchase them by exchanging shares of bond investments for shares of stock. If buying stocks with cash savings, don’t forget to always keep enough in cash reserves to cover 3-6 months of expenses. In other words, don’t sacrifice your emergency fund to take advantage of a bear market.

If you do not have enough cash savings to buy stocks, then you can still exchange bonds for stocks and that is where rebalancing comes in. Rebalancing means maintaining a constant stock:bond ratio in your portfolio. For example, if you had previously been maintaining a retirement portfolio of 70% stocks and 30% bonds and then the value of the stock component increases during a bull market, then your portfolio could end up being 75% stocks and 25% bonds. In this case, you would want to exchange some of your shares of stocks for shares of bonds so that you can restore your desired 70/30 stock:bond ratio.

Why rebalance now?

In the past six months the value of both stocks and bonds has fallen and we have now entered a bear market. However, stocks have fallen much more than bonds and as a result, many investors are now finding that the relative percentage of bonds in their overall retirement portfolio has increased and the percentage of stocks has decreased. Let’s use the Vanguard Total Stock Market Index Fund as a measure of overall stock market performance and the Vanguard Total Bond Fund as a measure of overall bond market performance:

Since the beginning of 2022, the Vanguard Total Stock Market Index Fund has fallen in value from $118.25 per share to $89.48 per share, a 24.3% reduction. During that same time period, the Vanguard Total Bond Fund has dropped from $11.10 per share to $9.80 per share, an 11.7% reduction. In other words, stocks have fallen in value more than bonds.

If the stock:bond ratio in your retirement portfolio was 70/30 on January 1, 2022, it has now fallen to 66.7/33.3. In order to rebalance and restore your portfolio to the desired 70/30 ratio, you need to exchange some of your bond investments for stock investments. Once you do the math, this means that if your total retirement portfolio is worth $100,000, you should convert $3,335 of your bond investments into stocks. If your portfolio is worth $500,000, you should convert $16,675 of bonds into stocks. And if your portfolio is worth $1,000,000, you should convert $33,350 of bonds into stocks. Investors who should exchange the most from their bond funds into stock funds are those who originally had a 50/50 stock:bond mix in January as shown in the table below:

From this table, it is clear that the current bear market has left all portfolios out of balance and just about everyone’s retirement portfolio is now too heavy in bonds. So, we should all be converting some of our bond investments into stock investments right now. How much to convert depends on what your desired stock:bond ratio is.

How long do bear markets last?

One of the problems with entering a bear market is that you cannot predict how much further the price of stocks will fall before they bottom out. The price of stocks could start to increase tomorrow or maybe not until 2024. No one has a crystal ball that can see into the future and anticipate all of the thousands of variables that affect the price of stocks. However, we can look back to history to see how other bear markets have behaved. Since 1950, there have been eleven other bear markets that have lasted anywhere from 1 month to 2.6 years. The time that it takes for full recovery from a bear market has taken anywhere from 3 months to 5.75 years.

Given the uncertainty regarding the duration of our current bear market, one tactic could be to incrementally rebalance your retirement portfolio over the next several months. That way, if the value of the stock market continues to fall, you can take advantage of lower stock prices.

Know your investment time horizon

Investment pundits often talk about the investment time horizon in terms of the number of years until retirement. I believe that a better investment time horizon is the number of years until death. No one withdraws all of their retirement investments on the day that they retire – those investments have to keep earning returns for your entire remaining life. Obviously, you can choose your retirement date but you can’t choose your death date. But if you believe that there is a reasonable chance that you will live to be 95 years old, then you have a longer investment horizon than if you do not believe that you will live past age 70. It is that investment horizon that should dictate your retirement portfolio’s stock:bond ratio.

The decision about whether or not to rebalance your stock:bond ratio should not depend on your investment horizon. It is just as important to rebalance if you are 80 years old as it is if you are 30 years old. Those investors with a short time horizon should have a relatively higher percentage of their retirement portfolio in bonds than investors with a long time horizon. This insulates the short horizon investor from the worst effects of bear markets. Although short horizon investors’ portfolios have dropped in value, their portfolios have not fallen as far as portfolios of investors with a long investment horizon (who have a high percentage of their portfolios in stocks). This is illustrated in the table below, again using the Vanguard Total Stock Market Index Fund as a measure of stock performance and the Vanguard Total Bond Fund as a measure of bond performance:

A retirement portfolio that was valued at $100,000 on January 1, 2022 would now be worth $769 if the investor had a 90/10 stock:bond ratio whereas it would be be worth $870 if the investor had a 10/90 stock:bond ratio.

What is the best stock:bond ratio?

In a previous post, I discussed the factors that should determine what the ideal stock:bond ratio should be for any given investor. The most important determinate is your investment horizon which is generally tied to your age.

However, age alone should not be the only determinant of your retirement portfolio’s stock:bond ratio. Equally important is your personal degree of investment risk. Investors who should adopt a low risk portfolio include those who get anxious about market volatility, are pessimistic about the future economy, lack a pension, anticipate a short life expectancy, and have annual living expenses that are close to their annual retirement income. On the other hand, investors who can adopt a high risk portfolio include those who do not get anxious about market volatility, are optimistic about the future economy, have a pension, expect to live to an older age, and have annual retirement income that substantially exceeds their annual living expenses.

Those investors who adopt a low risk portfolio are those who need the relative safety of bonds in the event of a protracted bear market whereas those who adopt a high risk portfolio are those who can afford to ride out a long bear market without fear of running out of money later in retirement. It is important to note that an investor’s personal degree of investment risk should not affect the decision about whether to rebalance their portfolio. Every wise investor should rebalance in a bear market. One’s willingness to take investment risk should only affect their desired stock:bond ratio.

The stock:bond ratio is an oversimplification of most retirement portfolios. A healthy portfolio should consist of U.S. stocks, U.S. bonds, foreign stocks, foreign bonds, and real estate. Some investors may also include commodities, gold, collectibles, etc. No matter what your retirement portfolio is composed of, you should always know what the ideal percentage of your portfolio should be in each type of holding, based on your age and personal investment risk. You should then periodically rebalance those holdings in order to ensure that the percentage of each component stays constant.

Bears are scary animals and bear markets are scary financial times. Although it is easy to be frightened when you look at your finances right now, the current bear market should be viewed as an opportunity to increase long-term returns from your retirement investment portfolio.

June 21, 2022

Whenever you hear the words ‘bear market’, you should be thinking the words ‘Roth conversion’. The U.S. stock market is currently down more than 15% compared to its all-time high on December 27, 2021. A falling stock market is the best time to do a Roth conversion. Therefore, now is the best time to do a Roth conversion.

 

There are two situations when it is to your advantage to convert a traditional IRA into a Roth IRA: (1) when your income tax rate is low and (2) when the value of your traditional IRA falls. We are currently in a time when both federal income taxes are low compared to the past and the value of stocks and bonds has fallen. When you convert a traditional IRA into a Roth IRA, you will pay federal and state income tax on the value of the IRA at the time of the conversion. Therefore, if the value of the traditional IRA is low, you will pay less in income taxes when you do the conversion. History teaches us that when the stock market falls, it eventually goes back up. After you do the Roth conversion, the value of that Roth investment will eventually go back up and when it does, you will not have to pay any income taxes on it!

Let’s say that on December 27, 2021, you had $50,000 invested in an S&P 500 index mutual fund in a traditional IRA and you decided to convert it into a Roth. And let’s further say that your federal income tax rate is 15%. You would have to pay $7,500 in federal income tax when you did the conversion. But if you did that conversion last week, when the S&P 500 index had fallen to 3,901, the $50,000 in your traditional IRA was now worth $40,926 and you would have paid $6,139 in federal income tax – a savings of $1,361!

But what if I don’t have a traditional IRA?

There are 3 ways to put money into a traditional IRA. First, you can contribute pre-tax income directly into a traditional IRA but only if you have an income of less than $78,000 per year ($129,000 if married, filing jointly). In this situation, the traditional IRA is very similar to a 401(k) or 403(b).

Second, you can contribute post-tax income into a traditional IRA if your income is above $78,000 per year ($129,000 if married, filing jointly). Under either of these two situations, the annual contribution limit to a traditional IRA is $6,000 per year (or $7,000 per year if you are over age 50 years old). This is a great strategy for doing an annual ‘backdoor’ Roth but it is generally not a good strategy to put post-tax dollars into a traditional IRA and then leave it there. The reason is that you will pay regular income tax on the accrued value of the traditional IRA but would have paid the lower capital gains tax on the accrued value had you put that money in a regular investment.

The third way of putting money into a traditional IRA is to do a rollover from an employer-sponsored retirement plan. These plans include the 401(a), 401(k), 403(b), and 457 retirement plans. There is not a limit to the amount that you can rollover each year. There are several important rollover rules, however:

1. You can only do 1 rollover per year. When you do a rollover, you have to wait 12 months before you can do another rollover.
2. You must deposit the rollover money into the traditional IRA within 60 days of withdrawing it from the employer-sponsored retirement plan. The safest way to do the rollover is to do a “trustee-to-trustee” rollover meaning that the investment company that holds your traditional IRA arranges for the money to be directly transferred from the employer-sponsored retirement plan into the traditional IRA without touching your hands. If, instead, you have the employer sponsored retirement plan send you a check, then it is up to you to ensure that you deposit that money into the traditional IRA within 60 days.
3. You can only do a rollover if either the employer discontinues the retirement plan or you are no longer employed by that employer. The latter most commonly occurs when you change jobs to a new employer or you retire.

Traditional IRAs give you more investment choices than employer-sponsored retirement plans. Also, you can often find similar investments with lower annual expenses that you can include in your traditional IRA. When you leave your employer for a new job, you have the option of either rolling your old employer’s 401(k)/403(b)/457 into your new employer’s 401(k)/403(b)/457 or rolling the funds into your traditional IRA. I would argue that it is better to do the rollover into your traditional IRA because of the prospect of lower expenses, the wider choices of investments, AND the opportunity to do Roth IRA conversions during bear markets.

It is easiest if you have your traditional IRA with the same investment company that you have your Roth IRA. If you have your Roth IRA with Vanguard, then also have a traditional IRA with Vanguard. If your Roth IRA is with Fidelity, then have a traditional IRA with Fidelity. Using a large investment company for both makes it very simple to move money from the traditional IRA into the Roth IRA when doing a conversion. Large investment companies (like Vanguard or Fidelity) will also work with you to facilitate trustee-to-trustee rollovers from your employer-sponsored retirement plan, even if that plan is with another investment company. On-line accounts allow you to do your rollovers and conversions from your own home on your own time, without having to drive someplace to meet with an investment advisor.

Beware of the 5-year rule

When you put money into a Roth IRA, that money grows tax-free and you do not have to pay any tax on withdrawals when you take the money out in retirement. That means no income tax, no capital gains tax, no interest tax, and no dividend tax. Furthermore, unlike other deferred income accounts (such as a traditional IRA, 401(l), 403(b), or 457), there are no annual required minimum distributions from the Roth IRA after you turn age 72.

However, it is important to be aware that you cannot withdraw money that you put into a Roth IRA for 5 years. In other words, if you convert $10,000 from a traditional IRA into a Roth IRA today, you cannot withdraw that money from your Roth IRA account until 2027.

Because of the 5-year rule, you should consider any Roth conversion to be a long-term investment. In other words, don’t put the newly converted money into a low rate of return investment such as a money market account or certificate of deposit within the Roth account. Money from Roth conversions should ideally be put into a broad stock market index fund in the Roth account. In the past 30 years, there have only been 2 times that the S&P 500 index took more than 1-year to recover from a downturn: in 2000 (7 years to recover) and 2007 (6 years to recover). In both of these prolonged downturns, if you had waited to do a Roth conversion until the S&P 500 index had fallen by 15% of its peak, you would have only had 3 1/2 years to recover after the 2000 downturn and only had 2 1/2 years to recover after the 2007 downturn. In both cases, your Roth fund would have fully recovered and then increased in value by the time the 5-years was past.

How should I time my Roth conversion during a bear market?

One of the simultaneously wonderful and maddening things about the stock market is that no one can predict when it is going to go up and when it is going to go down. In a bear market, when stock prices are falling, the only way to know for sure when prices have bottomed out is in retrospect, after prices have started to rise again. Rather than trying to guess when stock prices have hit their lowest and then doing your Roth IRA conversion, it is safer to spread your conversion out and do multiple small conversions every month or two.

A bear market is usually defined as a 20% drop in the prices of stocks. But for the purposes of Roth conversions, I don’t think you need to wait for the S&P 500 index to fall by 20%. Instead, think of a ‘big bear’ market as a 20% drop in value and a ‘little bear’ market as a 15% drop in value. Begin doing small Roth conversions when the broad stock indices fall to the level of a ‘little bear’ market, you can continue regular small conversions until the indices rise back up and out of the ‘little bear’ market values for those indices.

Unlike a rollover from an employer-sponsored retirement plan into a traditional IRA that can only be done once per year, you can do many Roth conversions per year. There is no limit to the number of traditional IRA to Roth IRA conversions you do each year nor is there a limit to the amount that you can convert. However, it is important to remember that the money that you convert from a traditional IRA into a Roth IRA is taxable income by IRS definitions. Therefore, the money that you convert will not only be subject to federal income tax but it will also add to your total taxable income for that year. As your annual taxable income goes up, your effective income tax rate will also go up. At some point, the amount that you convert will result in a large enough increase in your federal income tax rate to outweigh the advantages of doing a bear market Roth conversion.

Which investments should I convert?

If you have been a prudent investor, then you will have a diversified retirement investment portfolio. Your deferred income accounts may include your 401(k), 401(a), 403(b), 457, 415(m), and traditional IRA accounts. Within these deferred income accounts, you should have a mix of U.S. stock mutual funds, foreign stock mutual funds, U.S. bonds, foreign bonds, real estate investment trusts, and cash. The best individual investments to convert are those that have lost the most value in a bear market. Because bonds are less volatile than stocks, the value of stock mutual funds will generally fall more than the value of bond mutual funds and thus it is generally not a good idea to convert bond funds. It is almost never a good idea to convert cash (including money market accounts and certificates of deposits) since there will be no (or very little) tax advantages to convert these accounts in a bear market.

Look at your deferred income portfolio and identify those investments that have lost the most value and convert those investments from your traditional IRA into your Roth IRA. For example, if your Emerging Markets Stock Index Fund is currently down 23% and your U.S. Total Stock Index Fund is down 16%, then convert the Emerging Markets Stock Index Fund. In order to maintain your portfolio diversification balance, put the converted money into a new Emerging Markets Stock Index Fund in your Roth IRA.

It is wise to regularly replenish your traditional IRA by doing rollovers from your employer-sponsored retirement plans (assuming you are eligible to do rollovers, as discussed above). Since you can only do one rollover per year, you will want to do a sizable enough rollover to allow you to maximize any Roth IRA conversions that you might do later that year. Ideally, you should start each year with enough money in your traditional IRA to fund bear market Roth IRA conversions later in the year since no one can predict when a bear market will occur. You want to be prepared so that you can take advantage of those bear markets to do your Roth conversions. As an example, on January 3, 2022 when the NASDAQ composite index closed at 15,832, investors did not anticipate that the NASDAQ would fall by 29% to 11,264 less than five months later on May 24, 2022.

It’s all about investment strategy

 

Your retirement investment goals are to have enough money to do the things you want to do when you are retired, to ensure that you do not outlive your retirement savings, and to pay as little in taxes as legally possible. A strategy of periodic rollovers from employer-sponsored retirement plans into a traditional IRA and conversions of the traditional IRA into a Roth IRA during bear markets can help you meet all three of these retirement investment goals.

May 27, 2022

Recently, a physician asked me whether it is better to put retirement savings in a regular 403(b) or a Roth 403(b). My answer was… do both. The strongest retirement portfolios are diversified portfolios that allow you to strategically withdraw from different retirement “buckets” in different years in order to keep taxes as low as possible. This means having both Roth and non-Roth deferred income accounts.

What is a Roth 403(b)?

A regular 403(b) is a deferred income retirement account that you pay local income tax, Medicare tax, and Social Security tax the year that you earn the money but you do not pay federal income tax or state income tax until the year that you take the money out in retirement. With a Roth 403(b), you pay federal and state income tax the year you earn the money and then you pay no income taxes the year that you take the money out in retirement. In other words, with a Roth 403(b), you pay income taxes now and with a regular 403(b), you pay income taxes later, when you are retired.

The 403(b) is a deferred income savings program used by non-profit organizations. Similar deferred income retirement savings programs include the 401(k) which is used by for-profit companies, the 457 which is used by government institutions, and the IRA which is used by anyone with a taxable income. Each of these deferred income programs can be offered as either a regular 401(k)/403(b)/457 or as a Roth 401(k)/403(b)/457. Some employers will offer both a Roth and regular option and other employers will only offer a regular 401(k)/403(b)/457.

This post will address what you should do if your employer offers both a regular 401(k)/403(b)/457 and a Roth 401(k)/403(b)/457 as well as the factors that affect your choice of one versus the other. Although I will be discussing the Roth 403(b), the information is also applicable to the Roth 401(k) and Roth 457.

What is the difference between a Roth IRA and a Roth 403(b)?

Most people are familiar with the Roth IRA and as I’ve posted before, I think everyone should have a Roth IRA as part of a diversified retirement portfolio. If your income is too high to contribute directly to a Roth IRA, then you can do a “backdoor Roth IRA” by first contributing post-tax dollars into a traditional IRA and then promptly converting that traditional IRA into a Roth IRA.  The Roth IRA and the Roth 403(b) are similar in that with both, you pay income taxes now and then the distributions are tax-are in retirement. However, there are some important differences between them:

• Contribution limits. In 2022, the contribution limit for a Roth IRA is $6,000 ($7,000 if over age 50). The contribution limit for a Roth 403(b) is $20,500 ($27,000 if over age 50).
• Investment options. With a Roth 403(b) account, you can only put money in specific investment options chosen by your employer. These are typically mutual funds or annuities offered by 403(b) administrators such as TIAA or Fidelity. With a Roth IRA, you can put the money in a much wider variety of investments, chosen by you.
• Employer matching. Some employers will match a portion of your contributions to a 403(b). This is more common with 401(k)s than 403(b)s and rarely if ever found with 457s. These matching contributions are free money that you should never turn down. There is no matching contribution options to a Roth IRA.
• Early retirement. If you retire before age 59 1/2, you cannot take money out of your Roth IRA without incurring a large tax penalty. However, you can withdraw money from a Roth 403(b) before age 59 1/2 without a penalty if you separated from your employer before age 55.
• Required minimum distributions. The IRS requires you to take a minimum amount out of Roth 403(b) accounts starting at age 72 years old.  Roth 401(k) and Roth 457 accounts are also subject to these required minimum distributions. Unlike Roth 403(b)s, Roth IRAs are not subject to required minimum distributions.

It’s all about tax rates

The main determinate of whether to contribute to a regular 403(b) or a Roth 403(b) is whether your income tax rate will be higher or lower when you are retired than your income tax rate today.

If your taxes are higher today than they will be in retirement, then you should contribute to a regular 403(b). If your taxes are lower today than they will be in retirement, then you should contribute to a Roth 403(b). If your taxes are the same today as they will be in retirement, then there is no difference between contributing to a regular 403(b) or a Roth 403(b). The problem is knowing if your taxes today will be higher or lower than your taxes in retirement. There are three factors that will influence this.

1. Tax brackets. In a previous post, I showed how everyone pays an effective federal income tax rate that is less than the income tax bracket that they are in. However, the federal income tax brackets do determine your effective income tax rates. Congress changes the tax brackets and therefore the effective tax rates every few years and it is impossible to predict what those tax brackets will be in your retirement years. Currently, Americans have been enjoying relatively low federal income taxes since the 2017 tax cuts making this a good time to contribute to Roth accounts. However, these tax cuts are set to expire in 2025 and then federal income tax rates will rise back up to 2016 levels (unless congress passes new legislation otherwise) at which time it will be more advantageous to contribute to a regular 403(b). Tax rates will also fluctuate during your retirement years so that there will be some years in retirement that your tax rates will be higher (favoring taking distributions from a Roth 403(b) and some years that your tax rates will be lower (favoring taking distributions from a regular 403(b).
2. Income level. Most people start off their career with lower incomes and their income gradually increases as they get promotions and greater experience on the job. As income goes up, tax rates also go ups. Therefore, it is generally favorable to contribute to a Roth 403(b) early in your career, when your tax rates are lower. It is generally favorable to contribute to a regular 403(b) later in your career, when your tax rates are higher. In addition, there will be some years during your career that your income will be lower for a variety of reasons: going part-time, being laid off, not getting an annual bonus, etc. In these years, it is more favorable to contribute to a Roth 403(b).
3. Retirement spending. The amount of money that you withdraw from your retirement savings will vary from year to year, depending on your spending. On retirement years that you do a lot of traveling, buy a vacation home, or buy a new car, you will need to take larger distributions from your retirement accounts. These larger distributions mean a higher income in those years and with higher income comes a higher income tax rate. Therefore, in those retirement years that you have a lot of expenses, it is better to take distributions from a Roth 403(b) and in retirement years that you have fewer expenses, it is better to take distributions from a regular 403(b).

Summarizing these factors, we can see that there are times during your career that contributing to a Roth 403(b) is more favorable than contributing to a regular 403(b). Similarly, there are years in your retirement when withdrawing distributions from a Roth 403(b) is more favorable than withdrawing distributions from a regular 403(b):

You should have BOTH a regular 403(b) and a Roth 403(b)

If you have access to a Roth 403(b) (or a Roth 401(k) or a Roth 457), then you should contribute to it in years when congressionally-determined tax rates are low and in years when you have a lower income (such as early in your career). You should contribute to a regular 403(b) in years that income tax rates are high and in years when you have a high income (such as late in your career). This will result in you having both a regular 403(b) and a Roth 403(b) so that when you are retired, you can withdraw distributions from one or the other, depending on whichever is more favorable from a tax standpoint on any given year.

The result of paying less in taxes is that you have more in disposable income. In order to maximize that disposable income in both your working years and your retirement years you need a diversified retirement portfolio. This allows for a tax-advantaged withdrawal strategy of withdrawing from regular deferred income accounts some years and Roth deferred income accounts other years. Thoughtful retirement saving today will pay off in a healthy finances when you use those savings once retired.

March 31, 2022

 

There are a lot of suggested ways to calculate the amount of money you need to have in retirement savings in order to comfortably retire. The problem with most of them is that they are overly simplistic and do not take into account the nuances that each of our individual circumstances bring. Rules such as you need “10 times your annual salary” or “25 times your annual spending” can result in either underfunding your retirement portfolio or overfunding your retirement portfolio. The result of the former is that you will outlive your retirement savings, the result of the latter is that you will be funding a million dollar funeral. I have created an Excel spreadsheet that allows you to calculate the amount you need to save for retirement each year in order to maintain your current disposable income. You can download the spreadsheet with it pre-filled with an example using the average income for a general internist by clicking here:

Retirement Savings Calculator Example 1

Instructions on how to enter data into the spreadsheet can be downloaded by clicking here to download the Word document:

Retirement Savings Calculator Instructions

This blog post will explain the background for this calculator. Because life is complex, calculating your retirement needs are complex, so reading this post may seem overwhelming. However, this calculator takes most of the complexity into consideration to allow you to arrive at a reasonably accurate number with relatively little effort. I encourage you to download the Excel spreadsheet and play around with the numbers based on your own particular financial circumstances.

Building your retirement portfolio

There are two ways you can increase the amount of money in your retirement portfolio: (1) save more money each year or (2) work more years. Followers of the FIRE movement (Financial Independence Retire Early) will tell you to put more money away early in your career so that you can retire as soon as possible. There are two problems with this approach. First, excessively increasing your retirement savings in your youth reduces your disposable income and forces you to live austerely when you are young thus sacrificing quality of life. Second, the FIRE approach assumes that working is unpleasant and something to stop doing as soon as possible. My own opinion is that if that is the case, then you made a wrong career decision and have an unrewarding job that you are not passionate about.

The second way to increase your retirement portfolio is to work past the age that you planned on retiring. This may be totally acceptable if you are continuing to work because your job is fulfilling and you would rather be engaged in your career than be retired. On the other hand, working past your planned retirement age simply because you cannot afford to retire can result in you working in a career that you are not passionate about and missing out on doing the things you dreamed of doing in retirement when you are still healthy enough to do those things.

Thus, the goal of retirement saving is not to be rich monetarily, but to ensure that you can have a rich life, both while you are working and in retirement. In this post, you will learn how to calculate the amount you will need to save each year while you are working in order to meet your financial needs in retirement and ensure that you do not run out of money as you get older.

First, determine your current disposable income

Your disposable income is your annual income after you have paid all of your taxes and after you have paid expenses that you will have in your working years but not in your retirement years. Your taxes will include federal income tax, state income tax, local income tax, and FICA tax (composed of Medicare plus Social Security tax). The easiest way to get these values is from last year’s W-2 forms and IRS 1040 forms. You can also calculate these by using an online calculator such as the SmartAsset calculator and entering your total salary, filing status, number of dependents, geographic location, and deferred income contributions to calculate all of your various taxes.

Expenses that you will have during working years include retirement savings, mortgage payments, children’s college savings, and life insurance. Hopefully, once you are retired, your house will be paid off and your children out of college. As I have written in previous posts, I am not in favor of buying whole life insurance and instead, prefer buying term life insurance but only during the term of years that others depend on your income – once you are retired and drawing from your retirement accounts, you no longer need to purchase life insurance.

The amount of money left over after subtracting taxes and working year expenses is your annual disposable income. This is the money that you use to pay for food, housing upkeep, travel, clothes, entertainment, utilities, property taxes, healthcare, etc. These are purchases and expenses that you will have in both your working years as well as your retirement years. A major goal of retirement savings is to ensure that you have sufficient money to cover at least this same amount of disposable income once retired.

The amount of your current disposable income will need to be adjusted for inflation in order to calculate the amount of disposable income you will need when retired. Although it is impossible to predict exactly what the future inflation rates will be each year between now and your retirement, historically, inflation runs about 3.5% every year on average. In other words, what costs you $100.00 today will cost you $103.50 a year from now. By adjusting for inflation, you can maintain a constant purchasing power with your disposable income.

Many retirees will have new expenditures in retirement years that they do not have during working years, such as travel, a second home, a boat, etc. If you plan on doing any of these things, then add an annual amount to your retirement year disposable income – for example, if you plan on spending $30,000 per year in retirement traveling, then add $30,000 to your retirement disposable income. This amount will also need to be adjusted for the effects of inflation between now and when you retire.

Second, calculate your fixed income in retirement

The most common retirement fixed income is Social Security. The average American’s Social Security benefit is $20,000 per year and the maximum is about $40,000 per year. However, to get the higher amount, a person would need to have a very high income, contribute to Social Security for 35 years, and wait until after age 70 to begin taking Social Security benefits. The second form of fixed income is the pension. In the past, many Americans relied on pensions but these are increasingly uncommon for non-government employers. However, physicians employed by state supported universities and federal government agencies may have access to pensions through their State Teacher’s Retirement System or through the Federal Employees Retirement System. The third type of fixed income is the annuity which is essentially a self-funded pension sold by an insurance company.

In order to calculate the amount of money you will receive from fixed income sources, you can check your annual Social Security statement or pension statement. Social Security benefits have increased an average of 2.6% per year for the past 36 years so adjust your actual Social Security benefit for these anticipated cost of living increases in the years before you retire.

Third, determine the amount you will have in your investment portfolio when you retire

To calculate the value of your retirement portfolio in the year that you will retire, you will need to estimate the number of years until your retirement. Next, determine the amount of money in all of your retirement accounts at the end of the last calendar year. Finally, determine the total amount you are contributing to retirement this year – this should include all deferred income accounts (401k, 403b, 457, 415m, SEP, and IRAs), all employer matching retirement contributions, and all regular investments used for retirement saving. Because a person’s income will usually increase as inflation increases, it is expected that the amount contributed to retirement savings will also increase, proportionate to the increase in income each year. As such, the IRS periodically increases the annual maximum contribution limits for deferred income accounts and historically, this increase has averaged 3.0% per year over the past 36 years. Therefore, you can assume increasing your retirement contributions by 3% each year.

Because your retirement savings will be invested, you will need to estimate the annual rate of return that you expect during your working years. Historically, over the past 94 years, the average annual rate of return of bonds has been 5.33% and the average return of stocks has been 10.29%. Portfolios containing a mix of stocks plus bonds over this period of time have average annual returns falling in-between as shown in this table.

Historically, a common retirement investment portfolio of 70% stocks and 30% bonds has an average 9.2% annual return on investment. In reality, most investors will have a higher percentage of stocks in their retirement portfolio early in their careers and a lower percentage of stocks in their late careers. However, a 70%/30% mix is convenient to represent the average mix over the course of one’s entire working years. Not all stock investments have equal rates of return, however. Because of their higher expense, managed mutual funds will have lower net returns than low-cost index funds. Also, if you hire a wealth adviser to manage your portfolio, their fees will reduce your returns. In these situations, you should reduce your expected annual return by 1-2%.

The reason for the change in the stock:bond ratio with age is because stocks are far more volatile than bonds and are more likely to lose money in the short run, even though they are more likely to make money in the long run. As a person gets closer to retirement age, the risk that a retirement portfolio comprised of stocks will fall in the next few years because greater volatility increases and this could result in you having to withdraw money from your portfolio when the value of the portfolio is lower, thus depleting your retirement savings faster. From the graph below, if a person held stocks in 2000, the subsequent fall in the stock market resulted in the value of those stocks not recovering to the break-even value until 2007. Thus, a person retiring in 2000 with a retirement portfolio consisting primarily of stocks suffered a catastrophic loss of their retirement savings.

Not only will the ratio of stocks:bonds in your retirement portfolio change as you get older, but the ratio is also affected by your individual ability to accept investment risk. This risk assessment is affected by many factors including:

1. Anxiety created by market volatility. If you lose sleep when stock prices fluctuate or if falling stock prices make you want to sell your shares, then you should adopt a low-risk portfolio.
2. Optimist or pessimist? If you believe that the United States’ best years are behind us, if you are pessimistic about the economy or geopolitics, then you should adopt a low-risk portfolio.
3. Pensions. If you have a pension, then a sizable portion of your retirement portfolio will be a non-volatile, dependable amount of income. This gives you the luxury of having a higher percentage of more volatile stocks in your other investments since the stability of the pension will substitute for the stability of bonds allowing you to have a higher-risk portfolio. Notably, state government institutions (including public universities) usually do not participate in Social Security and if their employees elect to self-direct their retirement contributions (rather than participate in the state teachers retirement system or public employees retirement system), then those employees will have no Social Security and no fixed income in retirement – these employees should choose a lower-risk portfolio because of the lack of a fixed income buffer to their retirement income.
4. Anticipated life expectancy. If you anticipate living many years in retirement, then your investment horizon is longer and you can afford to have a higher-risk portfolio. If your life expectancy after retirement is shorter, then it is safer to favor the stability of a lower-risk portfolio.
5. Annual living expenses. If your projected disposable income in retirement is very close to your projected living expenses, then you cannot afford the volatility of a portfolio comprised mostly of stocks and instead should favor the predictability of a lower-risk portfolio.

Here is an example of how to structure a retirement portfolio based on both age and risk assessment:

Fourth, determine the annual withdrawals from your retirement portfolio to achieve your desired disposable income

In your retirement years, your deferred income distributions, fixed income, and annuity income will all be subject to federal and state income tax (except for Roth accounts). Inevitably, income tax rates will go up and go down on different years when you are retired so it is not possible to accurately predict what your income tax rates will be in any given retirement year. The most conservative estimate is to use your current federal and state income tax rates. Once you calculate your desired disposable income in the first year of retirement, you can then calculate the amount of income tax that you will have to pay on fixed income sources and deferred income accounts in order to fund that desired disposable income.

In each year of retirement, inflation will result in an increase in the amount of money that you will need in order to maintain a constant purchasing power from your disposable income. Inflation rates will inevitably be higher in some of your retirement years and lower in other years but for convenience, use the historical average annual inflation rate of 3.5% per year. In addition, your retirement portfolio will increase each year based on your annual rate of return on the investments. Once again, it is impossible to know with certainty what your rate of return will be but if you assume a 50% stock and 50% bond mix in your retirement portfolio in the years after you retire, then based on historical rates of return, you can assume an 8.3% average increase in the value of your portfolio. The goal is to ensure that your investment rate of return exceeds the inflation rate, otherwise, your portfolio will lose purchasing power every year.

By estimating the value of your retirement portfolio at the time of your retirement, estimating how much you will need to withdraw from that portfolio each year to achieve your disposable income needs, estimating the inflation rate during your retirement years, and estimating the rate of return on your retirement portfolio investments, you can calculate how many years your retirement portfolio will last. In order to determine if it will last long enough, you will need to estimate your life expectancy (and your spouse’s).

According to the CDC, the life expectancy from birth is 77.0 years. However, this is not an accurate number to use in calculating how long your retirement portfolio needs to last. The problem is that a lot of people die between birth and age 65 and this brings the average life expectancy from birth number down. What you are interested in is how long you will live after age 65 since you are assuming you will not die before retirement. The average life expectancy for 65-year-old Americans in 2019 was 83.2 years for men and 85.8 years for women. In 2020, those life expectancy numbers dropped by an average of 1 year due to excessive deaths from COVID. Assuming COVID is now largely behind us, the 2019 life expectancy numbers are probably more valid than the 2020 numbers. But remember, these life expectancy numbers are an average and therefore, half of 65-year-olds will live longer than the average. To be conservative (and optimistic!), I recommend using a life expectancy of 95-years-old for financial planning purposes and then adjust that number up if you have a family history of longevity and you have no major medical problems. Adjust the number down if you have chronic medical conditions, if you are a smoker, or if you are unvaccinated. As an example, if you plan to retire at age 65, you should plan on funding 30 years in retirement (to age 95).

Fifth, determine the effect of changing your annual retirement contributions

If you calculate that your retirement portfolio will run out of money before your estimated age of death, then increase the amount you will contribute to your retirement portfolio this year and re-run the numbers until you estimate that you have enough to last for your entire estimated life. On the other hand, if you find that your retirement portfolio will still be large on your estimated death age, then scale back your annual retirement contributions or increase your desired annual disposable income in retirement and re-run the numbers.

Knowledge is freedom

To calculate the amount of money you need takes time and is complicated. The downloadable retirement calculator attached to this post can help and will probably take about 20 minutes once you assemble your current financial documents. However, doing the calculations can bring you the security to ensure that you do not run out of money in your retirement years and the security of knowing that you will be able to do all of the things that you dream of doing once retired. But most importantly, it gives you freedom – freedom to work in your 60’s or 70’s because you want to work and not because you have to work.

March 26, 2022

The best time to do a Roth conversion is in the next 4 years. There are two situations when contributing to a Roth IRA is particularly advantageous: when the stock market plummets and when income tax rates are low. In 2016, Congress voted to reduce income taxes, beginning in tax year 2017. Without additional legislation, those tax reductions will expire in 2025. Given historical precedent and the amount of Federal spending that has occurred in the past 2 years in combating COVID and in infrastructure spending, it seems likely that income tax rates will return to the 2016 levels in 2025. That means that we have 4 years  left to take advantage of some of the lowest income tax rates in recent memory. It also means that we have 4 years left to take advantage of lower-cost Roth IRA conversions.

To understand why Roth conversions are going to be less expensive now than in 2025, you first have to understand how income taxes work. In a previous post, I discussed the differences between income tax brackets and effective marginal income tax rates. The bottom line is that we place way too much emphasis on the tax brackets. What we actually pay in income tax depends on the effective tax rate and not the bracket. The effective tax rate goes slowly and steadily up for every additional dollar we earn. The income tax brackets simply determine the slope and position of the curve of the effective tax rates. In the graph to the right, you can see last year’s income tax brackets in the dotted line but the actual income tax rate a person pays is always less than the bracket that they are in, as shown in the solid line.

When congress voted to reduce the tax brackets beginning in 2017, the effect was to shift the curve of the graph downward so that everyone at all income levels paid lower effective income tax rates. Depending on one’s taxable income, the effective tax rate dropped by 3.5 to 6.0 percentage points. The graph on the right illustrates the difference in the effective tax rate for annual taxable incomes between $40,000 and $700,000 for 2016 (before the tax cuts) and 2020 (after the tax cuts). For example, a family with a taxable income of $250,000 per year had an effective income tax rate of 21.5% in 2016 but that dropped by 4.6 percentage points to an effective income tax rate of 16.9% in 2020. Looked at in a different way, that family paid $53,750 in federal income tax in 2016 but only paid $42,250 in 2020.

So, what do lower income taxes mean for Roth conversions?

Roth IRAs have two important advantages over other retirement savings accounts: (1) you do not have to pay taxes when you take money out of the Roth account and (2) you do not have to take required minimum distributions at age 72 like you do with a 401k or other deferred income accounts. There are two ways that you can contribute to a Roth IRA: direct contribution and conversion contribution. If you are married filing jointly, then you can annually contribute up to $6,000 ($7,000 if over age 50) directly to a Roth IRA if you make less than $198,000 (you can do a partial contribution if you make between $198,000 and $208,000). If your income is over $208,000, then you cannot contribute directly to a Roth. However, you can do a Roth conversion by first contributing to a traditional IRA and then converting those funds into a Roth IRA within 60 days. This sometimes called a backdoor Roth approach.

It is easiest to do a Roth IRA conversion from a traditional IRA, especially if both the traditional and Roth IRAs are in the same investment company. It is also possible to convert funds from a 401(k), 403(b), or 457 plan into a Roth IRA but it can be more complicated. You generally must be over age 59 1/2 and also no longer employed by the employer that sponsored the 401(k), 403(b), or 457 plan. Also, the administrator of the 401(k), 403(b), or 457 plan may not permit you to convert funds directly into a Roth IRA and so you may have to first rollover funds from the 401(k), 403(b), or 457 plan into a traditional IRA and then convert the traditional IRA into the Roth IRA within 60 days. Of critical importance is that when you convert funds from a tax-deferred account (such as a 401(k), 403(b), or 457 plan) into a Roth IRA, that money is subject to regular income tax the year that you do the conversion. This means that not only do you have to pay income tax on the value of the conversion, but the amount converted adds to your total taxable income so it will push you up to a higher income tax rate the year that you do the conversion. The extra steps involved in doing this type of conversion can be a headache; however, as we will see, it can be worth it from a tax savings standpoint.

Although I personally think that everyone should have a Roth IRA as component of a diversified retirement portfolio, there are 2 situations when it is especially advantageous to do a Roth conversion: (1) when there is a significant drop in the stock market and (2) when your income tax rate is lower now than it will be when you are retired.

• When the stock market falls. If you already have money in a traditional IRA, then the best time to convert that money into a Roth is when the value of the IRA is at the lowest (and therefore you pay the least amount in income taxes). The best example of this in recent years was in March 2020 when the S&P 500 index fell by 32% as a consequence of the COVID pandemic. If you had $1,000 in a stock index mutual fund traditional IRA on February 10, 2020, then it was only worth $680 on March 16, 2020. However, by August 2020, the stock market had completely recovered back to its January 2020 value. If your effective tax rate was 16.8%, then you would have paid $168 in taxes to do a Roth conversion of the total amount of the traditional IRA in February but only $114 in taxes to do the conversion in March. If you are older than 59 1/2 and retired, then you could also have done a Roth IRA conversion from a 401(k), 403(b), or 457 account. The stock market inevitably goes up, goes down, and then goes back up again. Take advantage of the drops in the stock market to do the Roth conversions – that way, when the stock market rises in the future, the recovery in value of your investment will all be tax-free. How much does the stock market need to drop to trigger a Roth conversion? That is a matter of opinion but a 20% drop is a reasonable trigger.
• When your income tax rate is lower. For most people, income tax rates will be lowest when they first start out in the work force and their taxable income is relatively low. Their income tax rates will be highest in the years just before retirement when they are in their peak earning years. In retirement, their income tax rate will usually fall to a rate somewhere in-between their lowest and highest income earning years while working. Therefore, for most people, the best time to do a Roth conversion is early in their careers, when their taxable income (and thus their income tax rate) is still relatively low. However, the other time that a Roth conversion is advantageous is when everyone’s income tax rates are low but will go up in the near future.

History tells us that tax rates, like the stock market, periodically go up and periodically go down, as illustrated in the graph to the right. The problem is that no one can predict with certainty exactly when tax rates will go up or down. Federal income tax rates are low now so it is highly likely that they will go up in the future. The current lower tax rates are set to expire in 2025 at which time they will revert to the higher 2016 rates (unless congress votes to extend them). Which political party is in charge of congress and the White House will have a big impact on whether taxes will go back up in 2025 (as planned) or stay low (requiring additional legislation). However, unless there is a significant reduction in federal spending in the next 4 years, then it is likely that there will be no alternative to letting the tax rates go back up in 2025.

Therefore, if your income remains relatively constant, it will cost you less to do a Roth conversion now than it will cost beginning in 2025. As an example, in 2021, a person making $200,000 has a federal income tax rate of 15% but in 2025, a person making $200,000 will have a 20% income tax rate. So, by doing a $50,000 Roth IRA conversion in 2021 (and thus increasing their taxable income to a total of $250,000), this person would pay a total of $42,250 in income tax but if they wait to do the Roth IRA conversion in 2025, this person would pay a total of $53,750 in income tax. In other words, as shown in the calculation below, this person will pay $11,500 more in income tax to do a Roth conversion in 2025 than in 2021:

In fact, a person would need to make $380,000 per year in 2021 to be taxed at the same rate that an income of $200,000 will likely be taxed in 2025. Therefore, a person making an annual income of $200,000 in 2021 can convert an additional $180,000 into a Roth IRA this year and still pay the same income tax rate that they will pay on an income of $200,000 (with no Roth conversion) in 2025.

Know the rules about Roth Conversions

The tax laws regarding Roth IRA withdrawals are complicated and depend on your age, how long ago you opened the Roth IRA, whether you are withdrawing the contribution (amount you originally put in) versus earnings (amount you made off of the contributions), and whether the contribution was a direct contribution or a conversion contribution. For direct contributions (eligible for couples filing jointly with an income of < $198,000), you can take money out of the Roth contributions anytime but you cannot take money out of the Roth earnings until you have had the Roth account open for at least 5 years and you are at least 59 1/2 years old. For conversion contributions, the conversion must have occurred at least 5 years previously, regardless of your age, before you can withdraw the contributions from the Roth account. The IRS uses a “first in, first out” rule when tracking the conversions so that every conversion amount that you make to a Roth IRA has its own 5-year requirement before you can withdraw it. In other words, consider the amount of each Roth IRA conversion to be locked up for 5 years.

Roth IRAs are not subject to required minimum distributions, unlike other deferred compensation accounts (such as traditional IRAs, 401(k)s, 403(b)s, and 457s). Required minimum distributions are a certain percentage of the deferred compensation accounts that the IRS requires you to withdraw each year after age 72. If a person has a lot of money in these deferred compensation accounts at age 72, this can result in taxable income high enough to push the person’s effective income tax rate up. Therefore most retirees will start to preferentially draw down their traditional IRAs, 401(k)s, 403(b)s, and 457s before age 72 and hold off on taking withdrawals from their Roth IRAs until after age 72 in order to maintain the lowest income tax rates during their retirement years. In general, you cannot convert required minimum distributions into a Roth IRA.

Now is the time to do a Roth conversion

If the 2016 tax cuts are left to expire in 2025, then there will be 4 more years of lower income taxes before income tax rates go back up. Therefore, it will cost you less to do a Roth IRA conversion in 2021, 2022, 2023, and 2024 than it will to do a Roth conversion in 2025 and later. The best Roth strategy depends on a person’s age:

If you are younger than 59 1/2: Do a direct Roth IRA contribution if your income is less than $198,000 (married filling jointly). If your income is higher, then you can make a contribution to a traditional IRA (up to $6,000 per person under age 50 and $7,000 per person over age 50) and then promptly convert the traditional IRA contribution into a Roth IRA (backdoor Roth). A common question that comes up is whether it is better to contribute to a deferred income account such as a 401(k)/403(b)/457 (pre-tax dollars) or better to contribute to a traditional IRA and do a backdoor Roth conversion (post-tax dollars). If your employer offers a matching contribution to your 401(k)/403(b)/457, then it is always better to contribute to the 401(k)/403(b)/457. There are two situations when doing a backdoor Roth is advantageous:

1. • You have already contributed the maximum to your 401(k)/403(b)/457 and you have some additional post-tax money that you want to invest for retirement. In this situation, if you put the money into a regular investment, you will eventually pay capital gains tax on the earnings but if you put the money into a backdoor Roth, you pay no taxes on the earnings.
   • You believe that you will have a higher income tax rate in your retirement years than your current tax rate. Remember, however, that by contributing to a 401(k)/403(b)/457, you are lowering your taxable income for the contribution year and thus lowering your tax rate that year. Conversely, your income tax rate will be higher if you do not contribute to your 401(k)/403(b)/457 and do the backdoor Roth instead. Nevertheless, for the next 4 years, if you do not have a lot of extra cash on hand in your checking account, you may be better off to reduce your 401(k)/403(b)/457 contributions by enough to give you $6,000 after-tax ($7,000 if over age 50) and then put that $6,000 into a traditional IRA followed by a backdoor Roth conversion.

If you are between 59 1/2 and 67: You can do a direct contribution (if your income is low enough) or a backdoor Roth. But you should also consider converting a portion of your traditional IRA, 401(k), 403(b), or 457 into a Roth IRA. The optimal amount to convert will depend on how much higher you project your taxable income will be in 2025 than it is in 2021. If your taxable income is going to be about the same, then you may be able to convert up to $100,000 – $150,000 and still come out ahead from a tax standpoint. If you project that your income will be higher in 2025 than it is now (and thus have an even higher income tax rate), then you can convert more than $100,000 – $150,000. If you project that your income will be lower in 2025 than it is now, then it still may be advantageous to do a conversion now but the conversion amount should be less. If you are still working, you can do a Roth conversion from your traditional IRA but you probably will have to wait until retirement to do a Roth conversion from an employer-sponsored 401(k), 403(b), or 457 (withdrawals from these accounts while still working are usually not permitted). Importantly, remember that you will pay income tax on the amount of the conversion so you should only do the conversion if you have sufficient cash on hand to pay that extra tax.

If you are between 67 and 72: Things get a bit more complicated. Remember, each conversion contribution needs to be in your Roth account for at least 5 years in order to avoid an early withdrawal penalty. So, if you plan to start taking money out of your Roth at age 72, then the year you turn 72, you should only take an amount equal to the conversions that you did before age 67 to avoid paying the IRS penalty. This means that you have to track your Roth conversions and have a record of how much you converted each year. It may still be advantageous for you to do Roth IRA conversions between ages 67 and 72 but you should be sure that you do not plan on withdrawing those annual conversions from your Roth IRA for at least 5 years.

If you are older than 72: Doing a Roth conversion after age 72 is usually unwise. Because required minimum distributions from deferred compensation accounts are necessary starting at age 72, taking additional money out of these accounts to do Roth conversions will result in more taxable income and thus push the income tax rate up higher. Some people who are still working and contributing to a 401(k)/403(b)/457 after age 72 may be exempt from required minimum distributions and thus be in a position where a Roth conversion is still advantageous but they should check with a tax advisor because this is a very complicated area.

It’s all about the math

If the current tax rates expire in 2025 and revert to the 2016 rates as anticipated, then there is a 4-year window of opportunity for Roth conversions in order to take advantage of the lower tax rates. A carefully timed Roth conversion can save you money by reducing the total amount of income tax you pay over your lifetime. But you have to be strategic with your timing or you could end up paying more in income taxes. If you are not sure, then get help from a tax expert.

September 7, 2021

So, you are finally done with all of your education and you are now actually earning an income. You want to start saving for retirement but the number of investment options can seem overwhelming. Many people turn to their company’s 401(k) and a “target date” mutual fund that automatically invests a certain percentage of the fund allocation in U.S. and foreign stocks and a certain percentage in U.S. and foreign bonds. When the investor is young, a higher percentage goes into stock and as the investor ages, the percentage invested in bonds increases. In fact, 24% of all money held in 401(k) accounts is in target date funds. Although this approach is simple and works reasonably well for most people, the savvy retirement investor can do better with understanding of the 4 buckets of retirement assets and the 4 types of retirement investments.

Retirement Investment Summary

Deferred Compensation Accounts

• Do include:
  • Stock and bond funds in a pre-determined ratio
  • REIT funds
• Do not include:
  • Cash
  • Tax-free bond funds

Roth Accounts

• Do include:
  • Stock funds
  • REIT funds
• Do not include:
  • Cash
  • Bond funds (until you are close to age 72)

Regular Investments

• Do include:
  • Cash
  • Stock and bond funds in a pre-determined ratio
  • Tax-free bond funds
  • Any stocks held in individual companies for your entertainment (non-retirement) purposes
• Do not include:
  • REIT funds
  • Certificates of deposit

The 4 buckets of retirement assets

The money that you use in retirement is going to primarily come from 4 sources or “buckets”: (1) defined benefit income, (2) deferred compensation, (3) Roth accounts, and (4) regular investments.

First, there is defined benefit income. This is a dependable amount of money that you get every month from a source such as Social Security, a pension, or an annuity. For most people, Social Security will not be enough to cover a retiree’s expenses. If you can get one, a pension is a great component of a balanced retirement asset portfolio but pensions are increasingly uncommon. Annuities have their place for some investors but for the majority of people, annuities are too expensive and too complicated to be worth it, particularly if you have a moderate to high income during your working years. Defined benefit income can serve as an important safety net in retirement so that even if there is a major recession, you still have enough income coming in each month to ride out that recession, without having to sell your stock or bond funds at a time when you can potentially take a substantial loss on those funds.

The second bucket is deferred compensation. This includes IRAs, 401(k)s, 403(b)s, and 457s. This is money that you put away into an investment without paying income taxes on it while you are working. When you withdraw the money in retirement, you pay regular income tax on those withdrawals at whatever your income tax rate is during that year. Any interest and dividends generated from the investments in deferred compensation accounts just gets added to the value of the account so when you take that money out, you pay regular income tax on the withdrawal no matter whether the money in that withdrawal was derived from your original deposit into the account, interest earned on that investment, dividends earned from that investment, or the capital gain in value of that investment. At age 72, the IRS requires you to take a portion of money out of deferred compensation accounts each year; this is called “required minimum distributions”. If you have a lot of money in your deferred compensation accounts at age 72, those required minimum distribution can push you into a high tax bracket; this is why many advisors recommend drawing down from your deferred compensation accounts early in retirement, before age 72. For many people, deferred compensation accounts will be their main source of retirement income.

The third bucket is Roth accounts. The most common of these is the Roth IRA but some people can invest in a Roth 401(k) or Roth 403(b). This is money that you pay income tax on during the year that you earned and deposited the money into Roth account. That money then grows tax-free in the account with the addition of any interest or dividends from the investments. When you withdraw money from the Roth account, you do not pay any tax on it. Money in Roth accounts are not subject to required minimum distributions so you can leave money in these accounts beyond age 72. Regular Roth IRAs are only available to people with lower incomes; however, a “back-door Roth IRA” is available to anyone and is a great idea for most middle and high income people. The Roth 401(k) and Roth 403(b) are only advisable if you anticipate that you will be in a higher tax bracket in retirement than you are when you are working, which is uncommon except for young people early in their careers when their annual income is relatively low.

The fourth bucket is what I will call regular investments. This is money that you pay regular income tax the year that you earn it and then invest that money in stocks, bonds, etc. You can pay taxes on these investments in three different ways: interest, dividends, and capital gains. Interest income is taxed each year at your regular income tax rate. Dividends can be taxed two ways: “ordinary dividends” are subject to your regular income tax rate the year that you earned the dividends. On the other hand “qualified dividends” are taxed at your capital gains tax rate the year that you earned the dividends. A typical U.S. stock index fund will have approximately equal amounts of ordinary and qualified dividends each year. When you sell an investment, such as a stock, you pay capital gains tax on the amount that that investment has increased in value since you purchased it. For most people, the capital gains tax rate will be lower than their regular income tax rate. The current capital gains tax rates for people married filing jointly are 0% for annual income < $80,800, 15% for annual incomes $80,801 – $501,600, and 20% for annual incomes > $501,600. The IRS also has a 3.8% dividend surtax for anyone with more than $200,000 in annual investment income (this is uncommon). Note that interest, dividend, and capital gains taxes only apply to regular investments and do not apply to deferred compensation investments (which are taxed at your income tax rate) or Roth investments (which are not taxed at all).

The 4 types of retirement investments

Okay, this is a little oversimplified. In reality there are more than 4 types of investments but I am not going to include less common investments such as fine art, jewelry, wine collections, and digital currency as these are considerably less common in the typical retirement portfolio. The main 4 types of retirement investments most people have are (1) stocks, (2) bonds, (3) real estate, and (4) cash. Knowing which of these to put in each of your retirement buckets depends on how they are taxed and when you will want to use them.

The first type of investment is stocks. It is inadvisably risky for most people to buy stocks in individual companies. It is preferable to buy shares of mutual funds which are composed of stocks from many different companies, thus allowing you to spread out your risk. For American investors, stocks can be divided into U.S. stocks and foreign stocks – a diversified portfolio will have some of both. In the short-run, the value of stocks can swing widely, losing value some years and gaining value in others. However, in the long-run, stocks will outperform all other kinds of investment.

The second type of investment is bonds. Once again, most people don’t buy individual bonds but instead buy shares of bond mutual funds. Bonds can come from U.S. companies, the U.S. government, local governments, and state governments. Some government bonds are tax-free, meaning that you do not pay tax on the income from those bonds. However, tax-free bonds tend to pay the investor lower yields than taxable bonds. Bonds can also come from foreign companies and foreign governments. An advantage of bonds is that their value does not fluctuate from year to year as much as the value of stocks (in other words, bonds have less volatility than stocks). However, over the long-term, the return on bonds is less than the return on stocks.

The third type of investment is real estate. Most of us cannot easily go out an purchase a plot of land or a building as a retirement investment but we can invest in shares of real estate investment trusts (REITs). Functionally, these are similar to mutual funds and an REIT will own many different properties, such as apartment buildings, office buildings, warehouses, retail centers, etc. Like stock mutual funds, the value of REITs can fluctuate widely from year to year and will outperform bond funds in the long-term. However, REITs are subject to different economic forces than stocks, so the performance of REITs may not mirror the performance of the stock market in any given year.

The fourth type of investment is cash. These are investments that do not earn a very high return but are relatively safe and dependable; their value does not fluctuate much from year to year. Because the annual inflation rate will usually be higher than the annual return on cash investments, those cash investments will actually lose value over time; for this reason, you do not want to have too much of your retirement portfolio in cash. Included in this category are checking accounts, savings accounts, and money market accounts. Some people include certificates of deposit (CDs) in this category but I consider cash as money that you can take out with immediate notice; the problem with certificates of deposit is that those funds are locked up for the term of the CD and so you cannot access them on short notice without paying a penalty. Another disadvantage of certificates of deposit is that the yield on the CD is taxed as interest, in other words, at you regular income tax rate.

Putting the right investment type in the right asset bucket

So far, we’ve seen that there are 4 basic buckets of retirement assets and 4 basic types of retirement investments. The next step is to determine how much of each type of investment to put in each bucket of retirement assets. The decision will be based on how each investment is taxed in each bucket, how far in the future you plan on taking money out of the investment, and the short-term volatility of each type of investment.

Defined Benefit Income Bucket

For the most part, you are not going to have any say in how the money in your defined income bucket is invested. Social Security income will be determined by congress and pension payments will be determined by a central pension committee. You can have some limited control over annuity investment by purchasing different types of annuities.

Some advisors argue that an investor is better off not contributing to a pension and instead investing that money themselves. Although I agree that most investors can outperform their pension, the key advantage of having a pension as a component of a balanced retirement portfolio is that by having the guaranteed monthly income from the pension, you can afford to put a larger percentage of your other retirement investments in stocks than you otherwise would. In the long-run, those riskier stocks will result in higher overall returns.

Deferred Compensation Bucket

Most people will start to withdraw money from their deferred compensation accounts shortly after retirement. Therefore, the composition of your deferred compensation account will depend on the number of years until you retire. If you are younger, then the stock-to-bond ratio should be primarily U.S. and foreign stocks with relatively little bonds – you have plenty of time to weather out the year-to-year volatility of stocks. As you get closer to retirement, the proportion of bonds should increase and the proportion of stocks should decrease. The idea of the “target date” mutual fund is that you choose a fund that corresponds with your planned year of retirement and the fund automatically adjusts the ratio of stocks to bonds each year as you get closer to retirement. Target date funds are designed to meet the needs of the average person but the problem with target date funds is that we are not all average and the target date funds do not take into account an individual person’s unique circumstances that can affect the ideal stock:bond ratio for that individual’s retirement portfolio. The ideal ratio of stocks:bonds will depend on (1) your own willingness to accept risk inherent in stock market volatility, (2) whether or not you will have defined benefit income in retirement, and (3) how long you expect to live in retirement. One strategy is to look at the stock:bond ratios from investment companies such as Vanguard, Fidelity, or Blackrock and use those ratios as a starting point. If you are risk-adverse, then increase the percentage of bonds in your portfolio. If you will have a pension or if you anticipate living a long time in retirement, then increase the percentage of stocks in your portfolio. A small portion of the deferred compensation fund should be real estate, for example, 5-6% of the funds invested in an REIT.

Do NOT put a lot of cash in your deferred compensation accounts – you want investments that are going to grow in value over time in these accounts. Do NOT put tax-free bonds in your deferred compensation accounts – these bonds will not increase in value as much as taxable bonds and the annual interest generated by these bonds does not get taxed each year in the deferred compensation fund, anyway.

Roth Bucket

Ideally, you want Roth accounts to hold investments that are going to have the highest long-term increase in value. Therefore, your Roth accounts should be mostly composed of stocks, both U.S. and foreign. Because your Roth account is not subject to required minimum distributions at age 72, you will likely want to withdraw money from your Roth accounts at an older age than you start to tap into your deferred compensation accounts (in other words, you want to spend down your deferred compensation accounts before reaching age 72). As with your deferred compensation bucket, a small amount of the Roth accounts should be in REITs, say 5-6%.

Do NOT have cash investments in your Roth accounts – there is little to no tax advantage. Do NOT have bond funds in your Roth accounts (at least when you are younger) – since you will not start to take withdrawals from your Roth accounts for 5-10 years after you start to take withdrawals from your deferred income accounts, you can afford to have a higher percentage of stocks in your Roth bucket than in your deferred income bucket. As you get close to age 72 (or whatever age you anticipate starting to withdraw money from your Roth account), you can then begin to shift some of the Roth funds into bonds. Even more importantly, do NOT have tax-free bonds in your Roth accounts ever – the Roth accounts are already tax-free and tax-free bonds will have a lower annual return than regular taxable bonds.

Regular Investment Bucket

This is the bucket that you want your cash investments in. Everyone, regardless of age, should have enough money in cash to cover at least 3 and preferably 6 months of normal expenses. You or your spouse could lose your job, have an unexpected (and expensive) illness, or suffer a financially catastrophic loss such as a house fire.

For most middle and high income earners, it is better to maximize annual contributions to your 401(k), 403(b), 457, IRA, and/or Roth before investing money meant for retirement in regular investments. But if you have maximized your deferred compensation and Roth account contributions and you still have some money left over to invest for retirement, what you invest in? The decision will largely be based on taxes.

If you want tax-free bonds in your retirement portfolio, this is where you should put them – where you can benefit by not having to pay annual regular income tax on the annual yields that these bonds generate. As I stated in a previous post, most people should not invest retirement money in individual stocks – you are better off diversifying your stock holdings. However, if you do want to hold a few individual stocks for your own entertainment purposes, this is also where you should put them.

Most people should have a higher percentage of bonds in their regular investment bucket than in their deferred compensation bucket. There are two important reasons for this. First, if you need money for an unexpected expense before you retire, you are better off drawing that money from your regular investment bucket rather than your deferred income bucket since you will be charged an early withdrawal penalty from deferred income accounts. Therefore, you may need the money sooner than your planned retirement date so you want to have less investment volatility given your potentially shorter investment horizon. Second, since you want to have your Roth account composed mostly of stocks, you will need to have someplace else to put bonds in order to maintain your overall desired stock:bond ratio across all of your retirement buckets.

Do NOT put certificates of deposit meant for retirement saving in your regular investment bucket. You will pay regular income tax on the interest each year and your regular income rate will usually be higher during your working years than during your retirement years. Certificates of deposit are better used for non-retirement savings, for example, savings for a new car or down payment for a house.

Do NOT put REIT retirement investments in your regular investment bucket. Unlike a stock mutual fund that generates about half ordinary and half qualified dividends, REIT dividends are almost all ordinary dividends and thus taxed each year at your regular income tax rate. Because most people will have a lower income tax rate in retirement than when working, you will pay more tax on REIT dividends in a regular investment when you are working than you will on REIT dividends in a deferred compensation account when you withdraw in retirement.

Some financial advisors argue that dividend-generating stocks should be in your deferred compensation bucket and not in your regular investment bucket for the same reason. I do not have as strong of an opinion – the explanation is a bit complicated, so bear with me (if you feel like your head is ready to explode after reading this far, skip reading this paragraph). If a stock mutual fund is held in your regular investment bucket, you will be taxed each year at your regular income tax rate for the ordinary dividends and at your capital gains tax rate for the qualified dividends. On the other hand, if that same index stock fund is held in your deferred compensation bucket, you will not pay annual tax on the dividends each  year – those dividends just build up in the account until you make a withdrawal in retirement and then you will be taxed at your regular income tax rate on that withdrawal. Your income tax rate will likely be higher during your working years than in your retirement years so you might think that it would be better to have dividend-producing stocks in your deferred compensation account. However, your income tax rate in retirement will likely be higher than your capital gains tax rate when you are working. Therefore, in order to minimize taxes, you are better off having stocks that generate ordinary dividends in your deferred compensation bucket and having stocks that generate qualified dividends in your regular investment bucket. Since most index stock funds generate approximately equal amounts of ordinary dividends and qualified dividends, I believe that taxes on ordinary and qualified dividends balance out whether the index stock fund is held in your regular investment bucket or in your deferred compensation bucket. For that reason, I do not believe that dividend generation should be a factor in deciding whether a stock fund should be in your regular investment bucket or in your deferred compensation bucket.

Diversification is the key

Diversification is at the core of every healthy retirement portfolio. That means diversifying across all 4 of the buckets of retirement assets and across all 4 of the types of retirement investments. The optimal amount of each type of retirement investment you have in each bucket of retirement assets will depend on tax implications, your age, your risk tolerance, and whether or not you will have a pension.

August 9, 2021