HCMI Quick Take - March 22nd, 2007
Retirement Planning

From time to time, Heron Capital Management, Inc. issues a “Quick Take” on topics ranging from retirement and estate planning, charitable giving, education planning, family wealth distribution, trust services, to executive benefit planning, especially diversification out of single stock or stock option positions.

“Quick Takes” are oriented towards the needs and experiences of HCMI’s own clients and are designed to prompt current and prospective clients in asking questions.  By no means are these commentaries substitutes for the full and informed advice of an investment advisor, attorney or accountant.  These professionals should be consulted before clients make any final decisions.

What’s the minimum amount clients should have for retirement? 

Most retirement estimating programs assume that retirees will get by on 60-75% of their retirement income and will run their assets down to zero over the remainder of their lives.  Our clients typically want income at 100% of their pre-retirement spending, wish to live off their assets, and pass those assets on to their heirs.  Our own Quick and Dirty Retirement Planner gives our clients very conservative projections based on these requirements, generally targeting higher overall savings than typical retirement programs.  Here’s an example drawn from the model, which is included in the attached spreadsheet:

You can enter values as a single person or a couple, and you don’t need to know exactly what your annual expenses are, just a good guess.  In our experience, clients’ overall spending rate doesn’t change when they retire (although you can change that parameter in the model), just the mix (less on housing, more on travel and charitable giving.)

In the current low interest rate environment, we advise clients to target a draw rate of 5-7%, with 5% being quite conservative.  Beyond a draw rate of 8%, clients risk running their assets down to zero.

What are the different retirement savings options?

The following list outlines most options (specifications as of March 2007) in descending order of utility to the typical HCMI client:

1. Defined Benefit Pension Plan – Once a universal perquisite of most employees, Defined Benefit Pension plans are fast becoming obsolete except for government workers.  After a waiting period, employees qualify for a pension, the amount of which usually increased with an increasing years of service.  On retirement, the employee would qualify for a monthly distribution, often with health benefits as well.  The dollar amount of the distribution is “defined,” so it’s up to the corporation or government entity to come up with the cash.  Over time, corporations have become less willing to offer these plans given the cost and investment risk of providing pensions and have switched to “Defined Contribution” plans.  Another disadvantage is that employees who job hop often lose accrued benefits (the plans are not “portable.”)  Hardly any HCMI clients under the age of 50 are beneficiaries of such plans.
2. 401K and 403B plans – 401K for corporate employees, 403B for non-profit employees.  These plans are named after the section of IRS code that authorized their existence.  Employees make pre-tax contributions to these plans, which are invested in an array of mutual funds, and employees often match part or all of these contributions.   For 2007, employees can contribute up to $15,500 (or 100% of salary,) and employees over 50 can contribute an additional “catch-up” of $5,000, subject to some limitations by the employer (e.g. employers can specify that a cap on contributions of 5% of salary.)  Employers typically contribute $.50 for every dollar contributed (and the money is painlessly deducted from paychecks,) so we encourage our clients to maximize their contributions   Maximum contributions from all sources can’t exceed $45,000 in 2007 (some plans allow additional “after-tax” contributions.)

Upon switching jobs, after 6 months, employees may “roll over” the 401K or 403B assets to a plan of their new employer, or may elect to move the assets to a Rollover IRA, which is exactly like a regular IRA except that the employee retains the option to move the assets back into a 401K at a future date.  The employee can also consolidate the assets in a new or existing regular IRA, but loses the ability to roll out the assets into another 401K down the road.  Given that 401K’s are typically limited to 10-30 mutual funds, while IRA’s can be invested in any mutual fund, stock or bond, we’ve never had a client take that option.

Upon retirement, the client may retain the assets inside the 401K or 403B and take distributions directly, or may move the assets to a Regular or Rollover IRA.  We’ll discuss those distribution options below.

3. Simplified Employee Pension (SEP-IRA) – commonly used as an alternative to 401K’s for small companies, most often self-employed individuals.  The employer is allowed to make contributions in 2007 of up to 25% of the employee’s income for a maximum contribution of $45K.  The employee has unlimited investment options among stocks, bonds and mutual funds. 
4. Savings Incentive Match Plan for Employees IRA (SIMPLE-IRA) – confusingly, not the same as the Simplified Employee Pension (SEP-IRA) described above.  This alternative to both 401K plans and SEP-IRA’s allows employees to make contributions up to $10,500/year in 2007.  Their employer may make a dollar for dollar match up to 3% of the employee’s salary, or may make a “non-elective” contribution of up to 2% of salary regardless of whether the employee makes contributions.  Employees older than 50 can make additional “catch-up” contributions of up to $2,500/year.
5. Keogh Plan – attributes similar to SEP IRA’s in terms of contribution limits, some twists in terms of determining contribution amounts.  Keogh plans are oriented to self-employed individuals and partners and workers in unincorporated firms with no other retirement options.  Contributions are defined as: 0-25% of compensation for a Profit Sharing plan and 3-25% of compensation for a Money Purchase plan, or a combination of these options (Paired Plan) not to exceed $45,000 in 2007.  Contributions are made by the employer, so the Profit Sharing option allows firms with highly variable profits to control their employee retirement expense.

Tip: Individuals who are self-employed are most likely best served by the SEP-IRA – it’s easy to set up and offers maximum flexibility on funding

Tip: Companies with a handful of employees might be well served by a SIMPLE IRA if management wants employees to be primarily responsible for their retirement saving.  If management wants to use retirement saving as an incentive, then a Keogh or 401K plan is a more attractive option.  Larger companies (more than 15 employees) are usually best served by a 401K plan.

6. Regular IRA – Anyone can make deductions to a regular IRA, $4,000/year in 2007 plus an additional $1,000/year if you’re 50 or over.  However, the deductibility of your contribution will be limited if you’re covered by a retirement plan at work.  For single tax-payers, the deduction begins to phase-out at $50,000 in income and is eliminated completely at $60,000.  For married tax-payers, the phase-out range is $80-$100K in 2007.  The phase-out applies to a couple even if only one spouse is covered by a retirement plan (i.e. contributions to a spousal IRA are non-deductible if family income exceeds $100K.)  If neither spouse is covered by a plan, then the contributions are tax-deductible regardless of income.  Also, there are no caps on contributions as a percentage of income. 
7. Roth IRA and Roth 401K – Roth IRA’s offer a different tax angle compared to regular IRA’s.  Contributions to Roth IRA’s are not tax-deductible but distributions in retirement are.  If you’re in the 35% Federal tax bracket, for every $1000 of earned income deposited in a Roth IRA, you’d have to pay $350 in taxes now.  However, if after 10 years the money had grown tax free at 8%, for every $1000, you’d have $2,158 with no taxes owed on withdrawals (saving you $755.62 for a net tax benefit of $405.62.)  If you can afford the extra taxes now, the tax advantage when you retire could be substantial.  Also, Roth IRA’s, unlike any of the other options listed above, do not have Minimum Required Distributions (MRD’s) – legally required minimum distributions at age 70 ½.) 

Contributions limits are $4,000/year/per person, not to exceed 100% of employment income, and clients over 50 can contribute an additional $1,000/year.

Unfortunately, Roth’s are available only to single taxpayers earning up to $99,000 in 2007, $156,000 in 2007 for joint filers, which rules out most of our clients.  Clients on the cusp of those limits may find that they have to reverse contributions (without penalty) if they exceed the income limits by year end. 

A recent innovation for employees of certain firms which have elected this option is the ability to contribute to a Roth 401K.  This plan has the same contribution limits as a regular 401K, the same tax free distribution status as a Roth IRA, and there’s no income limit preventing you from participating.  However, you don’t get the tax deduction on the original contributions.  If you switch jobs or retire, after 6 months you can roll your Roth 401K over to a Roth IRA.

8. Conversion of Regular, SEP and SIMPLE IRA’s to Roth IRA’s –Clients whose modified adjust gross income, whether filing singly or married filing jointly, is less than $100K are eligible to convert a Regular, SEP or SIMPLE IRA to a Roth IRA.  Clients who are married but file separately aren’t eligible unless they can prove separation of a year or more.  These requirements rule out most HCMI customers.  However, some of our clients who are authors and actors with highly variable income can take advantage in low income years.  Also, clients whose income is reduced, for example, while they’re in graduate school can take advantage.  

The principle is that, if you pay tax now, you can avoid tax on retirement distributions.  Here’s a simple example: a client, a 30 year old actor who’s single, had an off year in 2007 and earned only $25,000.  His IRA is worth $100K.  He elects to convert the entire IRA to a Roth.  Without the conversion, his Federal tax would have been $782.50 plus 15% of the amount over $7,825 or $3,358.75.  Converting the IRA would push his income up to $125K, so his Federal tax would be $15,698.75 plus 28% of the amount over $77,100 or $29,110.75.  If the client had savings in taxable accounts to pay that tax, the conversion might make sense.  If the client didn’t plan to retire until 65, that $100K Roth IRA might grow to $1,478,534 assuming an 8% annual return.  Given a 35% tax rate in retirement, the tax on the regular IRA might total $502,701 or more over the distribution.

The decision to convert to a Roth is non-trivial and is dependent on your current tax bracket, your expected tax bracket in retirement, the number of years to retirement and whether you have available funds outside your Roth to pay the taxes (you can pay taxes from within the Roth, but you want those funds to enjoy the maximum tax deferred growth.)  You can also do partial Roth conversions if a full Roth conversion would push you into too high a tax bracket, or if you don’t have enough free cash to pay taxes on a full conversion.

9. Beneficiary Distribution IRA – if a husband or wife dies before their IRA is exhausted and they have named their spouse as the beneficiary, then the spouse has the option of rolling that IRA into their own IRA, or into a Beneficiary Distribution IRA (BDA).  Any non-spouse beneficiary only has the option of receiving the funds into a Beneficiary Distribution IRA.  In a BDA, regardless of the age of the beneficiary, you must take Minimum Required Distributions now.  The rate is based on the age of the benefactor at death, the current age of the beneficiary, and the previous year end account value according to IRS tables (HCMI does this calculation every January for BDA holders.)  The beneficiary can’t make further contributions to the BDA.
10. Taxable Investment Accounts – Clients can always save additionally in regular taxable accounts including Individual, Joint, Tenant-in-Common and Trust accounts.  The assets do not grow tax free, but, if invested for capital growth and dividends, the maximum Federal tax rate is 15%.  Income tax rates apply to interest income, but this can be mitigated with municipal bonds.  One key advantage: there are no restrictions on taking money out for non-retirement reasons.
11. Social Security – The maximum Social Security benefit in 2007 is $25,392 at age 66 for a single recipient, $38,088 for a married couple including a non-working spouse, and $50,784 for a married couple where both worked.  Actual sums will depend on your work history.  If you haven’t received a Social Security Statement in a while, order one at http://www.ssa.gov/mystatement/ and check your history for errors and omissions.

Distribution strategies

After a life time of accumulation, how and when can clients actually take distributions?  With the exceptions of Beneficiary Distribution IRA’s and for reasons of health, the earliest you can take money out of these plans is at 59 ½ (62 for Social Security, but your monthly benefit will be reduced.)  However, we encourage our clients to hold off on withdrawing from IRA’s as long as possible, preferably right up to the mandatory withdrawal age of 70 ½. 

The reason has to do with taxes.  With the exception of Roth IRA’s, every dollar drawn from an IRA is taxed at your income rate (for example, 35 cents on the dollar if you’re in the 35% Federal Tax Bracket.)  By comparison, every dollar drawn from a taxable account incurs tax only if drawn from an asset sold at a profit.  For example, if a client sold stock with a long term cost basis of $0.85 to raise $1.00 then the tax is ($1.00-0.85) *15% (Federal LT Capital Gains Rate) or about 2 cents per dollar.  If we can net out capital gains and losses in a taxable account, we can also net out taxes on withdrawals.

This tax imbalance has further implications:

1. Within ten years of retirement, we reduce investment risk by upping the percentage of income instruments (bonds, REITS etc.) and reducing the level of stocks.  We place the income producing investments in IRA accounts to defer paying tax at the higher income rates (up to 39% Federal).  You’ll only have to pay tax when you withdraw the funds from the IRA.  We retain the capital gains and dividend producing investments in taxable accounts to take advantage of the lower capital gains and dividend rates (up to 15% Federal.)
2. We want clients to stop making additional investments to IRA accounts within 5 years of drawing on those accounts if there’s no tax benefit today of those contributions.  If you put a dollar into your taxable account today, and take it out tomorrow, there’s no tax.  If you put a dollar into your regular IRA account today, and you get no tax benefit on that contribution because you’re also covered by a 401K, then if you take that dollar out tomorrow, you’ll owe 35 cents in tax (assuming the 35% Federal bracket.)  In that situation, it takes about 5 years of growth at 8%/year, just to break even. 

After a client turns 70 ½, you must take distributions from all IRA sources except Roth IRA’s.  Every January, HCMI calculates the Minimum Required Distribution (RMD), which is computed based on the year value of the account, the age of the client, and life expectancy tables from the IRS.  In December, we confirm that the total MRD amount for the year has indeed been transferred; otherwise, the client could be subject to an IRS penalty.

The client has the choice of taking a lump sum distribution, monthly, quarterly or semi-annually distributions.  The distribution can be made as cash directly to the client’s checking account or to another taxable account at a brokerage.  With brokerage accounts, the client can elect to receive either cash or securities, including stocks, bonds or mutual funds.  The client can elect to have taxes withheld on the distribution, or can pay the taxes owed separately.

Every February, your IRA custodian will issue a form 1099-R showing the amount distributed from your IRA for the previous year and also if any taxes were withheld.  You’ll need to give that form to your accountant.

How Heron Capital Management, Inc. can help 

·         HCMI manages Defined Benefit plans for corporations, and advises individuals on investment strategy in their regular, SEP, SIMPLE, Keogh, Beneficiary Distribution and ROTH IRA’s, and can optimize tax planning between these accounts and taxable accounts such as Individual, Joint, Tenant-in-Common and Trust.

·         HCMI advises individuals on how to rebalance their 401K’s and recommends that such rebalancing be done every 1-2 years.  Because 401K’s have limited investment choices, we provide this service as part of the overall relationship without charging additional fees.

·         HCMI advises clients on how to withdraw assets from their taxable and non-taxable accounts in retirement to optimize their tax situation.

·         HCMI tracks Minimum Required Distributions (MRD’s) to ensure that clients aren’t subject to IRS penalties.