Taxes and inflation have this nasty way of diminishing your money in retirement.
Investors who have amassed a $1 million portfolio find that this money has a way of shrinking before they have spent a cent of it. That’s the dispiriting message of Lewis Walker, a financial planning and investment strategist at Capital Insight Group in Peachtree Corners, Ga. He sketches out this problem—and what you can do about it:
Larry Light: So we have a lot of millionaires these days?
Lewis Walker: Adam Shell of USA Today has noted that the number of 401(k) millionaires hit a record high. As of June, 168,000 people had $1 million in their Fidelity 401(k) accounts, versus 118,000 people a year earlier.
When folks squirrel away more money to support financial independence, that’s wonderful. Of the 1% of Fidelity account holders who reached the $1 million milestone, they know it took time. They stayed diligent about contributions, allocating mostly to stocks, perhaps increasing contributions in down markets when equities were on sale.
Light: But that $1 million is deceiving, right?
Walker: Assuming that $1 million is the result of growing tax-deferred dollars in a non-Roth account, do you really have $1 million? Not really. You have a partner with his hand ultimately in the pot, Uncle Sam’s bagman, the IRS. All distributions from a qualified retirement plan are taxed as ordinary income.
Suppose you wait until age 70½ to begin taking distributions, allowing the account to continue to grow. You take the minimum amount mandated under required minimum distribution (RMD) rules. Using the lifetime table to figure your RMD, if the value of your account was $1 million at the start of the year you take your distribution, your first RMD is $36,496.35. Taxed at a 20% average (not marginal) federal plus state tax bracket (if applicable), you have $29,197.08 to spend, or $2,433.09 per month.
Light: What about Social Security? That’s a good income supplement. What’s the tax situation there?
Walker: Yes, Uncle Sam is not done with you by a long shot. For annual provisional income over $32,000, single, or $34,000, joint, 50% up to 85% of your Social Security income may be taxed. Provisional income equals adjusted gross income (AGI), not including Social Security, plus tax-exempt interest. Who dreams this stuff up? Many are surprised to learn Social Security benefits may be taxed.
Light: What about Medicare, another big benefit for retirees?
Walker: Medicare also isn’t free. Medicare Part B premiums have five tiers ranging from $134 per month up to $428.60 per month ($1,608 to $5,143.20 per year). This doesn’t include premiums for prescription drug plans or supplements. The Part B premium calculation is based on your AGI two years back. Retire in 2019 and the premium is based on your 2017 income, likely higher than in 2019 since you were still working.
The brutal fact is that $1 million dollars, while certainly not crumbs, ain’t what it was. You plan to live in retirement for 20 years. It takes $1,530,000 in today’s dollars to equal the buying power of $1,000,000 back 20 years ago, 1998. The annual inflation rate over that time frame averaged 2.14%.
One or both of you, if married, could live 30 years or more in retirement. It takes $2,140,000 to buy what $1,000,000 did in 1988. The average annual inflation rate over the last 30 years was 2.56%. Trailing one-year all-items inflation currently is running at 2.9%, higher than the average of the last 20 to 30 years.
Light: Is there any bright side?
Walker: When you add the tax and inflation drag to your savings calculation, you must get serious about building investment net worth. The good news is that in the Fidelity study, the average balance in their 401(k) plans was $106,900, up almost 7% from the year before. A long-lasting bull market has helped.
More workers are signing up to contribute and fewer are raiding plan balances to take out loans (not recommended except as a last resort). Since 2008, the average savings rate of employees has jumped to 6.7% from 4%, reflecting growing confidence in the future.
Before retirement you depend on work for your paycheck. You don’t worry about periodic stock market declines. Dollar-cost-averaging works. In a down market you get more shares for your contribution than you do when equities are expensive. But when you no longer have work-related income, you look to retirement savings accounts for your paycheck or “playcheck.” You worry about volatility and ask if you should get more conservative in your investment policy?
Light: What can you do?
Walker: The answer varies with individual or family circumstances, your need for a certain cash flow to run your life and feel secure, and other considerations that make up a retirement cash flow plan. If you are going to spend 4% of your retirement cash flow net of tax, you have to have a gross return of 8.625% annually to overcome inflation at 2.9% and taxation at an average tax bracket of 20% federal and state. Balancing reality and peace of mind is inherent in the planning process.
A writer of inspirational books, Catherine Pulsifer, said, “Planning to retire? Before you do find your hidden passion, do the thing that you have always wanted to do.” Money does not provide purpose and meaning. If your ultimate goal on your last day is to hear, “Well done, my good and faithful servant,” how does money figure into the richness of a life that lives up to that final achievement?”
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