[This is one of my monthly columns I wrote for MDMag.com (formerly Physician Money Digest) about decumulation strategies. It originally ran here.]
Physicians and other high-income professionals may spend 20 to 40 years accumulating money inside tax-free (Roth), tax-deferred, fully taxable accounts, and even cash value life insurance.
By the eve of retirement, many of them are quite well-versed in the advantages and disadvantages of the various types of savings, investing, and retirement accounts with regards to the accumulation of money. However, very few have given a great deal of thought to the process of actually spending the money.
It is not that they cannot think of vacations to go on, toys to buy, and grandkids to spoil. It is simply that they have not determined the best way to take their accumulated nest egg and, in a tax-efficient manner, ensure it lasts longer than they do while maximizing their ability to spend and the money they can leave behind to heirs and their favorite charities.
This article will discuss some of the main themes of the decumulation phase (as opposed to the much more straightforward accumulation phase) and give the individual investor some guidelines to determining how best to withdraw and spend his or her money.
Strategies For Decumulation in Retirement
Guarantee Your Needs With Annuities
An immediate annuity—particularly an inflation-adjusted immediate annuity—should play a role in the decumulation stage of most investors. Immediate annuities are similar to the increasingly rare employer-provided pension, whereby the employer pays you a certain amount every month in retirement until the day you die. Social Security is a similar form of annuity.
Many investors are not aware they can purchase their own annuity from dozens of insurance companies. Basically, you take a lump sum of money and give it to an insurance company in exchange for a guaranteed payment every month for the rest of your life.
Since pensions, Social Security, and annuities are guaranteed, they allow you to spend more of your money each year. A good general guideline for how much of a balanced portfolio you can spend each year in retirement, while having a reasonable expectation that the money will last, is 4%. So a $1 million portfolio can be expected to provide an inflation-indexed income of about $40,000 per year. However, if you annuitize a lump sum at age 70, you can enjoy an income of over 8% on a nominal basis, or over 6% on an inflation-indexed basis. In short, by annuitizing, you can safely spend 50% to 100% more in retirement!
The basic concept here is that you guarantee your income needs using guaranteed sources of income like Social Security, a pension, or an immediate annuity. Then, you use your remaining portfolio of stocks, bonds, and real estate to provide for your wants, vacations, new automobiles, college money for the grandkids, charitable giving, and inheritances. Along these same lines, one of the best deals in annuities out there, at least for single people and the higher-earner in a couple, is to delay Social Security to age 70, at least if you enjoy good health.
Determining how much of your portfolio to annuitize can be difficult, but an honest assessment of your true spending needs should get you most of the way there. Also, be sure to consider the maximum annuity size your state insurance guaranty corporation will back in the event of insurance company bankruptcy. The guaranteed amount is state-specific, but typically in the $100,000 to $300,000 range. If you desire to annuitize more than this, you may wish to purchase annuities from more than one company.
How to Approach Required Minimum Distributions
A typical investor will arrive at retirement with a tax-deferred account, a smaller tax-free or Roth account, and a taxable investment account of some size. Prior to age 70, the investor can withdraw from each of these accounts in any manner he or she should so choose.
Beyond age 70, the investor is required to at least withdraw the required minimum distribution (RMD) from the tax-deferred account. This amount is as small as 3.6% of the portfolio at age 70 but rises to 5.3% at age 80, 8.8% at age 90, and 15.9% if you are lucky (or unlucky) enough to live to 100 years.
Just because you withdraw that money from the tax-deferred account doesn’t mean you have to spend it; you can always reinvest it in a taxable account.
Who Do You Want to Pay the Taxes?
If your desire is to minimize the amount of taxes you pay during your lifetime, the best way to do that is to take only the minimum out of the tax-deferred account, and then spend from the tax-free account by borrowing from life insurance and selling taxable investments with a high basis (meaning they’re not worth much more than you paid for them) at the long-term capital gains rate.
However, your heirs would prefer that you choose to spend a little bit differently. The best asset to inherit is a tax-free account. Not only are there no income taxes due upon inheritance, but that account can be “stretched” providing decades of additional tax-free growth for the heir(s). Taxable assets are also a fantastic inheritance. Since the basis on the investment is “stepped-up” as of the date of your death, there are no income taxes due to the heirs on that inheritance.
Life insurance proceeds also make for excellent inheritances, although, given the low returns of cash value life insurance, the amount you leave behind is likely to be less than if you had simply used a taxable account in the first place. On the other hand, if they inherit a traditional IRA, all of that money is “pre-tax” and so every withdrawal from the account is associated with a tax bill.
If your goal is to minimize the overall tax bill due, a careful balancing act must be maintained.
Charitable Giving
If charitable giving is a big part of your estate plan, you should also consider where that contribution should come from.
Charitable giving is a fantastic use of a tax-deferred account. When the charity inherits the IRA (or receives a distribution from it) neither you nor the charity will owe income taxes on that money. So if you have a $1 million IRA, you can either give your children $600,000, or you can give the charity $1 million.
Taxable assets are also a great charitable gift, especially for low-basis assets given during your lifetime, since you get the full deduction for the gift and the charity won’t owe any capital gains taxes on it.
Compared to a tax-deferred account, leaving a Roth to charity seems a waste.
State Taxes
Another benefit of decreasing the relative size of the tax-deferred account, either by spending or charitable giving during your lifetime, is that this account partially belongs to the government. But if the size of the estate is greater than the estate tax exemption amounts, the estate will owe estate taxes on both your portion and the government’s portion of the accounts.
Cash Value Life Insurance
In general, I recommend against using cash value life insurance (such as whole life) as an investing and retirement account. Although it has certain asset protection, tax, and insurance benefits, these benefits cannot usually overcome the typical low returns and high fees associated with these policies.
However, if you own cash value life insurance, that money can be used for retirement spending, charitable giving, and perhaps most beneficially, as an inheritance for heirs. The key concept to remember is that during your life the cash value is borrowed from the policy in a tax-free, but not interest-free, manner.
| Best Account | |||
| To Minimize Your Income Tax | To Leave to Heirs | To Give to Charity | |
| 1. Tax-Free | 1. Tax-Free | 1. Tax-Deferred | |
| 2. Life Insurance | 2. Life Insurance | 2. Taxable | |
| 3. Taxable | 3. Taxable | 3. Life Insurance | |
| 4. Tax-Deferred | 4. Tax-Deferred | 4. Tax-Free | |
Finding the Balance
Most investors are trying to find the right balance between maximizing retirement spending and the size of their bequests, while minimizing taxes now and taxes paid by their family. A balanced strategy is likely to work best.
Delaying Social Security until age 70 and maximizing any employer-related pensions is a good first start. The next step is annuitizing sufficient tax-deferred assets (or exchanging life insurance cash value into an immediate annuity) to provide for basic needs not covered by Social Security and pensions.
Dividends, interest, and rents from the taxable accounts are added at this point. Then, take out the RMDs from the tax-deferred account. Beyond this, withdrawing from tax-deferred accounts up to the top of the lower tax brackets (10%, 15%, and perhaps even 25%) is a smart move. Then, sell taxable assets with a high-cost basis. If cash value life insurance was purchased, it can be borrowed tax-free (but not interest-free) at this point.
If additional income is needed, tax-free assets can be tapped or low-basis taxable investments can be sold. In general, the goal is for inheritances to be composed of as much tax-free money, taxable money and life insurance as possible, with the remainder of the tax-deferred account being left to charity.
For most investors, the decumulation strategy is going to be more complicated than the accumulation strategy, especially when it is combined with estate planning. However, like with anything in personal finance and investing, failing to plan is planning to fail.
What do you think? Did I miss something? How do you plan to decumulate your assets? Comment below!
I still love asset protected taxable accounts. Capital gains rates, tax loss harvesting, step-up basis at death are powerful wealth building tools. No RMD’s! An annuity seems to add an additional level of risk (the insurance company) and fees.
While there is some risk of the insurance company going out of business, that risk is low, and is lowered by state insurance guaranty corporations, it lowers a far more important risk, longevity. On average will you do worse than you would investing the money yourself? Of course. That’s the price of the insurance.
I just recently mull over Annuity topic and would appreciate more writing over it—it looks more than 3 years since you last article on it? any update?
thanks
Has something changed with regards to annuities that would need an update? Rates haven’t even changed much.
Dr. D – excellent article. I recently commented on a posting about 10 pay life and got criticized for trying to make my response more complicated by suggesting I needed more information to properly answer the posed question. My comment here is say that again, how you decumulate starts with the client, and how they want and expect to live out their lives. From an advisory perspecetive, having all the variables at your mental fingertips is critical. And this influences when you apply and how you apply for Social Security, knowing there are arguments in favor of waiting as long as possible as opposed to finding which one of the possible 97 months generates the most income. And that assumes you live to normal life expectancy, which is not a given. It comes down to a dialog between the client and his or her ability to figure it all out for themselves, or to reach out to a trusted advisor for help.
Of course it starts with the client. If a client doesn’t have any Roth assets, it simplifies things greatly! But unfortunately, when writing for tens of thousands of readers, you have to generalize a bit. If someone wants information more personally directed to their situation, they can hire an advisor for a few hours.
Good article for a general starting point.
The annuity rates seem high. I’m seeing 6.5% for a fixed annuity male, age 70 and closer to 4.9% for an annuity adjusting 3% for inflation. This may seem like a small change, but makes a huge difference. Also a single male waiting until age 70 makes the annuity case look much better than it really is. When you add in a spouse, retiring younger, and maybe goals of passing assets to the kids the picture isn’t quite as rosy. Many of your readers may be more in this type of scenario, so it might be worth making them aware of this. As you know I’m all for a good annuity in the right situation, but once you take into account loss of future flexibility for withdrawals, tax planning, etc. I typically ends up being an exception more than the rule.
There’s nothing that says you have to annuitize all or even a majority of assets. But it can make sense to annuitize a few hundred thousand because it makes it decreases risk.
Those were the rates I saw a few months ago when writing that chapter of my book. Rates have fallen a bit since then, but not as much as your figures indicate. Maybe I should send you the sources I get quotes from as yours don’t seem that competitive!
SPIA definitely has its uses. I find that, ironically, that it’s use is almost a given in the case of a 70-year old with very limited assets who wants to make sure that they don’t outlive their income. However, for someone with significant after-tax assets, SPIA is probably not the best solution. Several hundred k will not make much of a difference as far as income, and going all in when interest rates are lowest is the best way to lock yourself in at the bottom. Also, SPIA generates taxable income. If you have significant pre-tax assets with a large RMD, SPIA will be taxable at the higher brackets, so a preferred approach to generating after-tax income (for those in the higher tax brackets in retirement) is to use individual municipal bonds. This way you can protect yourself against interest rate increases by properly structuring the portfolio, as well as to generate a predictable stream of income without having to worry about taxes.
Several hundred thousand does make a difference when you have a million dollar portfolio plus inflation. When you have a $10 Million portfolio, not so much. But let’s take a guy who needs $80K of income, gets $30K from SS, and needs $50K from a $1 Million portfolio. That’s more than the 4% rule would allow. So annuitizing some of the stash reduces his risk. If he gets 8% out of a $200-400K annuity, that’ll provide $16-32K in income, so now his $600-800K portfolio only has to provide $18-34K in income, or 3-4.25% withdrawal rate instead of a 5% withdrawal rate- lower risk of running out of money.
If you have significant pre-tax assets, you’ll pay a high tax rate on taking that money out, whether you do it as RMDs or as SPIA income.
My only problem with SPIA is that you lock up the money, and if interest rate rises in the future (which is bound to happen someday), the effect can be devastating. For someone who can not afford to outlive his money (and who is old enough, or 70+), SPIA is the only guaranteed solution. But for someone with a larger portfolio, they can certainly avoid locking their money in if they don’t have to do that (whether they wait until interest rates rise or wait until they are older).
Right now the market is seriously dislocated as far as fixed income. If the interest rate rises significantly, a 5-year CD can yield 4%-5% a year. Heck, a money market used to yield that much. That’s why the risk of running out of money is balanced with the risk of not beating inflation when locking in your money for 30+ years in retirement.
So one way to play this would be to buy SPIA say after you are 70+, ideally when you are 75 or so to get the highest rates, and not before that. Prior to that it might be better to invest in bonds (a little tougher to do pre-tax, but corporate bonds and even treasuries might be a solution).
Sure, I agree that the later you buy a SPIA the higher the rates. And of course if you buy a nominal SPIA you are running inflation risk. And of course you lock up the money. The higher rate and guarantees are paying you for that. While it is a great solution for someone without much of a portfolio, it also reduces longevity risk to annuitize some portion of even a larger portfolio. Many physician retirees will find that annuitizing a portion of their nest egg will be a good move.
The article is very good, but I would suggest keeping in mind that it is possible for high earners who start saving early and defer a lot in IRA/pension accounts that over time the amount grows large enough that your RMD and social security benefit cause you to be in a relatively high tax bracket making your tax planning more complicated and low tax brackets for dividends/gains limited.
Absolutely true. Although that problem is a lot more rare than most people think. Almost all Americans and the vast majority of physicians have undersaved for retirement. Many physicians in their late 50s still have a portfolio under $1 Million.
My math at age 68 did not make sense
500k-2400/month joint. Guaranteed 20 yrs
Will come out ahead buying munis at 3.5 and keeping the 500k