Converting Your Nest Egg To Income
Forecasts & Trends

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By Mike Posey


1. Retirement Income Planning Is Nothing New
2. The Five Basic Retirement Income Options
3. Projection Protection
4. A Word About Taxes
5. Periodic Monitoring Is Essential


In my July 24, 2007 Retirement Focus E-Letter, I kicked off a series of discussions about the various aspects of post-retirement planning. In that first installment, I dealt with the pros and cons of taking an annuity payment from a retirement plan. Later on, in my August 21, 2007 Retirement Focus issue, I discussed the issue of taking lump-sum distributions from retirement plans, and also how scam artists are gearing up for the millions of Baby Boomers who will soon be receiving these large payouts.

In this next installment of post-retirement income planning, I'm going to set the stage for a detailed discussion of the various ways to convert your retirement nest egg to income. As I have noted before, one of the biggest areas of concern that I get from E-Letter readers is how to take income from their retirement nest eggs, and how to invest so that they won't run out of money.

This week, I will be listing the various ways you can approach your retirement income needs. I'm also going to provide some important background information that you will need to know before seeking out the best way to convert your lump-sum distribution into income.

Since I am neither an attorney nor tax professional, it is important that you realize that what I present will be very broad guidelines and generalizations based on my retirement planning experience, and not specific tax, legal or investment recommendations. My goal is to briefly discuss enough options to at least give you some direction as you seek more specific advice.

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Retirement Income Planning Is Nothing New

It amazes me that the financial services industry is treating the thought of retirement planning as if it never existed before. The fact is that there has always been a need for retirees to figure out how much income they could take from their accumulated assets and how to invest those assets. Of course, today there are 78 million Baby Boomers bearing down on retirement, and the financial services industry sees this as a potential bonanza, the likes of which has never before been seen.

Thus, they are rolling out new "retirement" products, as well as dusting off some existing products with new names or marketing plans to appeal to those needing retirement income. Some are probably good, some are bad, but all are creatures of a new marketing emphasis on retirees. So, just be prepared for the onslaught of ads and promotions aimed at you, especially if you are at or near retirement.

Just remember that every person's financial situation at retirement is likely to be different from anyone else's, so there is no "one-size-fits-all" approach to retirement income planning.

Since retirement planning is nothing new, allow me to list some of the very basics of converting a lump-sum distribution into retirement income. When wages from employment cease and you are faced with managing a lump sum of accumulated retirement assets, there are essentially five broad options available to you:

  1. Continue to grow the money and take withdrawals only as needed or required by law - also sometimes called "legacy planning;"

  2. Take investment income without touching your original principal;

  3. Take a fixed dollar amount over a specified period of years or as long as your nest egg lasts;

  4. Systematically distribute both income and principal over your remaining lifetime, usually as a fixed percentage of assets each year, with an underlying goal of not outliving your money; and

  5. Give it away.

I will discuss each of these options in more detail in future Retirement Focus issues, along with ideas about how to invest for each of them. However, because of the importance of the decisions you need to make in regard to taking retirement income, I think it is necessary to first cover some information you need to know before making such a decision.

Projection Protection

As I noted above, financial services companies are working overtime to promote their retirement planning services, usually with an aging movie star touting their particular approach. The obvious goal of all of this promotional material is to get you to sit down with one of their representatives, discuss your retirement goals, and then produce a plan for what you need to do. With any luck (for them), this plan will convince you to invest with that firm.

Retirement projections are usually produced with the help of computerized programs that are designed to factor in a variety of variables. Obviously, some software programs are better than others, but all attempt to boil down the myriad of alternatives in order to help you make a decision about your retirement needs.

Now for the sad truth - much of the material you will receive will likely be what we call "boilerplate," which is just a term that means it is general information that applies to pretty much everyone, but is presented in such a way as to look as though it was customized just for you. It's not that there's anything wrong with the information, just that you don't need to feel sorry for the person presenting this, thinking they were up all night typing this stuff into a word processor.

Boilerplate aside, the real value of the planning process is that it forces retirees to focus on planning for retirement income rather than just putting the money in the bank and hoping for the best. However, it's important to note that the value of any pre-retirement or post-retirement computerized projection depends upon: 1) the accuracy of the input; 2) the number of variables considered; and 3) the way in which these variables are factored into the equation. At the very least, any retirement income projection should include the following variables:

  1. Expected Returns - The mutual fund industry has done an admirable job in educating investors about the long-term average returns available from various investment asset classes. However, that doesn't mean that you should necessarily crank these into a computerized projection for your retirement.

    For example, the long-term average annual return of the broad stock market is in the 11% range, plus or minus a bit, depending on the time frame. However, there have been a number of time periods of as long as 17 to 25 years when the stock market (as measured by the Dow Jones Industrial Average) has essentially gone sideways. When you are faced with a life expectancy of 20 years or so at age 65, it makes sense to make conservative assumptions about your future returns.

  2. Factor In Potential Investment Losses - Even more important than a consideration of long-term gains is the expectation of investment losses. One of the problems with even a conservative return expectation is that many software programs assume it will occur each and every year. However, the market is not likely to be that kind to you after you retire.

    Studies have shown that losses in the early years of retirement can have a very detrimental effect on your retirement income goals. This is true even if your eventual long-term gains equal or exceed your conservative estimate. That's because if you lose money in the early years when you are also taking income, your assets may be reduced to such an extent that you can no longer afford to continue the same level of withdrawals.

    Many good software programs include stress-testing factors that consider investment losses. One common method of illustrating the potential for losses is known as a "Monte Carlo" simulation, named after the gambling center in Monaco. A Monte Carlo simulation is simply a means of statistical sampling that tests a range of assumptions over literally thousands of trials. In the end, it provides an estimate of the likelihood of an event, such as running out of money during retirement.

    While the Monte Carlo method is not perfect and there are alternative ways to do statistical sampling, the important thing to remember is that such an evaluation helps you to come to the realization that your retirement portfolio may not always increase in value.

  3. Effects of Inflation - It is also important to factor inflation into your planning process because your income dollar 20 years from now won't buy what it does today. Most of the retirement software systems I have seen allow you to factor inflation into the equation, but it doesn't require you to do so. Thus, it's important that you make sure your Advisor adds this factor into the mix when doing retirement projections.

  4. Effects of Income and Other Taxes - I'll discuss taxes in more detail later on, but at this point, it's important that the effect of taxes be considered when projecting retirement income. This is an area where not all retirement software options shine, since factoring in all of the various tax issues can present quite a daunting programming task.

    One of the main things I want to mention in regard to income tax projection is the fact that if you need $2,000 per month to cover expenses, taking that exact amount of income from a fully-taxable retirement account will not net you that amount of money, after taxes. Thus, it's important that your projections factor in "tax shrinkage."

    Also, don't overstate the effect of taxes. I have seen a number of people use an income tax assumption that simply applies the marginal rate to all income, which is wrong. Someone in the 28% income tax bracket (married couples with taxable income between $128,500 and $195,850) pays 28% income tax only on each additional dollar earned over $128,500, not on the entire taxable income. In fact, a couple would have to have a taxable income of over $375,000 before their income tax bill would equal 28% of their taxable income, based on 2007 tax rates.

    By the way, it's also important to remember that income taken from accumulated retirement assets will not be subject to Social Security Tax (at least not under current law). I have seen some retirees use their pre-retirement total tax rate when factoring in taxes after retirement. That is not accurate, since the 7.65% paid to Social Security does not apply to retirement income, unless you are employed and earn wages.

    Sadly, it is also important to think about future tax policy as well. Back in the old days when I first started helping clients plan for retirement, all of our promotional material stated that one of the benefits of retirement plans was that they deferred payment of taxes on contributions and earnings until after age 65 when the retiree would most likely be in a lower income tax bracket. My, how things have changed!

    Even without Charles Rangel's "Mother of all Tax Reforms" that Gary recently wrote about, Baby Boomers retiring in the next few years may find that their tax bracket after retirement may actually be greater than it was when they were working. The Bush tax cuts that lowered income tax rates across the board are set to expire in 2011, unless extended or made permanent by Congress. With the Democrats in control in both the House and Senate, don't hold your breath until that happens. Thus, when planning for retirement income, it may be prudent to assume a higher level of taxation than might be applicable on income today.

  5. Life Expectancy (Mortality) - At age 65, males have an average life expectancy of approximately 16.33 years, while females can expect to live another 19.20 years, based on the Social Security Administration's Period Life Table. However, it's not a good idea to assume that your retirement income needs to last only that long. With continued advances in medical treatment, today's retirees can expect to live longer than any prior generation. Thus, I recommend that retirees "shoot for 100" in their retirement planning.

  6. Special Needs - As I have always maintained in these articles, retirement planning is a very individual thing. You may have special needs or circumstances that merit consideration in your planning process. Thus, it's important that you make your Advisor aware of any special situations, such as a chronic medical condition with associated costs, a special needs child, a desire to leave a legacy or even donate money to a charity. With many families having children later in life, it may also be necessary to plan for a college education out of retirement income, if you have not already otherwise done so.

In the end, however, you should know that a projection is a very imprecise planning tool designed to get you to take action. To the extent that it prompts you to do something about saving for retirement or making a decision on how to withdraw income from your nest egg, it is beneficial. However, you should not place too much confidence in any projection as it is, at best, an educated guess about the future, which is unknowable.

That brings up another point - just as you would get a second opinion about a serious medical condition, you need to get a second opinion in regard to your retirement decisions. After all, these decisions will determine your well-being for the rest of your life. So let me be characteristically blunt: if insufficient or inaccurate assumptions were made, it's not going to be your broker or financial planner who may be faced with the consequences of outliving your money - it will be YOU.

So, you need to do all you can to make sure you make the best possible decision, and this includes getting a second opinion. It also means that you should periodically monitor your progress, but I'll talk more about that later on.

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Planning Retirement Income Needs

As a financial planning professional, I personally think it is unproductive to simply select a certain percentage of assets to withdraw each year for income purposes. Sure, it may be fine as a general guideline for someone far away from retirement, but for someone nearing retirement, I think better alternatives exist.

I personally like the budgeting approach to assessing retirement income needs for those about to retire. As you near retirement, get out your pencil and ledger pad and start budgeting what your expenses will be. One good way to do this is to use your pre-retirement budget as a guideline, and make adjustments where necessary. If your home will be paid off by then, you can take off the mortgage payment and leave only insurance and taxes. If you plan to travel a lot, gasoline and other travel-related expenses may actually be greater after retirement, but you may be able to get by with just one car for everyday needs.

You may find that your post-retirement expenses will be far less than pre-retirement levels, but you might also discover that they're not going to be much (if any) less. Doing a line-item budget is one way to customize the retirement planning process for your own personal situation.

Once you get your estimated budget together (and don't forget to add a little "fudge factor" for an occasional Starbucks coffee or expenses you didn't think of), then see how that compares to your estimated Social Security and any pension income you may be able to count on. The difference (if any) will be what you will need to fund from your accumulated retirement assets.

The benefit of this exercise cannot be overstated. In many cases, it's necessary for the retiree to go back and adjust estimated spending to "fine tune" the withdrawal percentage in order to have a better chance of making the nest egg last throughout retirement. It's far better to budget expenses early on than to draw down on assets so far that you're destitute in your golden years.

More About Taxes

Just as important as the investment planning for retirement is tax planning. When you have multiple sources of retirement income that may include a combination of personal savings and investments, Roth-type retirement programs, IRAs and other qualified retirement plans, it's important to consider all of the tax issues.

While I'm not a CPA or tax professional, there are some general guidelines I can provide as you plan for your retirement. That way, you can do some of the necessary groundwork before consulting with your Certified Financial Planner, CPA or other professional tax counsel. In general, you should categorize your retirement assets into the following broad categories:

Tax-Free Sources of Retirement Income: Principal withdrawals from these assets do not create a taxable event, but earnings may be taxable each year. Many Financial Advisors will recommend taking initial retirement income withdrawals from these assets, thus allowing any tax-qualified accounts such as traditional IRAs and annuity contracts more time to grow tax-deferred (more about that below).

However, it's generally not a good idea to completely deplete these assets, since it may be wise to keep some as a "cushion" that can be withdrawn tax-free for emergency expenditures. The various types of assets that can be withdrawn without tax consequences include the following:

  1. Roth IRA or Roth 401(k) distributions held for the required time period. Both principal and earnings may be withdrawn tax-free as long as certain guidelines are met.

  2. Potential tax-free gain from the sale of a principal residence, over and above what is needed to purchase a retirement home. Under current law, a married couple filing jointly may keep up to $500,000 ($250,000 for single filers) of gain tax-free, creating a large pool of assets from which to draw future retirement income. However, you must qualify and special rules apply, but it's worth checking out.

  3. CDs, money market accounts or other personal savings. Personal savings that are not part of an IRA or 401(k) type plan may always be withdrawn without taxation. However, annual earnings may be taxable, and some of these savings vehicles also have early withdrawal penalties. So, it's important to plan withdrawals to coincide with maturity dates.

    Municipal bond investments may also be a good source of tax-free income, since earnings are not currently taxed for federal income tax purposes. However, some of these bonds may be subject to state income tax, so check with a local tax professional before investing in these instruments.

  4. Non-interest bearing cash accounts such as demand deposit accounts. I am sometimes shocked at how much money some people will keep in a checking account that pays no interest. One old soul I recall said she didn't want to put it into savings because she'd earn interest and then have to pay the IRS more money.

    For the record, I don't recommend keeping large amounts of money in non-interest bearing checking accounts. However, to the extent that you do, these demand deposits are usually the most liquid of all cash investments, so they can be called upon to cover expenses without delay.
  5. Social Security Benefits. Unfortunately, many retirees think that their Social Security should fit in this category with benefits flowing to them tax-free. For some, this may be true, but for anyone who has adequately planned for their own retirement, it's likely that up to 85% of their Social Security benefit will be subject to income taxation. This is an emotionally charged issue for many retirees and is far too complex to cover in this short space. However, you can get the full picture from my June 5, 2007 Retirement Focus issue in which I discussed the potential double-taxation of Social Security benefits.

Tax-Advantaged Sources of Retirement Income: There are some assets you may have that enjoy favorable tax treatment under certain conditions. If you have no tax-free sources of income as discussed above, or have drawn down these assets to the point that you need to supplement your income from other sources, these assets are usually the next in line. Examples of tax-advantaged sources of retirement income include the following:

  1. Annuity contracts. Even when not part of a retirement plan, certain types of annuity contracts have favorable tax treatment of accumulations and payouts. For example, money left to grow in a deferred annuity contract will generally do so on a tax-deferred basis, meaning that taxes are due only as withdrawn. However, penalty taxes may apply if money is withdrawn prior to age 59 1/2.

    Another type of annuity is an "immediate annuity," which pays guaranteed income as long as you live. This treatment also helps to spread out taxation on gains in the contracts. One criticism of annuity contracts, however, is that they convert tax-favored ways of receiving income such as long-term capital gains and dividends into ordinary income, which is generally taxed at higher rates under current law.

    Thus, you need to consider the tax status of your accumulated assets before deciding upon an annuity. Plus, you should be aware that there are many different types of annuity contracts, and some have high fees and expenses that could offset any favorable tax treatment. Just be sure to do your homework before purchasing any annuity contract.

  2. Appreciated property such as stocks, bonds or real estate. Many types of property with appreciated values can continue to shelter the appreciation from current income taxation as long as they are not liquidated. Careful planning for the liquidation of appreciated assets is absolutely necessary, and can be especially important in light of favorable long-term capital gains rates now in effect. In addition, some stocks pay dividends that can also be a tax-favored way to receive income under current law.

  3. Collectibles (including your gold hoard). I remember once talking to an individual who had a whole room full of valuable antiques that he called his "401(k) Plan." Obviously, he felt more comfortable investing in tangible assets rather than contributing to a retirement plan. One benefit of art and collectibles is that any appreciation is generally not subject to tax until sold.

    However, it is important to note that collectibles are also not subject to any favorable capital gains income tax treatment, and this includes investments in gold coins or bullion (including some gold Exchange Traded Funds). Collectibles are also sometimes hard to value, hard to sell, usually produce no ongoing income and are not guaranteed to always increase in value. Unless you are a true expert in a certain collectible and know how to access a ready market when you need to liquidate, I'd pass on having them be your retirement plan. They're fine as a hobby, but can be far too illiquid for retirement income planning.

Fully Taxable Sources of Retirement Income: As the heading suggests, this final category describes sources of retirement income that are taxable from the first dollar. Because of this tax treatment, some Advisors recommend that, where possible, these "fully taxable" assets be allowed to grow tax-deferred and utilized last, when taxable income from other sources may be less. Examples of fully-taxable retirement income are as follows:

  1. Qualified retirement plans and Traditional IRA, 403(b), or 457 plan assets. As a general rule, employer-sponsored retirement plans allow assets to grow without current taxation until they are withdrawn. Upon withdrawal, however, any distributions are usually fully taxable at ordinary income tax rates.

    Some employers do sponsor retirement plans that incorporate after-tax employee contributions. In such cases, you will need for your Advisor to be aware of any such contributions, since distributions from this type of plan will be non-taxable to the extent that distributions represent the return of after-tax contributions.

    Distributions from retirement plans may be gradual or as a lump-sum. Lump sums are fully taxable as ordinary income, so they should generally only be considered if you plan to roll the distribution over to a Rollover IRA. Otherwise, the tax bite could be huge, depending upon other taxable income you may have.

    Another factor to consider in regard to traditional IRAs and various other types of retirement plans is that they require distributions to be made after age 70 1/2. These "Required Minimum Distributions" must be factored into your retirement planning projections, since failure to take a minimum distribution can lead to a penalty of 50% of the amount that should have been distributed.

  2. Other fully-taxable sources of income. There are a variety of other sources of income that are fully taxable, such as interest earnings on CDs even if the principal is after-tax money. In addition, any wages you earn will be fully taxable, though the tax bite may be less if your overall income is lower after retirement.

Other Tax Issues: Depending upon where you live, you may have other tax benefits available to you during retirement. For example, many of the states with state income taxes offer special provisions for taxpayers over age 65. In addition, some states offer property tax relief for seniors, such as expanded homestead exemptions, freezing of valuations, and some even offer deferment of property taxes.

Thus, tax planning above and beyond income taxes may pay dividends after you retire. This is especially true if you plan to move to another state. One good place to check out the total taxation issues by state is the Retirement Living state tax information web page at the following Internet address:

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Conclusion - Periodic Monitoring Is Essential

I hope that you have benefited from the above discussion about retirement planning. I'm sure that many of you are thinking that these points are really just common sense, and you're right. Unfortunately, some retirees will suspend their common sense when presented with a professional-looking computerized proposal. Just remember that any proposal is only as good as the assumptions used to generate it.

Even if you have never, ever used professional tax guidance before, I recommend you do so prior to retirement. I also recommend that you use a local tax professional rather than one on the Internet or through an infomercial. Some retirement tax benefits depend upon the state in which you live, and a local professional is more likely to know about them than someone who is headquartered all the way across the country.

And finally, it is essential to monitor your progress in regard to investment returns, living expenses, taxes, health care costs, etc., etc. to make sure you stay on-track. The nifty computer illustrations and Monte Carlo projections will not comfort you if they turn out to be off-target. It's not that financial services professionals don't care or have it out for you, it's just that they have no way to predict what's going to happen in the future. Yet, what happens in the future will have everything to do with your ability to live well in retirement.

Best regards,

Mike Posey


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Gary Halbert is the president and CEO of ProFutures, Inc. which produces this E-Letter. Mr. Halbert is also president and CEO of Halbert Wealth Management, Inc., an affiliate of ProFutures, Inc. Both firms are located in Austin, Texas. Halbert Wealth Management is a Registered Investment Advisor that offers professional investment management services to a nationwide base of clients, and specializes in risk-managed investments and its recommended programs include mutual funds, managed accounts with professional Investment Advisors and alternative investments. For more information about the programs offered, call 800-348-3601.


"Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc. are not affiliated with nor do they endorse, sponsor or recommend any product or service advertised herein, unless otherwise specifically noted."

Forecasts & Trends is published by ProFutures, Inc., and Gary D. Halbert is the editor of this publication. Information contained herein is taken from sources believed to be reliable, but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgment of Gary D. Halbert and may change at any time without written notice, and ProFutures assumes no duty to update you regarding any changes. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Any references to products offered by Halbert Wealth Management are not a solicitation for any investment. Such offer or solicitation can only be made by way of Halbert Wealth Management’s Form ADV Part II, complete disclosures regarding the product and otherwise in accordance with applicable securities laws. Readers are urged to check with their investment counselors and review all disclosures before making a decision to invest. This electronic newsletter does not constitute an offer of sales of any securities. Gary D. Halbert, ProFutures, Inc. and all affiliated companies, InvestorsInsight, their officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Securities trading is speculative and involves the potential loss of investment. Past results are not necessarily indicative of future results.

Posted 11-14-2007 5:39 AM by Gary D. Halbert