Strategic Tax-Free Retirement Income: A Case Study Part II

This tax-free retirement income case study illustrates the power of a strategic income planning for retirement.

This is the second installment of a tax-free retirement income case study that has been adapted from the book Tax-Free Income for Life by David McKnight. It references The Power of Zero, also by David McKnight.

Most of the articles you’ll read here on this blog cover one or more aspects of a comprehensive approach to tax-free retirement income. In my last article, I introduced a case study featuring hypothetical couple Mike and Julie Smith in order to illustrate what it looks like when you put all the pieces of the puzzle together. In this second installment, I’ll pick up where we left off, which is at Step 2 of their plan.

Last time, we ended with the first step for Mike and Julie, which was to qualify for the LIRP. If you need a refresher, you can revisit that article here. Now, we move forward in their story.

Step 2: Implement the LIRP

Now that Mike and Julie are approved, their next step is to implement their LIRPs. This is accomplished by submitting the first-year contributions for both policies to the insurance company. In Mike and Julie’s case, this funding would come directly from their IRAs. Given their goal of completing their asset- shifting plan by 2026, and assuming death benefits of $400,000 each, they would need to shift a total of $45,000 per year for 5 years. We’ll talk about how to pay the tax on that $45,000 annual IRA distribution shortly.

The implementation of the LIRPs goes a long way toward removing long-term care risk from the Smiths’ retirement picture. What’s more, they’ll build a tax-free pool of money from which to pay aspirational and shock expenses later in retirement.

SEE ALSO: Aligning Your Tax-Free Stars


Step 3: Calculate the Income Gap

Our next step is to determine Mike and Julie’s retirement income gap. This will help determine what portion of their IRAs should be contributed to their fixed indexed annuity for the purpose of creating a guaranteed stream of lifetime income.

To determine Mike and Julie’s retirement income gap, we add up their anticipated sources of guaranteed income in today’s dollars, and then subtract that total from their total after-tax income requirement in today’s dollars. This after-tax income requirement should also include a small buffer amount for minor contingencies throughout the year. In the Smiths’ case, that calculation is as follows:

  • After-tax lifestyle requirement $80,000 (in today’s dollars)
  • Social Security $40,000 (in today’s dollars)
  • $40,000 (income gap)

Once we know Mike and Julie’s income gap, we have one additional step. Because their guaranteed lifetime income won’t begin until the Roth conversion period is over, we have to inflate their income gap over the intervening years.

When we inflate that $40,000 income gap at 3 percent over the five-year Roth conversion period, their future income gap is revealed to be $46,371. In other words, to close their income gap in their sixth year of retirement, they’ll need $46,371 of guaranteed lifetime income.

Step 4: Determine the Lump-Sum Contribution to the Fixed Indexed Annuity

Now that we know what Mike and Julie’s guaranteed, inflation-adjusted income need is in year six of retirement, we can back into the contribution they’ll need to make to their fixed indexed annuity (FIA) at the outset.

This two- step process goes as follows:

First: Project a Growth Rate

The first step is to project a growth rate for the FIA during the Roth conversion period. Because the growth of the FIA is linked to the upward movement of a stock market index, the Smiths’ initial contribution will have grown by the time they begin drawing their guaranteed lifetime income. The greater the anticipated growth rate over that five-year Roth conversion period, the less money they’ll have to contribute to the FIA on day one. In the Smiths’ case, we’ll use an average growth rate of 4 percent per year.

Second: The Guaranteed Lifetime Income Withdrawal Rate

The second critical variable that goes into calculating the initial contribution to the FIA is the guaranteed lifetime income withdrawal rate. This is the fixed percentage of income the Smiths can distribute from their FIA once they elect their lifetime income benefit. The longer they wait to draw this income, the greater their guaranteed lifetime income withdrawal rate. While percentages vary from company to company, a common withdrawal rate schedule might go as follows:

  • Age 61: 3.9 percent
  • Age 62: 4.1 percent
  • Age 63: 4.3 percent
  • Age 64: 4.5 percent
  • Age 65: 4.7 percent
  • Age 66: 4.9 percent
  • Age 67: 5.1 percent

As you can see, the longer the Smiths wait to draw a lifetime income, the higher the guaranteed lifetime income withdrawal rate once that income begins. Furthermore, the higher their guaranteed lifetime income withdrawal rate, the less they’ll have to contribute to their FIA at the outset to create the income necessary to close their income gap by year six. Given their need for guaranteed lifetime income starting at age sixty-five, we can apply a withdrawal rate of 4.7 percent.

SEE ALSO: An Approach to Tax-Free Retirement Income


Calculating the Contribution to the Fixed Indexed Annuity

Now that we’ve established how these two variables work, we can calculate the FIA contribution required to meet the Smiths’ inflation-adjusted income need by the end of their Roth conversion period. Given a 4 percent growth rate over 5 years, and a 4.7 percent withdrawal rate at age 65, Mike and Julie would be required to make an initial contribution of $700,000 to their fixed indexed annuity in year one. Considering those variables, they could lock into roughly $46,000 of guaranteed income for life in their sixth year of retirement. And given the ongoing growth of the underlying indexes, this guaranteed income can keep pace with inflation over the course of the Smiths’ retirement.

Step 5: Determine Annual Roth Conversion Amount

Because we want their guaranteed lifetime income to be 100 percent tax-free by year six, Mike and Julie will need to convert the entire $700,000 FIA over that 5-year time frame. Assuming the accumulation account grows at 4 percent per year, they’d need to convert about $157,000 per year. Now, while those annual conversions might seem large, they ensure the Smiths complete their Roth conversion before tax rates go up for good in 2026. More important, it keeps them in the 24 percent tax bracket. And by staying in the 24 percent bracket, they avoid having to pay taxes at the 28 percent bracket in 2026 when the tax sale of a lifetime draws unceremoniously to a close.

Step 6: Allocate Non-Annuity Assets to Time-Segmented Portfolios

A word of caution as we proceed into this section. The math here involves a lot of net present value calculations that can get complicated and messy. If you find this all a bit intimidating, don’t lose hope! I’ll be at your side, explaining and clarifying at every turn.

Ready? OK, let’s dig in. Because it took only $700,000 to close Mike and Julie’s income gap by year six, they still have $1.2 million to reallocate among their non-annuity investments. Mike and Julie currently have those dollars allocated in a traditional investment allocation of 50 percent stocks and 50 percent bonds. While such an allocation is less risky than a 100 percent stock market allocation, it won’t eliminate sequence-of-return risk during that 5-year Roth conversion period.

Given the massive consequences of sequence-of-return risk, the Smiths should allocate their non- annuity assets based on a time-segmented allocation model. The first step is to determine what portion of their non-annuity assets should be allocated to their cash account.

Cash Account (Year 1)

As a reminder, first-year expenses need to be paid out of a reliable account that isn’t subject to the ebb and flow of the market. This account should be risk-free and guarantee their money will be there when they need it. For those reasons, a cash account is the ideal source from which to pay the Smiths’ first-year expenses.

But how much money will the Smiths need to meet their cash flow needs in their first year of retirement? To determine this, they must first add the cost of their lifestyle needs, their LIRP contributions, and the Roth conversion amount for year one. This gives us their total gross income in their first year of retirement.

  • Lifestyle need $80,000
  • LIRP contributions $45,000
  • Roth conversion $157,000
  • Total gross income in year 1 $282,000

Their total gross income for year one of retirement is $282,000. This is an important number because it helps us calculate the Smiths’ total tax liability. Once we know their total year one tax liability, we can add that amount to the cash account as well.

Calculating the Tax

The first step in determining their year one tax liability is to determine their effective tax rate. This is the actual tax rate they’ll have to pay on their entire gross income. This can be done with the help of an online effective tax calculator.

A quick calculation reveals that $282,000 of gross income yields a total federal effective tax rate of 17.7 percent. Throw in another 5 percent for state tax, and that brings their total effective tax rate to 22.7 percent. This means they’ll need to allocate $64,014 for taxes their first year of retirement.

Now that we know the Smiths’ total tax liability, we can calculate their total cash flow need for their first year of retirement. Remember, their $157,000 Roth conversion is not a cash flow need and does not need to be accounted for in this calculation.

  • Lifestyle need $80,000
  • LIRP contributions $45,000
  • Total tax obligation $64,014
  • Total cash requirement $189,014

So, the total that needs to be allocated to their cash account for year one is $189,014. The next question that naturally arises is: From which bucket(s) will the Smiths distribute money to meet this total cash flow need?

Pay Taxes from Your Taxable Bucket

It’s important to remember that whenever possible, you should pay your taxes out of your taxable bucket. By doing so, you use your least valuable bucket (taxable) as a catalyst to shift your second least valuable bucket (tax-deferred) into your most valuable bucket (tax-free). This approach can help you maximize the amount of money you accumulate and ultimately distribute from your tax-free bucket.

In the Smiths’ case, they have $400,000 in their taxable bucket. This far exceeds the ideal balance for an emergency fund and is more than enough to pay for their tax obligations over the course of their five-year Roth conversion period. By paying their taxes out of their taxable bucket, they can whittle this balance down to a more manageable amount by the time they begin drawing their guaranteed lifetime income in year six. In doing so, they shrink this bucket’s tax obligations, which increases the likelihood they’ll reach the 0 percent tax bracket by the time the Roth conversion period is over.

In summary, the Smiths will shift $64,014 from their taxable investments to their cash account in year one to pay for taxes. They’ll liquidate an additional $125,000 from their non-annuity IRAs and transfer that to their cash account as well.

Total allocation to cash: $189,014

In Our Next Installment

Now, we’ve satisfied the Smiths’ cash flow needs in their first year of retirement. In my next installment,  Part III of this case study, we’ll discuss how to allocate the balance of their portfolios in years two through five and beyond.

In the meantime, feel free to read through the many other financial education articles on my blog. If you have specific questions or you’d like to speak with me and you are not yet a client, please schedule a strategy session today.

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