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

Mike and Julie’s tax-free retirement income case study illustrates the power of strategic income planning for your retirement years.

This is the third installment of a tax-free retirement income case study that I have adapted from the book Tax-Free Income for Life by David McKnight. It may reference The Power of Zero, another book by David McKnight.

In this article, I’m excited to bring you the conclusion of a case study featuring Mike and Julie, a hypothetical couple using a comprehensive approach to a tax-free retirement income. If you missed the earlier installments, catch up on Part I and Part II. In the last article, we satisfied the Smiths’ cash flow needs in their first year of retirement. Here, we will pick up with how to allocate the balance of their portfolios in years two through five and beyond. Let’s get started!

As a quick recap, Mike and Julie implemented their LIRP in our last installment. They calculated the income gap, determined the lump-sum contribution to their Fixed Indexed Annuity, determined their annual Roth conversion amount, and allocated non-annuity assets to time-segmented portfolios. Now, we move forward in their story.

Tax-Free Retirement Income: Portfolio 1 (Years 2 and 3)

Because the Smiths won’t need to access the money in Portfolio 1 for at least a year, they can afford to take some risk with this money. They want to take precisely the amount of risk that corresponds to this one-to-two-year time horizon. If they can grow this money at 2.5 percent per year, they can stay within shouting distance of inflation.

The Smiths don’t want to allocate any more money to this portfolio than is required to meet their cash flow needs in years two and three of retirement. Every dollar that is unnecessarily allocated to a 2.5 percent portfolio is one less dollar that can be allocated to the high-octane, aggressive-growth portfolio reserved for all post-Roth conversion investment dollars.

We can ensure that the amount we contribute to this portfolio is precisely the right amount by performing several calculations:

First, the Smiths must determine the amount of money they’ll need at the beginning of years two and three to pay for their inflation-adjusted lifestyle needs. Assuming an annual inflation rate of 3 percent, they’ll need $82,400 at the beginning of year two and $84,872 at the beginning of year three, for a total of $167,272.

Second, we add in $90,000 ($45,000 x 2) to fully fund their respective LIRPs for both years.

Finally, we calculate the taxes on their lifestyle, LIRP contributions, and $157,000 Roth conversions for each year. That total equals $64,558 for year two and $65,119 for year three. That means their total cash flow needs are $191,958 for year two and $194,991 for year three.

Next, we perform a net present value calculation on that total— the total of $191,958 and $194,991 which are from years 2 and 3— to determine the deposit necessary in year one to achieve the required distributions by the beginning of years two and three, given that 2.5 percent annual growth rate. A quick net present value calculation (a financial planning calculator comes in handy here) gives us the answer: $372,871.

Total allocation to Portfolio 1: $372,871

SEE ALSO: Aligning Your Tax-Free Stars


Tax-Free Retirement Income: Portfolio 2 (Years 4 and 5)

Now that we’ve laid the philosophical foundation for how to allocate dollars toward Portfolio 1, the allocation for Portfolio 2 is easier to calculate. We apply the same 3 percent inflation rate to their lifestyle need, only this time over three and four years, respectively. Assuming a growth rate of 3.5 percent on the assets in Portfolio 2, we can then perform the same net present value calculation to determine the amount of money the Smiths need to deposit in year one to yield the appropriate balances by years four and five.

When we perform all of these calculations, we determine the total allocation to Portfolio 2 to be $354,139.

Total allocation to Portfolio 2: $354,139

Is This Plan Realistic? Let’s Explore the Details

Upon seeing the total cashflow requirements for years one through five, your first blush response might be, “Wow, that’s an expensive way for the Smiths to spend the first five years of their retirement!” While this seems true on the surface, let’s step back and appreciate the broader picture.

First, the cash required to meet their lifestyle needs is unusually high because the Smiths have yet to draw their Social Security. By postponing receipt of their Social Security until age sixty-five, they lock into a much higher benefit. In essence, they’re spending more of their assets in the short term to guarantee higher, tax-free, inflation-adjusted Social Security payments over the long term.

Second, the $45,000 annual LIRP contribution should not be considered an expense. Rather, it should be understood in the same light as the Roth conversion. The Smiths are merely repositioning a portion of their IRA to the LIRP, where it can grow safely and productively, and ultimately provide them with a death benefit that doubles as long-term care. What’s more, the LIRP will be a reliable source of tax-free income over the balance of the Smiths’ retirement.

Lastly, if the tax liability seems large, it’s because we’ve intentionally made it so. The Smiths are preemptively paying taxes at historically low tax rates on their own terms, so the IRS can’t force them to pay tax rates on the federal government’s terms somewhere down the road when they really need the cash. And don’t forget the silver lining: by shifting their money over a five-year period, the Smiths stay within the 24 percent tax bracket. Ten years from now they will look back at that 24 percent tax bracket as a good deal of historic proportions.

In short, the cash outlays during the Roth conversion period may seem unwieldy, but they’re calculated to permanently remove tax rate risk and longevity risk from the Smiths’ retirement by the first day of their sixth year of retirement.

Tax-Free Retirement Income: Portfolio 5 (Post– Roth Conversion Portfolio)

Any of the Smiths’ assets not earmarked for Portfolios 1 and 2 get allocated to Portfolio 5.

Remember, Portfolio 5 is a high-octane, aggressive-growth portfolio earmarked for discretionary needs once the Roth conversion period is complete. When the Smiths start drawing their guaranteed lifetime income in year six, they won’t be constrained to take distributions from their stock portfolio when the market is down. This allows them to take much more risk than they might otherwise have taken were they solely reliant on this portfolio to meet their lifestyle needs.

To determine the allocation to Portfolio 5, we simply add all the assets that have been allocated to cash, Portfolio 1, and Portfolio 2, and subtract that from the Smiths’ total non-annuity investments. Remember, in step 4, we allocated $700,000 to the fixed-indexed annuity, leaving us with $1.2 million of non-annuity assets. When we add the balances in cash, Portfolio 1, and Portfolio 2, we get $916,024. We then subtract that figure from their total non-annuity assets of $1,200,000. That leaves them with $283,976. That’s the portion of their portfolio that gets allocated to Portfolio 5 on their first day of retirement.

Incidentally, should the money in Portfolio 5 average 5 percent net of fees during the Roth conversion period, they’d have closer to $360,000 by the time they draw their guaranteed lifetime income. Furthermore, they will have contributed $225,000 to their LIRPs over that same time frame. Barring any major shock expenses in the meantime, these two accounts could have over $750,000 in cash by the time the Smiths reach age 70. That’s a robust pool of tax-free capital that can be easily tapped to pay for discretionary expenses over the balance of their retirement.

Note that when the Smiths reach age 72, they’ll have to start taking required minimum distributions. These distributions start at 3.91 percent of their cumulative IRA balances and go up from there. It’s critical that the Smiths monitor the growth of their IRAs to ensure their balances stay low enough that their RMDs are equal to or less than their standard deduction and low enough that they don’t cause Social Security taxation. Should the growth of the Smiths’ IRAs put them on track to produce excessively large RMDs by age 72, they can perform preemptive Roth conversions along the way.

Total allocation to Portfolio 5: $283,976

SEE ALSO: What You Need to Know About the Three Percent Rule: Part I


The Big Picture

By completing this six-step process, the Smiths will have created four different streams of tax-free income that land them in the 0 percent tax bracket by their sixth year of retirement. These four tax-free streams of income are as follows:

Roth conversion: This inflation-adjusted, tax-free stream of income comes from the Smiths’ fixed-indexed annuity.

LIRP: Tax-free income from the LIRP is most impactful when accessed in the eleventh policy year and beyond.

Required minimum distributions: So long as the Smiths take distributions from their remaining IRAs that are equal to or less than their standard deduction in a given year, these distributions are likewise tax-free.

Social Security: Provided the Smiths stay below their provisional income threshold, they receive their Social Security 100 percent tax-free. This requires that they closely monitor their IRA balances and distributions along the way.

Let’s not forget that they also eliminated longevity risk by electing a guaranteed, tax-free stream of income from their fixed-indexed annuity in year six.

The Smith’s Plan in Summary

Let’s review the step-by-step process designed to shield the Smiths from higher taxes in the future and eliminate longevity risk from their retirement picture:

Step 1: We sent the Smiths through the qualification process for the LIRP. This accomplished two things: it helped predict their life expectancies and it corroborated the viability of the LIRP strategy. We also determined that an annual contribution of $45,000 over 5 years would give each of them roughly $400,000 of death benefit. Thanks to the LIRP’s chronic-illness rider, they could each receive $100,000 per year over 4 years for the purpose of paying for long-term care.

Step 2: Upon approval of the Smiths’ LIRPs, we put their policies in force by contributing a total of $45,000 in the first year. This secured their death benefits and gave them long-term coverage. This also provided them a pool of liquid capital that can be accessed beginning in policy year eleven and beyond to pay for discretionary expenses.

Step 3: We calculated the Smiths’ income gap for the year immediately following their Roth conversion period. We did this by subtracting their lifestyle need ($80,000) from their anticipated Social Security benefit at age 65 ($40,000). We then inflated this number over 5 years to determine the size of their income gap in year six. This amount was $46,371.

Step 4: By using a growth rate of 4 percent and an anticipated withdrawal rate of 4.7 percent, we determined the Smiths would need to contribute $700,000 to their fixed indexed annuity in year one of retirement.

Step 5: In order to completely transition their FIA to tax-free, we determined that the Smiths needed to do a $157,000 Roth conversion every year for five years. This provides them with a guaranteed, tax-free, inflation-adjusted stream of income starting in year six of retirement. Coupled with their Social Security, this income is designed to completely remove longevity risk from their retirement picture.

Step 6: Because of the disproportionate threat of sequence-of-return risk during the five-year Roth conversion period, we allocated their liquid investments among a cash account and three additional time-segmented portfolios. The cash account is designed to cover their lifestyle expenses, LIRP contributions, and taxes during their first year of retirement. The capital required for the Smiths’ cash flow needs in years two through five was allocated to Portfolios 1 and 2. These portfolios are designed to provide safe and productive returns while shielding the Smiths from the insidious effects of sequence-of-return risk. Any assets not allocated to these three accounts were allocated to Portfolio 5. This high-octane, aggressive-growth portfolio is designed to fund their discretionary needs once the Roth conversion period is over.

By completing this 6-step process, the Smiths accomplish three important things. First, by repositioning a portion of their tax-deferred dollars in the tax-free bucket, they create multiple sources of tax-free income that land them in the 0 percent tax bracket and shield them from tax rate risk.

Second, by choosing a fixed indexed annuity that has a piecemeal internal Roth conversion feature, they create a tax-free, inflation-adjusted stream of income that is guaranteed to last as long as they do.

Lastly, by funding the high-octane Portfolio 5 and their LIRPs, they’ll have a substantial pool of tax-free capital designed to meet all their discretionary income needs over the course of their retirement.

Is a Tax-Free Retirement Possible for You?

It took a bit of heavy lifting along the way, but by the time the dust settled, our hypothetical Smiths emerged with a dynamic, proactive retirement strategy that shields them from tax rate risk and longevity risk. Would you like to know if these strategies can work for you, too? 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. I look forward to hearing from you!

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