Retirement Income Planning – Spend early or make it last?

During our working years we plan for retirement or financial independence in part by saving maximally and investing in assets that are likely to appreciate.  While we are working and saving for retirement we are in the accumulation phase. As we approach retirement (within about 5 years) we continue accumulating assets and begin the process of distributing those assets to sustain our chosen lifestyle throughout retirement. When we use an income stream from our assets we have entered the distribution phase.

During the accumulation phase we all focus on portfolio returns and tolerate some volatility. We can weather market fluctuations and lack of liquidity since we are not dependent on the portfolio and have our earnings to support our lifestyle. The main objective is to pay required taxes, support our lifestyle, save, and establish a life that encourages us to flourish.

As we approach the time when our assets alone will be used to support our lives, it becomes essential that we address the nuances of how the assets will be deployed – this is termed Retirement Income Planning.

Retirement Income Planning addresses in a pro-active manner how to create a stream of income for our remaining days (using accumulated assets) once our income from work no longer fully supports our lifestyle. Since the retirement time horizon is unknown, we must marry wishes for early retirement or plans for having larger income distributions with having assets last through an unknowable lifespan.

Running out of money is never an option in retirement but leaving money behind is also not acceptable, if it limits your lifestyle. This balance becomes a challenge as lifespans extend and health preservation becomes more successful and expensive. The latest survey shows that couples aged 65 have more than half probability (56%) of at least one spouse living to age 92. Despite these findings many feel they will not live past 80 and yet, if healthy and productive, they might feel very differently once they reach 90. Planning effectively for longevity is essential and must be weighed against the benefits of early spending.

For Retirement Income Planning, we also need to manage tax liability since we want to be sure that assets last as long as possible, particularly tax-deferred assets that are taxed at ordinary tax rates on withdrawal.

A market downturn can more greatly impact a portfolio early in retirement or just before the distribution phase. In retirement, unlike in the accumulation phase, it is much more difficult for the portfolio to recover from a market downturn. A robust retirement income plan must include ways to deliver the needed income regardless of market behavior.

The new reverse mortgages are income distribution tools that retirees can use to access home equity as part of a retirement income plan. For some, they provide at least three advantages early in retirement: reduced tax liability, longer investment time for the portfolio, and enjoyment of their home until retirees are ready to downsize.

For all retirees preserving their purchasing power (not just preserving the dollar amount) is an essential part of an income plan. Failure to include inflation protection is evident when retirees hold little to no significant equity portfolio and the consequences are dire. Though annuity and pensions are useful income distribution tools they fail unless combined with a strategy that protects against inflation. Sustaining purchasing power is even more significant when considering healthcare expenses. Keep in mind that healthcare costs grow due to inflation and also as a percent of annual spending as we age.

Scenarios that use all available tools to address how to best deploy retirement income will provide each retiring person with confidence to spend early and throughout retirement without fear of outlasting their assets.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Should you be a landlord in retirement?

As you would expect, we often think about ways to supplement client retirement income and diversify a client’s finances beyond their market portfolio.

Owning one or more rental properties (commercial real estate) can provide a steady source of income and cash flow during retirement, with the added advantage of building owner equity (owner wealth). Once established, rental properties can also be a great resource to meet both planned and unexpected life events. And since they can be depreciated on your income tax, rental properties can provide a significant tax advantage while the asset actually gains in value. All this said, owning a rental property, let alone more than one, is not for the faint of heart. Without regular attention and constant re-appraisal, they can become a major headache and a huge liability.

The path to becoming a commercial real estate investor (a fancy way of saying “landlord”) often begins, innocently enough, with owning a single family home and then, for whatever reason, deciding to convert it to a rental. In this case, the property may need to be adapted in some fashion to accommodate renters. Others will approach a real estate agent with the deliberate intention of purchasing a rental property, in which case the property may be “turn key,” requiring little, if any, alteration. Whichever way you start out, the following are just some of the things you need to take into account before you commit to becoming a landlord in your golden years.

Commercial real estate requires at least 20%-30% down payment and an ongoing source of cash flow to fund expected and unexpected expenses. This means your equity will be locked in your property and only available through the available cash flow stream.

Real estate can be a great addition to an investment strategy, but rarely prudent as a sole investment. Unlike your portfolio, which will have fixed expenses, be liquid and globally diversified, your real estate will be impacted by local conditions with unexpected expenses and periods of poor liquidity. Expenses that are predictable include mortgage, taxes, landlord-specific insurance policies (both property and liability). Less predictable expenses are maintenance and repair costs as well as tenant related expenses. For those in control of their family cash flow, it is this difference that makes rentals a good consideration as a secondary investment and as part of their financial plan.

Like all investments it takes time and due diligence to generate a stable positive cash flow from rental properties – luck alone will not suffice. The price you set for rent is all important as are the expenses you incur. You need to be sure to cover your operating expenses which can include mortgage, property tax, insurance, maintenance, bookkeeping and accounting fees, utilities and if you use a management company you must also include their fee. In addition, the rent must provide you with a reasonable return based on cash flow, not just property appreciation, since you can’t sell the property to pay for ongoing expenses. The property must remain competitive with the local rental market and your cash flow able to cover expenses that may not be deductible in the year they are spent (a roof is an example of an expense that is depreciated and not deductible).

In addition to the financial considerations cited above, you will have legal obligations that are based on local laws and regulations pertaining to rental housing. A broken water pipe, furnace or refrigerator? Round-the-clock availability for emergencies is your responsibility. You can, of course, assign or pay for someone to take care of such things, but the legal responsibility will still be yours (always have sufficient liability and property replacement insurance). You are likely to be held liable for tenant or visitor injuries if due to unsafe conditions, especially in the common areas. Safety and habitability is paramount. On a regular basis, you must make sure structural elements are safe, the electrical, potable and wastewater infrastructure is sound, that trash containers are provided, that any known or potential toxins (such as mold or asbestos) are properly managed, that rodents or other vermin are kept clear off the premises.

However you come by your rental property, you will have to choose whether you should be your own property manager (directly overseeing and paying for maintenance yourself) or to take a more arms-length approach by contracting with a property management firm. Some clients hand these tasks to a family member who wishes to work part-time while others hand it over to a professional. A property manager can help those who wish to limit their day-to-day responsibilities, especially if you aren’t the handy sort or aren’t physically up to the task, but then you will have to cover the additional expense. Property managers, in simple terms, are hired to find tenants, maintain the property, create budgets, and collect rents. You will want to hire someone who knows about advertising, marketing, tenant relationships, collecting rent, maintenance, plus local and state laws in the location that you have the property. As the property owner, you can be held liable for the acts of your manager. It’s prudent, therefore, to hold the rental property in an entity that can provide some legal protection. Costs for contracting a property manager will usually run about 8% of rental income for management and about the same for engaging new tenants—this can eliminate your profit but if properly priced will provide you with a sustainable model well into retirement.

Finding reliable tenants is always a challenge, even if you employ a property manager. Tenants need to be able to pay their monthly rent, keep the property in good condition, and follow policies in the lease or rental agreement. You’ll find it easier to find good tenants if you select a property in an area experiencing low vacancies and high demand. Unfortunately, this means the property will also cost you more.

You should be prepared to have to deal with (or have someone deal with) evictions, wear and tear on your investment, unauthorized sub-lets, termination without proper notice, smoking, illicit drugs, pet odor and damage, parking and waste management issues, advertising, noise (including sometimes difficult neighbor relations), and other eventualities. Or, you can get lucky and find perfect long-term tenants! Realistically, as you age these tasks may become too stressful, eventually requiring you to hire a property management company or engage a (younger) interested and motivated loved one to take on this role. Either way, you must put this in writing as part of your purchase plan—including when you want this to happen, who this person should be, and finally, when the property should be sold.

During retirement some will love the ability to work part-time at managing their properties (even if only in a limited manner) whereas others will find it too complicated for their ideal retirement life. Invariably a well-managed property can generate ongoing income and create owner equity that will be a godsend in retirement or as an alternative to your market portfolio. Unfortunately for some, the process can become too complicated and stressful. So much so, that they avoid the tough decisions and derail their entire retirement plan. Being a landlord is very much an individual decision.

The bottom line is that rental property cash flow can generate a stable income during retirement, and can provide needed equity to fund contingency plans (such as disability, long-term care, health care needs, legacy) but profiting requires planning and annual review. It is a business that needs your ongoing attention or it will become a major liability. Even with the help of a property management firm, you may wonder in what way you can really consider yourself “retired” owning and managing rental properties.

Like any other financial investment, do your homework, and moreover, make sure it fits with your long-term financial goals and vision for a rewarding life.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

The skateboard champion and other stories

As a way to put money away and save on taxes we often think of retirement accounts for the self-employed that include a simplified employee pension plan (SEP), an individual 401K-profit sharing plan (401K-PSP), or Defined Benefit (DB) plan. DB plans are the least used and yet the most powerful at reducing tax liability and quickly increasing your tax-deferred savings. To illustrate how DB plans can be used, I want to share with you how creative individuals were able to leverage their DB plan to save maximally and retire early.

  • The Skateboard Champion – A 30-year-old skateboarder plans ahead and saves $130K per year from winnings and endorsements. He will have saved $2.6M by the time he turns 50 (without considering any market growth).
  • The Lobster Fisherman – A 61-year-old fisherman from Maine pays himself $35K in payroll from his C Corporation and saves $60K per year for the last five years before retiring. His reward: an estimated $300K in accumulated additional savings for his retirement.
  • The Clothing Store Sales Rep – At 57 years of age the rep contributes $150K per year for herself and $12K for her young assistant until retirement at age 65. She accumulates another $1.2M not including growth.
  • The Lobbyist from Virginia – Beginning at age 48, the lobbyist contributes $145K/year for 7 years saving just over $1M by age 55.
  • The University Professor & Guest Speaker – Starting at age 54, the Prof contributes $42K per year from guest speaking engagements. He does this for 12 years and adds $502K in savings (excluding growth) to his already substantial university benefit plans.

DB plans provide the highest contribution amounts particularly when combined with a 401K. To take full advantage of this type of plan, a business must have sufficient profit and cash flow. DB plans, like a 401k, must be established in the same year and have specific requirements including annual tax filings. DB plans are not limited by the fixed maximum contribution found in SEP or 401K plans but instead are based on age, payroll and future benefit. This year, the maximum annual future benefit is up to $210K (this can amount to substantially more than a $210K contribution in any one year).

If you have a side business or are starting your own full time business consider the DB plan. Even though these are powerful, the best type of retirement savings plan for you is dependent on your business’ current and projected cash flow. As you can tell from the stories above, a well-designed DB Plan is not just for those over 50 or those with large earnings. It can be a very smart way to defer taxes today and provide for your lifestyle in the future.

Defined Benefit plans are not appropriate for everyone but I’ve seen them work for so many different people in unexpected situations that I thought I’d share some success stories with you.

When does it make sense to payoff your mortgage before retirement?

It is relatively easy to make paying off your mortgage a goal, largely because you think it will “feel good” or because you imagine that it will be “liberating” to throw a mortgage burning party. But be careful that you are not mixing a critical financial decision with an emotional reaction. It may seem illogical, but there are many reasons why it is sometimes a better financial decision not to pay off your mortgage. That said, there are also some very good reasons for paying off your mortgage prior to retirement. The balance is often tipped by the amount the client spends on their lifestyle budget, the amount they have saved in available non-home assets, their tax liability, the source of the money used to pay off the mortgage and what they have decided to do for unexpected expenses.

For most of our clients, a mortgage on their principal residence is a low-rate loan that can be used (since 1997) to reduced tax liability (usual tax refunds drop the effective mortgage interest rate by as much as 1-3% for our clients). A mortgage repayment is stretched out (amortized) over a long period of time (15 or 30 years are common) with most of the interest paid during the first 2/3rds of the amortized period. When combined with inflation and a healthy appreciation in real estate valuations, a mortgage provides the buyer an opportunity to expense a very low cost loan while building equity in the home with money that would otherwise (at least in part) go toward rent. A mortgage loan can also be used to maximize and grow savings pre-retirement, obviously freeing clients to use these savings later while in retirement. The argument can also be made that a diversified portfolio started with assets that might have been used to pay off a mortgage (though not guaranteed) can yield a rolling average of 6-9% (with a margin of safety) and provide assets that grow above the mortgage rate and that are available for use outside of the home asset.

Many of our clients will have reduced or no earned corporate income during their retirement years, and plan to rely primarily on portfolio, pension, and social security to support them for 30-40 years. During this time they might have lower taxable income, but that is only true if their lifestyle expenses are low enough (something that is difficult to do in the Bay Area). If not, they might increase their taxable income to support their lifestyle and would benefit from available tax deductions (including mortgage interest). Most of our clients would like to remain in their homes throughout retirement, but this adds a further complication if they do not have enough non-home assets to support their annual budget. We find that home owners are surprised that they can’t tap most of their home equity (at reasonable costs) until they sell their home.

Paying off a mortgage is sometimes worth considering when the client has sufficient assets to support retirement outside of (i.e., above and beyond) their home. As an example, consider someone with a lifestyle expense in retirement of $100K annually (after social security). We can roughly estimate that they will need about $3M in portfolio assets to support their lifestyle and to ensure that they will not be forced to sell their home to support themselves. This $3M is only an estimate since it may not be sufficient if there is no supporting plan to cover unexpected expenses. But assuming there is sufficient savings and buffer, paying off the mortgage becomes a viable option which would reduce lifestyle budget (since there should be no mortgage payments) and tax liability.

Since several clients would like to hear scenarios that highlight the advantages of paying off their mortgage prior to retirement I’ve outlined two below:

1)  When a client plans to live in a mortgaged home until they need care, have low lifestyle expenses AND enough money outside of their home asset to support their lifestyle budget, including maintenance of their home. In this situation (particularly when their tax rate will not benefit greatly from remaining Schedule A deductions) the reduced expense derived from not paying a mortgage provides measurable benefit and real financial freedom. In addition, leaving a home with little or no mortgage is popular with those who wish to provide a legacy. However, clients have to be prepared for a potential increase in taxes in retirement particularly if they need to draw more from their portfolios. There is also the possibility that they may need to sell their home to unlock equity to cover unexpected expenses.

2)  Another scenario that encourages paying off the mortgage pre-retirement applies to clients with a low taxable income, sufficient non-home assets to support their lifestyle expenses and a sudden influx of cash to cover their mortgage (this cash must be more than the amount they can contribute in a tax advantageous manner and not needed to support their lifestyle).

It has been clearly demonstrated that anyone with a fully diversified portfolio benefits most from maximizing tax-advantaged savings prior to retirement. Usage of funds that could be contributed to these types of accounts to pay off a mortgage often results in too much home and not enough cash (house rich, cash poor, as the saying goes). This is particularly the case in areas where home appreciation is high and home equity grows, but can’t be accessed cost effectively. A misconception is that a large mortgage is the best way to reduce taxes because you can minimize them through Schedule A deductions. This is patently not true. The best way to minimize your taxes is through tax-deferred savings, not deductions. Do note that in retirement, neither tax deferral nor the option to obtain a mortgage at a reasonable rate may be available.

Each person needs to consider the best way to manage their mortgage payments in retirement. In this article, I have sought to help you recognize some of the key components that factor into whether it makes sense to pay off your mortgage prior to retirement. It is important that you realize that there is no single answer for everyone and that we must balance your budget, taxable income, amortization period and plan to cover contingencies during retirement before making this decision.

Retirement Plans for the Self-Employed – An introduction to reducing taxes by increasing retirement savings

The self-employed small business owner has at least three ways to save for retirement while saving on current taxes. The best known is the simplified employee pension plan (SEP). Not quite as well known, is the individual 401K-profit sharing plan (401K-PSP). And definitely least known is the Defined Benefit (DB) plan. Your choice should not be based on familiarity but on your retirement needs, current cash flow, and tax liability. Without planning the choices are limited to a SEP IRA or other IRAs. SEPIRAs can be created any time prior to tax filing but the contributions can only be as much as 20-25% of net earnings from self-employment (up to $52K).

A 401K-PSP, on the other hand, must be created in the same year (meaning that if it is used for 2014 contributions it must be created before Dec 31 of 2014). Ideally the contributions are made by December 31st for employee deferred compensation but employer contributions are made later, prior to tax filing. Employee deferral limits this year are $17.5K (plus an additional $5.5K after 50) or to the maximum earned, whichever is less. Profit sharing contributions can top up to $52K (plus an additional $5.5K after 50). Tax filings for the plan are required once the total assets exceed $250K. For most small business owners the 401K-PSP allows for higher annual contributions (than the SEP) and therefore lower tax liability.

DB plans are the least used by self-employed and yet the most powerful at reducing tax liability by allowing very high tax-deferred contributions. A business must have sufficient profit and cash flow to take full advantage of this type of plan. DB plans, like 401k, must be established in the same year and have specific requirements including annual tax filings. These types of plans are not limited by the fixed maximum contribution of $52K but instead on annually calculated contributions based on a future benefit. The maximum annual benefit is up to $210K this year. DB plans provide the highest contribution amounts particularly when combined with a 401K-PSP.

The best type of retirement savings plan for you, as a self-employed individual, is partially dependent on your business’s current and projected cash flow. Ideally you will match the features in all available plans with your retirement needs, selecting the plan that maximizes your retirement savings while reducing your current tax liability.

The key is to plan ahead with someone that knows the self-employed plan options and your personal and business finances. Working together you can provide for your future while reducing your tax liability today.

Self Employed Individual 401K Plan Loans

Who said you can’t have your cake and eat it too?
by Edi Alvarez, CFP

Self employed small business owners have an opportunity to not only save maximally through retirement plans but also build a safety-net through their ability to borrow from their individual 401K accounts.  Properly structured they can borrow from their retirement plan when the need arises without incurring the usual 10% penalty for early withdrawal.

In addition, 401k Loans for the Self employed business owners provides a loan, while allowing them to pay back interest to their own 401K rather than a financial institution.

An Individual 401k loan is permitted using the accumulated balance of the Individual 401k as collateral for the loan. Individual 401k loans are permitted up to 1/2 of the total balance of the 401k (but not exceed $50,000). A loan from an Individual 401k is received tax free and penalty free. There are no penalties or taxes if loan payments are paid on time.

Individual 401K Loans

  1. Can be used for any purpose.
  2. There are no income or credit qualifications to receive the loan.
  3. The monthly loan payments of principal and interest are repaid back into your own Individual 401k – you borrow and grow your retirement at the same time.

In addition, the assets can be from prior employer or IRA accounts that are rolled over to your individual 401K account.

Individual 401k are available to self employed individuals and small business owners with no full time employees other than a spouse. Your business can be a Sole proprietorships, LLC, S and C corporations,

The terms are set by the employer (yourself) but the 401k usually has a 5 year maximum repayment term for most loans, except it can be longer, for home purchase. There are no income or credit qualifications although you must charge yourself a competitive interest rate.

Although simple and fast to execute you  should remember that you are borrowing on your retirement nest egg.  It is only a valid action when you know you will have the ability to pay it back – default results in a withdrawal that can carry a 10% penalty.  The loan facilitates borrowing when it might be too difficult or too expensive to go through banks and lending institutions.

As good as it sounds consider that unlike a mortgage or a home-equity loan, if you use a 401(k) loan to buy or improve your home, you won’t get a tax deduction on the interest you pay. You may have to pay a one-time fee to the plan administrator for the cost of originating a loan; the fee is usually $50-100. Your retirement plan will also miss future targets if you don’t continue making annual contributions while you have this outstanding loan.  Though most self-employed who borrow from their 401K often pay their loans early it is important not to misuse your hard-earned retirement assets.

As can be seen the 401K Loan, like all tools, has advantages in disadvantages.  The advantages for the self employed should  encourage anyone who is or is planning to have their own business to begin saving in a tax deferred manner maximally.  By using an individual 401K account you can have your tax deferred savings and simultaneously build a safety net.