Category Archives: Retirement Planning

Dealing with topics relevant to retirement needs and approaches to reach long term goals. We aim to help you find ways in which you can reach your goals and make a difference

Retiring early – A reality check

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A letter published online by an ‘early’ retiree who encountered health difficulties has generated a lot of negative comments regarding early retirement. I thought it might be helpful to provide you with my perspective on the subject. Retiring early often means that there is NO paid work and that your assets are the only source of income for all living needs. The income from those assets needs to be able to support your chosen lifestyle for your entire life. For this reason, it is essential that this planning be completed with details based on your life and potential worse case scenarios. In this letter there seemed to have been little planning for healthcare, unexpected market changes, and potential disability which are essential in any retirement plan and particularly in one that would need to last 40+ years. The negative outcome for this early retiree might have been prevented with comprehensive retirement planning and annual adjustments.

Of course, the assets to support early retirement need to be much higher if retiring before age 65 when Medicare healthcare becomes available. In addition, retiring before age 59.5 needs to include significant non-retirement assets (or a willingness to annuitize retirement assets) to avoid a 10% early withdrawal penalty for retirement accounts. Early retirement must also account for retirement cash flow distributions over very long periods (longevity investment planning) which requires a careful combination of investment strategies to ensure that cash is available regardless of market behavior. A portfolio that needs to provide support for long periods of time must include sufficient growth potential with protections against the likely downturns.

If you are contemplating early retirement and have not yet discussed it with us, then let’s create planning scenarios for your situation and see how and if your assets will support your ideal ‘early’ retirement life.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Differences in Finances: Pre-retirement and Retirement

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I am sometimes asked how our work differs as clients move from a period in which they are accumulating assets (pre-retirement savings) to a period in which they withdraw/distribute from their assets (retirement or financial independence). This becomes a critical question as individuals transition out of earning years and begin to implement their retirement plan. As a matter of fact, our tasks are very different in each case though our role remains the same. Our role is to provide financial guidance to help make the most of available assets given current realities and future goals.

To help you understand the various financial tasks that occur in these two distinct financial planning periods, I’ve outlined some of the major tasks that we perform in pre-retirement (accumulation phase) and in retirement (distribution phase).

During the accumulation period, our focus is to encourage you to integrate finances with all major decisions. We work with you to save as much as possible using tools or techniques that we know will likely be successful in your situation and come up with ways that work better for you. We also support you to define spending that is meaningful because we want spending to be sustainable and satisfying later in life. Annually, we help set spending and savings goals and ask you to hold yourself accountable because with accountability comes financial self-confidence. We also want you to experience the ups and downs of portfolio behavior over a significant period so that overtime you will learn to relinquish unproductive human emotions that are associated with daily monitoring and fretting over your portfolio total (which feeds fear and greed). We want you to internalize that what really matters is that the portfolio delivers as expected to meet your goals. It is therefore important that during accumulation (when you are not dependent on the portfolio), you can confirm that the returns used to create your financial plan are attainable by the average return of your own portfolio (not a model or generic return). Overall, we want you to identify how you can best work with finances and gain confidence in your own ability to make financial decisions regardless of the obstacles.

During retirement we are more involved with your cash flow management as we help you transition to financial independence by implementing your financial plan. This requires providing the needed cash flow from your accumulated portfolio. In retirement we annually setup monthly cash-flow distributions (or an annual lump sum distribution) from the portfolio and we internally estimate the tax liability so that we have the best after tax result for each distribution. We find that tax planning also helps prevent unexpected increases in future Medicare premiums, helps make Roth conversion decisions, and helps decide on the best timing for Social Security benefits. RMD (Required Minimum Distributions which begin at age 72) are also calculated and implemented based on what is best for your overall finances. We may recommend QCD (Qualified Charitable Distributions, only for those at age 70.5) or DAF (Donor Advised Funds which are available to anyone who wants to make significant or regular charitable donations) in some cases. Finally, we serve as your financial resource or partner to support you during major financial decisions.

Let us know if you have different questions or want more details on what is currently most important in your life, regardless of whether you are in pre-retirement or already enjoying your well-earned financial independence.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Inflation Expectations as of January

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On Tuesday, January 11, 2022, Federal Reserve Chairman Jerome Powell called high inflation a “severe threat” to a full economic recovery and that the central bank was preparing to raise interest rates because the economy no longer needed emergency support. Powell further stated that he was optimistic that supply-chain bottlenecks would ease this year and help bring down inflation while the central bank begins removing the emergency support we’ve depended on for years.

The January inflation rate (CPI) is reported at 6.1%.

With U.S. debt approaching $30 trillion and growing at $2 trillion per year The Fed is in a tough spot, they must find ways to fight off inflation. Debt is often a drag on future growth unless the debt is used to increase GDP and stimulate the economy. With higher interest rates and without additional economic growth (GDP), the U.S. government will struggle to cover interest payments given that tax revenues are at about $1 trillion per year. So, I expect aggressive measures will be taken to check inflation.To be honest, there is little agreement on the likelihood that 2022 inflation will be permanent. Some believe that the current wave of inflation will prove to be transitory and expect, at worse, a slowing of the global economy in the first half of 2022. Others argue inflation is not temporary and will be devastating through 2023 (they usually use the 1970’s period as a painful reminder of extreme inflation).

I am cautiously optimistic and believe that in the long-term what matters is our ability to increase economic growth. I also believe that consumers have a lot more influence over inflation than they realize – inflation is not magical or something to be afraid of but rather a reaction to something we consumers encourage or discourage with our behavior. Every time we purchase something despite its excessive price, or we raise the price despite the actual cost, we contribute to inflation. Consumers can practice restraint over consumer discretionary purchases, but it becomes much more challenging when inflation impacts the essentials or basic spending. For example, if your rent increases at 4% (see the chart below), this is not optional so something else needs to be reduced or your income must increase thus fueling inflation.

Percent changes in CPI

In your portfolio we are continually monitoring and adjusting for expected inflationary pressures, volatility, and increased interest rates. Our belief is that with infrastructure funding we’ll reach a high GDP by year-end and a good portfolio outcome. Without economic stimulus we are likely to have a more volatile and less predictable performance this year. You may notice that we added tilts to the portfolio that increased commodities (primarily cereals, materials, energy) and digital/tech assets (like digital supply chain, traditional finance, and fin tech companies) which we expect to do better during inflationary periods. Fixed income is tilted to the short-term and should provide stability if the expected volatility in equity markets materializes.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

How does a tax-deferred IRA differ from a Roth?

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Tax-deferred savings (to an IRA or employer pre-tax retirement plan) reduce your tax liability today BUT are fully taxable (including gains) on withdrawal. The tax-deferral accounts are an excellent way to minimize your current taxable income. The goal is to use what would have been tax dollars as part of your savings. The main rules to keep in mind are that withdrawals shouldn’t be expected before age 59.5 AND that you MUST take mandated distributions (called RMD) when you reach age 72 (according to the new tax rules). Unfortunately, these accounts are now also not inherited in the same beneficial manner as in the past (these now follow the new Secure Act of 2019 rules).

A Roth on the other hand, doesn’t provide tax deferral when saved but it does provide tax-free dollars, on withdrawal. Contributions to a Roth are limited in amounts each year and not easily available for high earners. Whereas Roth conversions require income tax payment on converting pre-tax IRA dollars, not everyone is permitted to make Roth conversions. Fortunately, Roth IRAs are not impacted by the Secure Act of 2019 and remain free of RMD. They are also still inherited tax-free to individual or trust beneficiaries and are likely to be favored for those considering leaving a legacy.

As income tax rises (likely, given our debt load), Roth accounts will become even more powerful tools in retirement for those in the higher tax brackets. Currently they help us regulate your taxable income and keep taxes and Medicare costs reasonable during retirement.

We’d like to consider Roth conversions for you in years when you expect a lower tax rate. It is particularly useful when tax-deferred accounts are undervalued and when you have accumulated large tax-deferred accounts.

The basic takeaway is that a tax-deferred account should be maximized during years with high earnings (to reduce taxes) and high tax rates. When you expect a low earning year then a Roth conversion may provide you with an ideal situation BUT ONLY IF your retirement tax rate is expected to be high enough to trigger additional taxes or Medicare costs.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

New tax rules (Secure Act of 2019)

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As you know, we believe strongly that managing tax liability is essential to building wealth. The Secure Act of 2019 has made significant changes which we will use to create and action strategies best suited for each of you.
Everyone, near retirement, is aware that there was an extension to the Required Minimum Distribution (i.e., RMD) from age 70.5 to age 72. This is good for many since it gives you more control over your tax liability early in retirement, but it also has made the Roth accounts an even more powerful tool for some.

Sadly, the Secure Act of 2019 has made inherited IRAs a big tax burden for beneficiaries, particularly trust beneficiaries. Because of this, IRA accounts that use a trust as a beneficiary may need to be re-examined to ensure that the language allows beneficiaries to minimize their tax liability.
Let me know if these topics are of interest and we’ll include them at our next financial planning meeting.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Cyber-crime, Phishing, Robocalls, and Wanting to do Good

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Almost every day there is an article in the news about financial fraud. Much of it impacts seniors, like the telephone scam now doing the rounds that has fraudsters posing as Social Security representatives. However, we are all at risk, especially if we believe we are too young, too smart and too vigilant to fall for a scam. Sadly, scam artists are very sophisticated, intelligent, and focused so that they’ve become experts at separating people from their money. Only last month, “Shark Tank” magnate, Barbara Corcoran, was tricked out of nearly $400,000 through an email phishing scam in which fraudsters convincingly posed as her assistant.

A lot of financial fraud targets seniors or those in high pressure situations because cognitive agility decreases as we age or when we are stressed. Furthermore, seniors who live alone are particularly vulnerable.

Here are several things you can do to protect yourself and loved ones from financial fraud:

  1. Simplify your financial life. One of the best things you can do to reduce the chances you’ll be taken advantage of is to reduce the number of accounts you have and the number of financial institutions you work with. Fraudsters are experts at catching people off guard, posing as others and making their prying questions sound both reasonable and plausible. Make it a habit not to respond to phone calls regarding finances unless you know the person at the other end and never trust emails involving finances without first verifying the source.
  2. Limit access to and block large transactions. The first step in preventing fraud is to limit the money that can be easily accessed by not keeping large sums in checking accounts. Keep large accounts with a separate institution so that it takes a day or two to make a transfer. Next, if your bank allows it, set alerts for large transactions or block transactions over a certain size. Always use a credit card for online purchases since they give you the ability to reject a charge, while your debit card will automatically pay from your account.
  3. Always use maximum security on email accounts that you use for financial communications. We’ve seen most cyber fraud through yahoo.com and gmail.com accounts prior to the additional security currently available.
  4. For large transfers, particularly during hectic times, involve a trusted financial partner and NEVER accept changes to the receiving account and contact over email (or a call from someone you don’t know). It is better to halt the process entirely or at least confirm with a known financial entity than to change course midstream during a cash transfer. Most of the successful fraudulent transfers have been during escrow for a new house purchase or sale. The methods used are creative and ever improving.
  5. Families should plan their spending ahead and NOT respond to charitable requests on the fly. It is not unusual for seniors to receive many robocalls and mail requests from real charitable organizations because they know that seniors want to do good. It is not unusual for seniors to spend more on charitable donations made ad hoc than was planned. Make a point never to donate based on a phone call or last-minute request at a checkout unless that is part of your charitable plan for the year. I recommend families sit together and come up with an annual plan for charitable donations. When charitable opportunities present themselves defer them for review at your next family charitable giving gathering.
  6. For seniors or those facing high stress situations, you may want a backup notification sent to your spouse, financial caretaker, or a trusted person for high value transfers. If your bank does not provide for such alerts, then make it a standard practice never to make high value transfers without extensive planning and verification.
  7. For seniors, it’s important to have a potential financial surrogate in place long in advance of cognitive decline. Identify a trusted family member or friend or trusted professional to be your financial caretaker and start conversations long before you feel you need to turn over your finances. Consider providing view-only access to a trusted person so that they can help you monitor your account activity and be notified of large transactions and suspicious activity. It is a good idea to involve them with your tax preparation and filings as well.
  8. Due to the number of data breaches in recent years (that have exposed thousands of people’s Social Security numbers and other sensitive data), it has become increasingly possible for fraudsters to open accounts in another person’s name. On a regular basis, personally monitor your credit history with all three major credit agencies for new activity that you didn’t initiate.
  9. I’m personally uncomfortable with ongoing Credit Freezes unless you can monitor and implement them yourself at minimal cost and without involving a third party. Using a credit monitoring service is not recommended since you are involving an unregulated third party and, in any case, will only alert you after you’ve been victimized. The recommended approach when this happens is to freeze your credit at all 3 major credit agencies. Keep in mind that though this is often recommended by cybersecurity experts it can become a major hassle for you. Freezing your credit can be an issue for you if a company needs to legitimately verify a transaction with your credit history (this is the case for some insurance and bank transactions). Unfortunately, freezing your credit is sometimes the only way to prevent attempts to open a new account in your name, and maybe the preferred or only option for seniors.

Financial fraud is rampant. However, with a bit of preparation, a support system, and communication, you can significantly reduce the odds that it happens to you and your love ones.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Inflation, portfolio allocation and long-term goals

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The erosion of purchasing power through price increases is referred to as “inflation” (though it has a more detailed technical definition). A prosperous economy needs some inflation to sustain growth but excessive inflation can stall growth and derail a conservative portfolio. This year, we begin paying more attention to the inflation rate as it appears to tick above the Federal Reserve’s target rate (“green line”).

PCE Inflation - Bloomberg 2018 03 31

Source: Bloomberg; As of 3/31/18 US core PCE inflation

 

Inflation is a negative and important part of evaluating portfolio performance but, in the last years, we’ve been lulled into ignoring it (since it stayed below the Federal target rate). To help understand inflation’s impact on purchasing power, consider the following illustration of the effects of inflation over time.

DOC - Price comparison 1916-2017

Source for 1916 and 1966: Historical Statistics of the United States, Colonial Times to 1970/US Department of Commerce. Source for 2017: US Department of Labor, Bureau of Labor Statistics, Economic Statistics, Consumer Price Index—US City Average Price Data.

 

In 1916, nine cents would buy a quart of milk. Fifty years later, nine cents would only buy a small glass of milk. And in 2017, nine cents would only buy about seven tablespoons of milk. How do we protect your portfolio against this loss of purchasing power throughout our lives and particularly in retirement?

Investing and saving today for future spending

As purchasing power declines over time, investing in fixed income (bonds and annuities), in terms of inflation, increases the risk of outliving your assets. This is particularly exacerbated by fear of market volatility and the practice of increasing fixed income and reducing equity as we age. Although we agree that fixed income allocation is useful to reduce volatility we are not in agreement with tools such as Target Date funds which automatically increase fixed income based solely on age.

Investors know that over the long-haul stocks (equities) have historically outpaced inflation, but you may not know that there have been stretches where this has not been the case. For example, during the 17-year period from 1966–1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation it was 0%. Additionally, if we look at the period from 2000–2009, the so-called “lost decade,” the return of the S&P 500 Index dropped from -0.9% before inflation to -3.4% after inflation. These are a reminder that S&P 500 equity return alone is not always able to protect purchasing power.

Despite these tough periods, one dollar invested in the S&P 500 in 1926, after accounting for inflation, would have grown to more than $500 at the end of 2017 and would have significantly outpaced inflation. On the other hand, the story for US Treasury bills (T-bills), however, is quite different. T-bills are often used as a proxy for a safe fixed income allocation. From 1926 to 2017, T-bills were unable to keep pace with inflation, and an investor would have experienced an erosion of purchasing power. As you can see in the chart below, one dollar invested in T-bills in 1926 grew to only $1.51 at the end of 2017. Yet a purchase for $1 in 1926 would cost you $14 in 2017! [caveat: other bonds/fixed income did better than T-bills.]

Growth of $1 from 1926–2017

Dow Jones Indices 1926-2017

S&P and Dow Jones data © 2018 Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Past performance is no guarantee of future results. Actual returns may be lower. Inflation is measured as changes in the US Consumer Price Index.

 

Your portfolio with AIKAPA has a fixed income component to protect against loses based on short-term unexpected equity downturn. Instead of increasing the fixed income component of a portfolio with age or as fear of loss grows, we prefer to educate clients on how the portfolio works to both create and protect wealth. We do not encourage reduction in equity exposure based solely on increased age. Even so, we evaluate individual allocation, risk of outliving assets, and risk tolerance annually and encourage clients to let us know if they are anxious about their quarterly portfolio returns. Our target is to provide enough equity for growth/inflation with just enough fixed income to protect and not create anxiety over portfolio changes.

We think that experience with a diversified global portfolio needs to start well before retirement. Combining this experience with ongoing education and open communication we believe is the best way to determine fixed income allocation.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Funding Retirement Cash Flow (and RMD)

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The importance of a strategic and tax efficient portfolio withdrawal becomes very clear  to retirees or those funding their daily expenses from their portfolio (i.e., those who are financially independent).

Though we have all become pretty comfortable with deferring income to gain a tax advantage while working (through 401K, 403b, 457, Keogh, and IRAs), we delay learning about how we’ll deploy these accumulated assets until some later date. We usually include one possible distribution in retirement projections but we leave the actual details until closer to retirement. This includes ways to manage Required Minimum Distribution (or RMD).

Essentials of RMD:

Starting at age 70.5 and each year after you will be required to withdraw from your tax-deferred accounts a portion regardless of whether you need it to fund your expenses (this is the crux of RMD). This amount is fully taxable as if it were income (it is after all your prior deferred income). The required withdrawal amount is a portion that is dependent on your account balance and your age.

How is the amount of RMD determined?

Every year it is calculated on the total account balance, at prior year end, of all of your tax-deferred accounts divided by an annuity factor. This factor is based on your age and the age of your spouse (slightly different factor if the difference between you and your spouse’s age is greater than 10 years). As an example, I’m using factor 26.4 for a person age 71. If this person’s total tax-deferred portfolio on the prior December 31 had a balance of $500K then their RMD would be $18,939. If the same individual had a $3M portfolio they would have to withdraw at least $113,636.

Why not ignore this requirement and pay the penalty?

Required Minimum Distribution (RMD) has a 50% penalty. If the above RMD withdrawal is not made in the specified period, then the penalty for the $500K portfolio would be about $9.4K and $56.6K for the $3M portfolio – Yikes!

Keep in mind that RMD is the MINIMUM amount you MUST withdraw from your tax-deferred accounts each year but you can draw more if you wish. Everything you withdraw from your tax-deferred account (except for advisory fees) is fully taxable and impacts tax liability and cash flow.

When and why might RMD be a problem for retirees?

The basic problem is lack of control over timing of distributions. The strategic deployment of a portfolio is tax dependent, market dependent and most of all it is ‘needs dependent.’ If we have a choice, we only want taxable income to the level it is needed by you for that year. Sometimes we take more because we are planning for a future event.

Taking RMD can increase tax liability excessively in specific years, because you are temporarily in a higher tax bracket. This happens most often when a home or other large capital asset is sold (or may last longer if it is due to distribution from a company deferred compensation plan). In those years it would be best not to withdraw from a tax-deferred account since there is enough cash flow and tax liability from the sale. Adding RMD serves only to increase tax liability unnecessarily. It also impacts Medicare premiums (recall that Medicare is means tested – see the March 2016 Nibbles article (or online blog) for details on Medicare means testing).

An additional problem arises during years when market corrections take place or if portfolios are not fully diversified. During the 2000 and 2008 crises, equity markets were at their highest the prior year-end, but after the crisis they dropped significantly forcing a crisis for those who had not made their RMD withdrawals. We prefer not to add these potential risks to our client portfolios during retirement – we make RMD withdrawals early in the year and we ensure retirement portfolios are diversified and therefore less volatile.

What action may minimize the impact of excessive taxes caused by RMDs?

Currently there is only one solution after age 70 but several if you plan ahead.

In the years prior to age 70 you can take advantage of several strategies that effectively decrease the tax-deferred account balance and provide alternatives without RMDs. The objective is to even out the tax rates and reduce years of higher tax rates.

During retirement there is no way to avoid this increased tax liability from RMDs unless you don’t need the RMD for your personal retirement needs. If you don’t need the RMD, it can be donated to a qualified charity (there is a specific process that must be followed) and meet your RMD requirement without increasing your tax liability. Obviously this is a limited solution since to avoid the penalty and taxes you are giving away the RMD but hopefully it is going to a cause you care about.

How do we plan portfolio withdrawal given RMDs?

Like all questions regarding retirement or financial independence we need to always begin by knowing what you want to do and how much you need to spend (your burn rate). We’ve also found greater success when we have several funded pools of retirement assets with different tax natures. In planning distributions we consider cost basis, burn rate, tax brackets, social security, and RMDs, along with the current tax rules so as to create the most appropriate distribution from the portfolio. If we plan ahead, we find that spreading-out tax liability over several years (with a lower effective rate) often helps in this endeavor.

Financial plans create retirement scenarios that provide a high probability that the portfolio assets will support your planned retirement spending and provide you with confidence that your savings level today will support your chosen lifestyle in the future. It is during implementation of the retirement plan that rules and priorities (for example, how to handle RMD, taxes, cost basis) need to be applied as to further improve the probability that your portfolio will outlast you.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Cost effective implementation of Long Term Care insurance

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Long Term Care (LTC) decisions form a critical part of all retirement plans. That said, we can’t properly address individual LTC needs until a retirement plan is designed and participants are able to quantify the aspect of Long Term Care they will fund. If LTC insurance is part of their ideal LTC plan then we must identify the best policy and the most cost effective way to pay for it. This article is intended to review LTC and layout how a business can help pay for LTC insurance in a cost effective manner.

(1) Long Term Care – a review
Long-term care (https://longtermcare.acl.gov) is a range of services and supports needed to meet personal care which is not included in healthcare. About 2/3 of the population will need LTC after age 65 (and 1/3 before 65). Of those reaching age 65, 70% will need LTC or assistance with activities important to life. LTC includes everything from social services, physical and emotional support, finances, housing, a myriad of legal decisions, family interaction and social dynamics. LTC should include all assistance with tasks that will allow for productive, engaged and enthusiastic daily life. It should include assistance with routine tasks such as housework, money management, taking medication, shopping, traveling, caring for pets, responding to emergencies (these are known as Instrumental ADLs) and NOT just the “basic” Activities of Daily Living (ADLs, such as assistance with bathing or eating).

Currently, 80% of all LTC needs provided in the home are supported by unpaid family, friends or neighbors. The average support needed in the home is about 20 hours per week. Fortunately, as services develop, we find an increase in community support services. These include adult care services, transportation services, and home care that is round the clock or as needed.

If you require or prefer the use of LTC services provided by an institution or facility you will need to investigate Assisted Living, board and care homes, or Continuing Care retirement communities, not just nursing homes.

(2) What is LTC insurance?
LTC insurance is a contract to pay premiums every year for care you may need in the future. It will pay out an agreed daily amount for your care only if you are unable to do a certain number of Activities of Daily Living (ADLs). These are the basic ADLs (includes bathing, eating and dressing). LTC insurance is not usually available if there are pre-existing conditions. Benefits are provided for a set number of years of care based on a daily dollar amount dependent on local costs and total maximum benefits (these are usually capped at around $350K). But how many years of LTC will be needed is unique to the individual, though we have past indications that males need at least 2 and females 4 years. Three years is the standard, but we know that 20% of those over 65 years will need ADL assistance for longer than 5 years. For these reasons we recommend this insurance purchase be made based on your retirement plan.

Naturally, LTC insurance premiums are less expensive for the young (and healthy) but starting early will cost more over time and is not advisable if your personal cash flow can’t support this expense throughout your life.

(3) Best ways to pay for LTC insurance
How do we pay for LTC insurance if we think it fits within our retirement plan? It should be clear that healthcare or Medicare (except for very short periods of time and only in specific emergency situations) do not cover LTC costs. On the other hand, Medicaid does cover LTC but has very strict requirements to qualify. If you are fortunate to qualify, LTC coverage is provided by the Older American Act (OAA) and Department of Veteran Affairs.

The most common way to pay for basic LTC needs is through insurance or out of the personal or family budget. Other ways include a reverse mortgage, annuities, other assets, and income from a dedicated source (such as rental income).

LTC insurance premium costs are based on your age, your location, your wishes for level and amount of care. The premiums are not usually a burden on a yearly basis but they take a toll over time. These premiums must remain in effect for life. Additionally, policy premiums today can increase by more than inflation (over the last year we’ve seen 18% to 90%[!] increases in premiums for existing policies).

Long Term Care Purchasing Options

There are at least 2 ways to pay for a new LTC insurance policy – as an individual or as a business. The advantage of an individual LTC insurance policy is that it is based on your needs and can be tailored to you. The advantage of a business LTC insurance plan is that it can be paid by the business and therefore tax deductible. If you are the business owner it can also be tailored to your wishes (see the chart below assembled by Aikapa).

LTC insurance premiums are supposed to be deductible but we find that most of our clients with high AGI (Adjusted Gross Income) and low medical expenses are not able to deduct their premiums on their annual IRS tax filings (Schedule A has a 10% AGI floor). In addition, the deduction is also limited to age specific maximums (see table below) regardless of actual cost for the purchased LTC insurance policy. To help you understand the implications I’ll outline at LTC insurance for three separate age scenarios (ages 55, 61, and 71):

Currently a basic 3-year policy with $150 benefit per day would have an annual premium of around $2,100 at age 55, $2,900 at age 61, and $6,900 at age 71 (quotes may differ given different assumptions and are likely to be lower for males and couples but may be higher or not available based on health history).

Long Term Care Deductible Limits

To help understand how tax deductions actually work if buying this insurance individually, I’ll use the three LTC examples outlined above: To allow for this comparison, I’ve assumed that the cost of the above three policies are the only tax deductible medical expense. This is important because the deductibility is dependent on exceeding a 10% floor based on AGI. Anyone with an AGI (i.e. number at the bottom of the first page of your 1040 IRS filing) of more than $60K would not be able to deduct their LTC premium under any of these scenarios unless there were other deductible medical expenses. Most of our clients that purchase an individual policy are not able to deduct premiums. In retirement deductible medical expenses rise and then some of these premiums are tax-deductible.

On the other hand, the same insurance policy purchased by a business provides tax deduction of LTC insurance premiums up to age limits and may even cover the entire premium (see below for details).

Sole Proprietors, Partnerships, S Corporations, and LLCs can provide owners and spouses with LTC premium tax-deductions that are only limited by age specific maximums (see above table – which shows that at a business can pay up to $1,530 for an owner’s (aged 51-60) LTC premium tax-free). If we look at the same three examples AND purchase the policy using one of these firms the tax deduction in 2017 for the 55 year old would be $1,530 (less than the cost for a base policy of $2,100), the 61 year old would have their premium fully paid tax-free (since their premium of $2,900 is less than the maximum limit of $4,090 for her age group), and the 71 year-old would pay no tax on $5,110 (though premium total was $6,900).

C Corporation and non-profits may cover LTC insurance premiums  for owners or members tax-free (without age limits mentioned above).

Using the same three examples AND having the C Corporation or the nonprofit pay for the premiums, then the entire LTC insurance premium for all age groups would be tax-free.

In summary, Long Term Care planning involves much more than just buying a LTC insurance policy. It encompasses consideration of a myriad of integrated services and support that should be aligned with your wishes both early and later in life. LTC insurance is one way to cover basic ADLs. Before making a purchase of LTC insurance you must have calculated what you wish to cover yourself and what will be paid for by insurance benefits. It is more cost effective if LTC insurance is provided by an employer (with no cost to you) and even better if you are the employer. As the employer you can design a policy that best fits your plan and offers tax-free premiums.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

‘Burn rate’ should be key to retirement savings

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People often talk about “saving for retirement.” Few question the need to put aside adequate savings to ensure the successful funding of their retirement plan. The operative word though is “adequate.” How much in the way of savings is “adequate”? Of course, it differs from individual to individual, but you will most likely find that spending is the common variable that shapes the limits of what constitutes adequate savings. With few exceptions, our spending needs in retirement will exceed the amount provided by our inflation adjusted social security benefit. Everything else being equal, the success or failure of any effort to fund retirement is above all dependent on lifestyle and spending habits or ‘burn rate’.

To help you visualize “the power of spending” and its impact on a retirement portfolio, I’ve created four basic retirement funding scenarios. These scenarios assume the same retirement period (beginning 2017 and ending 28 years later), an annual social security benefit of $40K (adjusted for inflation), and a $1M diversified portfolio with a rate of return of 5.5%. The only varying parameter between scenarios is the amount of spending each year with associated tax liability. Each scenario was created using 500 cycles of Monte Carlo probability simulations that modify every parameter except length of retirement to address a range of economic variables and unexpected expenses. The charts include only four (out of 500) projection lines from “best case” to “worst case”.

For the first scenario, our hypothetical client spends $50K/year (before tax), having accumulated $1M at the point that she is ready to retire in 2017. As the chart demonstrates, for the best possible outcome the $50K annual spending client actually grows her nest egg to $1.4M over 28 years (this is the blue line or highest line at year 2045) ― leaving, I should add, a sizable chunk of change for a life beyond 28 years, long term care needs, or for her legacy (be it a favorite charity or her grandchildren). If all economic variables are worse than expected and things don’t quite pan out, she can still expect $250K in assets (see the gray line or lowest line at 2045) after enjoying 28 years in retirement. Not too shabby!

But what if our hypothetical client was in the habit of spending about $75K/year (before tax) instead of $50K? (again, assuming she starts her retirement in 2017 with a $1M portfolio). In this situation, assuming everything goes better than expected the Monte Carlo simulations show a surplus of over $1M after 28 years, BUT in a worst-case scenario the portfolio is depleted after 20 years (around 2037) ― enough to make a financial planner seek ways to protect against the worst-case scenario.

Approaching the Bay Area experience is a hypothetical client who spends $100K/year (before tax). What then? The $1M portfolio would not last her beyond 21 years (2038) even in the best scenario. Unfortunately, there is a higher probability that it will be gone after 15 years (2031). While the worst-case simulation shows that the portfolio could be depleted in as little as 10 or 11 years (2028).

Though there are many other possible spending targets (and also more parameters to consider than those in these scenarios), our final hypothetical client spends $150K/year (before tax) to maintain her lifestyle. In which case, the $1M portfolio would last 9 years tops (2026) and could well be depleted within 5 years (2022).

The story told by the 4 charts is very clear. Saving and spending levels must be aligned for a successful retirement strategy. Clearly, accumulated assets alone are not in and of themselves indicative of success over the long-haul. On the other hand, spending habits and your ability to adhere to a budget are very useful indicators. They can provide a realistic view of your retirement “burn rate” and better align your savings today with future need.

Think of it this way, your approach to spending and your connection to buying are formed throughout your life. It becomes an unshakable habit. For this reason, spending seldom decreases in retirement except with a great deal of stress, anxiety, and depression. To avoid this unhappy outcome, the smartest and healthiest action is to establish a realistic budget for the lifestyle that you seek, then plan your savings around the cost to sustain that lifestyle. The goal of your retirement savings would be to build enough wealth to support your lifestyle.

Though planning for retirement includes more than your burn rate and savings rate they are critical beginnings. What I like best is that these are aspects of retirement planning that we can control.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com