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Episode #549 - What Income Sources are Included for the IRMAA Calculation?
Roger: The show is a proud member of the Retirement Podcast Network.
Welcome to the show dedicated to helping you not just survive retirement, but to have the confidence because you're doing the work to really lean in and rock it. My name is Roger Whitney. By day, I'm a practicing retirement planner with over 30 years’ experience, founder of Agile Retirement Management and for the last 10 years or so, I've hung out on this show, maybe with you, noodling on this idea of retirement planning, but most importantly, how do you actually do this? Do it a way so it doesn't become a second job or a new job, but in a way that you can create a great life, which is the whole point of the exercise.
Today on the show, we are going to focus on answering your questions. I'm going to answer our title question on IRMAA. What aspects of income are included in the modified adjusted gross income calculation in order to determine your IRMAA surcharge? Don't worry. If that was greek to you, I will explain.
Then after that, we're going to bring on Taylor Schulte, an excellent retirement planner, founder of Define Financial and host of the Stay Wealthy Retirement Podcast to answer some of your questions, we go through a lot of questions. inherited IRAs, accessing home equity, pension versus no pension, a few others in there.
We're focused on answering your question, but you're also going to get a lens into what happens when you get two retirement planners that think about this stuff. all the time. What happens when you get them together? We may geek out a little bit here and there, but you know, this is our jam. This is what we love to do.
So, I'm excited to have Taylor on. With that said, let's get to answering your questions.
LISTENER QUESTIONS
Our title question comes from Gene related to IRMAA calculations, and we will explain what that means. But first, let's listen to Gene's question.
Gene: Hi, Roger. This is Gene from Tennessee. I have a question about IRMAA that I've had trouble finding an answer to anywhere online, and I don't remember it being specifically addressed in your podcast.
So, here's the question. What exactly gets added to taxable income to determine the modified adjusted gross income for IRMAA, or what exactly is reduced, subtracted from top line W2 1099 gross income for that IRMAA level to see if you get hit with the penalty?
Thanks for the podcast. Always learn a lot.
Roger: So, Gene, that's a great question and it should be an easier answer than it is, but luckily a good friend of ours, Andy Panko has a resource that he's shared in the club and we've talked about on the podcast that I'm going to share in our 6-Shot Saturday email. It's a one-page PDF that will clearly answer this, but we'll go through it here. Also make sure you check out Andy's great podcast, Retirement Planning Education.
All right, so first let's talk about what IRMAA is, Gene, so everybody else can catch up. So, when you are 65 and sign up for Medicare, You're going to have Part A, and assuming you have enough credits, you won't have any cost for that. Then you're going to have Part B, and then if you choose Part D, which is the drug prescription plan.
So, Part B, which everybody is part of, in 2024, the premium for Part B, which is 174.70 per month, but if you earn over certain amounts, you can have what's called an IRMAA surcharge over and above that 174. 70. So as an example, if you are a single individual that earned 193, 002, you're going to get up to an IRMAA bracket where you're going to pay an extra 384.30 per month for Part B, and this is a scale based on your income. So as an example, for a single person in 2024, if you earned less than 103, 000, you won't have a surcharge. So that's where the first surcharge level kicks in, and there's about six brackets there. If you're married, filing jointly, you just double that. If you earn two hundred and six thousand or less and that income number is based off of modified adjusted gross income, that's why Gene's asking this question.
Well, what's included in modified adjusted gross income?
One other little wrinkle here for those of you that haven't dealt with this before is when they determine Whether you are subject to pay extra for your Part B and Part D, this IRMAA surcharge, they're going to look at your tax return from two years ago.
So as an example, at the beginning of 2024, they're going to look at your 2022 tax return to determine whether you have these surcharges or have to pay extra for Part B and D. So, in 2025, when they determine your premium for 2025, they're going to look at your 2023 tax return. That seems weird and part of the logic is that that's the last filed tax return, so they're always going to look two years back. When you're 63, that's the year that they're going to look at when they're determining your Medicare surcharge premiums or IRMAA when you're 65.
All right, that aside, let's get to Gene's question. They're going to look at what's called modified adjusted gross income.
So, they're going to look at your adjusted gross income and then they're going to modify it and bring some things back into your income calculation in order to determine what bracket, if any, of this IRMAA surcharge you're dealing with. This can be confusing because modified adjusted gross income is not just one term.
There are different modifications of your adjusted gross income, depending on what you're solving for. This is best seen, not heard. So, I'm going to talk through it, but we have a resource, a one-page PDF that talks about adjusted gross income and modified adjusted gross income, depending on what you're trying to solve for and we're going to share that in our 6-Shot Saturday email. That's our weekly email that gives a summary of the show, but also where we can share resources like this. If you're not signed up for it, you can go to rogerwhitney.com or sixshotsaturday.com. This resource was created by Andy Pankow from Tenant Financial.
Andy is the kind of retirement planner you want to have somewhere in your life. He is wickedly smart, wonderfully kind, and a great teacher. He has a Retirement Planning Education podcast, that's the name of the podcast. So, we're going to share his resource and he shared this with the club and we've shared it on the show before with him.
So, on this worksheet, there are five different modified adjusted gross income or MIGA calculations. There's one for Roth IRA contribution eligibility. One for IRA contribution deductibility, one for Medicare premium surcharges, one for net investment income tax, and one for the Affordable Care Act tax credits.
Each one of those modified adjusted gross income calculations is a bit different. So that's how this gets confusing, right, Gene? So, when we look at the modifications to adjusted gross income for IRMAA surcharges, virtually everything is included. So, wages and interest from municipal bonds are brought back in interest from other sources, dividends. taxable portions of employer retirement plan distributions, taxable portions of Roth conversions, all of these are included, annuity payments that are taxable. So, the taxable portion of an annuity payment, the taxable portion of social security, capital gains, refunds of state and local taxes, at least the taxable portion, alimony from a pre-2019 divorce, self-employment income, rental, royalties, partnership, S Corp, trust income, unemployment compensation, and there's a few other things.
The things that decrease modified adjusted gross income, there's a list of those as well. So, we'll have this resource gene that will outline what the modifications are for IRMAA surcharge, but you also get the other ones on a one-page PDF that is very clear. That should help you on this journey.
With that, let's get to chatting with Taylor Schulte.
CHAT WITH TAYLOR SCHULTE
All right, now it's time to answer your questions. If you have a question for the show, go to askroger.me. You can type in a question, leave an audio question, or just say hi, really tell us whatever you want. To help answer your questions today, we have founder Taylor Schulte from Define Financial and host of Stay Wealthy Retirement Show.
Taylor, welcome back, buddy.
Taylor: Roger, thanks for having me again. It's good to see you. I know you've been off in Colorado doing Colorado things, so excited to catch up with you.
Roger: Yeah, and you've been off doing all those little, I got young kid things. So, we're like, yeah.
Taylor: Yeah, that is true. Yeah. Kids are out of school for the summer.
So, there's a lot of, what do we do with these kids during the day, conversations happening, but yeah, we're staying busy. We actually just took a week-long trip to Mexico with the family and had a lot of fun and didn't do a whole lot other than sit at the pool and the beach and just spend time with the kids.
So that was fun.
Roger: Two things before we get started answering questions.
Number one is a warning to you, and number two is I want to hear what's going on with our retirement podcast network.
So, number one, the warning is I started golf lessons again for our trip in November.
Taylor: Oh boy.
Roger: And they're going to stick this time. I'm committed to doing the work, although I really showed up last year. So just FYI on that.
Number two, what's going on at our retirement podcast network that we've been iterating on. You're the mastermind of a lot of things.
Taylor: Yeah, I'm glad you brought it up actually.
Yeah, I think we touched on it briefly here on the show. I don't know what it was a couple months ago and kind of talked about the genesis of the retirement podcast network and kind of our vision for it. Interestingly enough, and I think this happens a lot in the business world, you kind of pivot based on feedback that you get from your customers or your people, your followers, your audience.
What we learned really quickly is that all of you guys, all of our listeners, my respective show and yours are really enjoying our weekly email that we're sending out. So as part of the Retirement Podcast Network, we send out a weekly email called RPN Weekly. Every single week on Fridays, we send this email out and it includes five of our favorite articles that we read that week that have something to do with retirement planning, investing, tax planning. We're scouring the internet, we're reading all these articles all week long, and we're choosing the best five, and we're including them in this email as well as our favorite chart of the week. Again, that chart is related back to investing, retirement, financial planning, tax planning, something that makes sense for our target listener. Then also a summary of the episodes that we have all individually produced for that week. So, it's a really nice, concise email. Almost a thousand people are subscribed to that email right now, and the feedback that we're getting is phenomenal.
So, we've been pouring a lot more of our time and attention and resources into making that email even better as a way to add more value to the retirement podcast network and then the people that are following us there.
Roger: So much to listen to, and we have five shows in the network currently so you can go to Retirement Podcast Network and sign up for that email and hopefully save yourself some time.
All right We have our first question Taylor, you ready?
Taylor: I'm ready.
HOW TO USE HOME EQUITY AS A RETIREMENT RESOURCE
Roger: Yeah, we'll put a link to this in 6-Shot Saturday by the way, our weekly email summary of this show only.
All right. This comes from Jeff related to tapping home equity and retirement Taylor.
"I am still in the accumulation phase and on track relative to my bespoke plan."
Nice fancy word there.
"My wife and I find ourselves headed to a place where it's at a point where I want to retire. We will have one substantial 401k assets, non-Roth and two substantial amounts of home equity, probably two to three million.
It's clear that one option is to consider downsizing to a less expensive home and turn some of that home equity or use asset into productive asset. But if we decide to stay in our home, my research tells me that we should convert some home equity to cash vis a vis a home equity line of credit, a HELOC or reverse mortgage.
I'd love to hear your perspective on how you go about using home equity as a resource in retirement."
You live in California, San Diego, where you deal with, seems always rising real estate prices. How do people access their home equity if they don't want to move?
Taylor: Yeah, there is a lot to unpack here. We do run into some interesting scenarios out here where there are people in California with most of their money tied up in their home, which is an illiquid asset. So, they are faced with some decisions in many cases where they do need to either sell the house and downsize or find a way to get cash out.
This is a really huge topic, Roger, and we don't have all the relevant information here. This person is asking some really good questions about kind of order of operations and what to think about here. Maybe just to start here, maybe we'd start with like that order of operations just in general, and then kind of try to get to the root of his question and try to answer it as best as we can with the limited information.
So, for me, unless you have plans to sell the house in the future and downsize, within the next 10 years or 10 years from now, we want to sell this house and we want to downsize. We want to move closer to our kids or we want to just move to a lower cost area, or we've always wanted to live in Arizona. If you have the intention to sell that house in the future and downsize, then the house sale scenario, to me, is usually the last asset to sell in the order of operations. In other words, if you have no plans to sell the house, if you just want to live in it for as long as possible, then typically the order of operations is we're going to take money from our traditional IRAs first to ensure that we're maxing out favorable tax brackets. So, we'll withdraw up to those favorable tax brackets from our traditional IRA. You might be doing that through Roth conversions. If not, you can do it through straight withdrawals. Then from there, I want to look at our taxable brokerage accounts, where those more friendly capital gains exist.
Then third, that Roth IRA, if we have a Roth IRA bucket, we want that to grow as long as possible. So that would be third on the list.
Then to me, Fourth would be these other items like your home. If there's no plan, if you don't intentionally plan to sell the home in the future, then to me, that's kind of like the last thing on the list. Like if I have to sell this home, then that'll be the last asset I sell.
Now that's just your strict order of operations. That's not necessarily, well, how do I get some cash out now or set us up now in case we do want to tap into some of that cash. But just in terms of straight order of operations, if there's no intention to sell the house, then yeah, I'm going to put that at the very bottom of my list and when, and if I ever have to sell the house, I know that that asset is there and I'll sell it.
Roger: Yeah, I like this idea of order of operations of how I think through it in an organized way.
So, our order of operations would be first establishing a feasible plan of record to determine whether it's feasible to live the life that you want without selling the house. Let's say that's version one to see if it's even feasible, and it may not be right. It'd probably be good to know that.
Then creating if it's not, then it's, well, how long can we stay in this house? Right. What if version number one might be, and I've done this numerous times, like Taylor and where it wasn't feasible to keep the house or the second house forever, but it's feasible if you agree that you were going to sell it at some point in the future and recapture some of those assets. So, you can get an idea of what the roadmap looks like.
One thing I find interesting about this, Taylor, is someone told me, and I haven't googled this to see if the study is actually correct, but it said if you are on a perfectly flat surface and you are six feet high that you can only see like 2.9 miles before the curvature of the earth takes over. I think of this like that in that we're sitting here making assumptions about ourselves 20 years in the future or 15 years in the future. Nobody really has a forever house, or very few people actually do, so I think knowing whether it's feasible not to be able to do it, or if it's a lever that you can pull later on.
Do you have any specific thoughts on, now the HELOC, that seems a little bit more problematic to me because it's really just a line of credit and you're going to have payments on it, et cetera. Have you ever walked the journey of a reverse mortgage in your practice?
Taylor: Yeah, I think the reverse mortgage here, the comment about that, it truly is.
I know there's some part of the question about risks and considerations, and I think that's truly the biggest risk or consideration to factor in. Maybe before we go there, I just want to share that if you have an intention to sell your house or you realize, hey, we do need to sell this house 10 years from now to help fund retirement expenses. I know part of this question is like, what assumptions should I be using? I'm not sure exactly where he came from with saying what assumptions that I use, but just for whatever it's worth, we typically use a 4 percent growth rate for residential real estate, which is the long-term historical average. At least before the last couple of years where real estate went crazy. So, if you are going to model something out, Hey, in 10 years, we're going to sell the house. I might use a conservative growth rate, like three or 4 percent on that asset. Then I want to figure out my cost basis and ultimately end up with what's my tax bill is going to be after the sale of this house factor in real estate agent fees as well.
But essentially, what am I going to walk away with? 10 years from now, if I sold this house, you can use financial planning software, talk to your financial advisor or model something out in Excel, but those are really the basic assumptions is just the growth rate of this asset for the next 10 years, my cost basis, if you made any improvements to the home, you're going to factor those in because that'll increase your cost basis, the exclusion that you get when you sell a home and then real estate agent fees. What do I walk away with at the end of the day, that's a really important piece of information to know. What am I going to do with those proceeds? I need to go buy another house and then also use some of those proceeds to fund retirement.
So that's the exercise there.
Roger: I think another assumption there, Taylor, that in working through this exercise is, if I were to do it today, what would be the cost of the place I want to go to? Many times, it's not near as downsizing as you think it is just because depending on your local real estate market. So, getting an idea of the cost of the place that you want to go to today because the delta might not be as large as you think.
Taylor: Yeah, that's a really good point. Especially if you've owned your home for a long time, and there's a lot of capital gains in there, you might have a much larger tax bill than you thought and what you walk away with at the end of the day might not be as much as you had initially hoped. So, I think that's a really important piece of information.
I think what he's really getting at is like, I don't necessarily want to model the sale of my home, but I just want to be prepared in case I ever do want to tap into that equity, which has led him to this reverse mortgage question or some sort of a loan that I can tap into. In short for us, I know there's some academics out there that talk about using reverse mortgages to create retirement income. For us, reverse mortgages are typically like your last-ditch option. Like I've tapped everything in my last option because I want to stay in my house. I do not want to leave my house; the last option is reverse mortgage the house.
Now, most of our clients, all of our clients, do not proactively go and get a reverse mortgage now for a few reasons.
One, the application process is long and painful. You now have to go through counseling to ensure that a reverse mortgage makes sense for you. And then the big kicker is the origination fees for these reverse mortgages can be as high as like 40, 000 somewhere between 20 and 40, 000. This could change a little bit state by state, but it's expensive to set these things up, so unless you absolutely need this thing, most people don't want to go through all those hoops and then write a check for 20, 30, 40, 40, 000 on something that they may or may not need.
I would like to highlight that this is a loan. Don't kid yourself here. Like you are getting a loan. A reverse mortgage is a loan, and so unless you need to go and establish a loan to borrow from yourself or borrow from the bank, it's not really the most prudent option. Maybe the last thing that steers people away from reverse mortgage. Again, he asked about risks and considerations, your reverse mortgage will mature if you're away from the property for more than six months for non-medical reasons, and then more than 12 months if you're in a medical facility. So, if you have a medical event that requires you to be in assisted living for a year, well then say goodbye to your reverse mortgage and then hope that you still have enough equity in the house to avoid a foreclosure situation.
There's a lot of little nuances there that typically spook people away, especially those who are in really good financial positions, really kind of scares them away from doing a reverse mortgage. So, I'm not sure that that's the solution here, especially since this person said, I have a substantial amount of money in 401k assets and a substantial amount of money in my home. It doesn't sound like there's a huge income need here from these assets.
Roger: Yeah, and I think that's build that feasible plan of record first to know if it's even something you need to think about pulling. We'll get into reverse mortgages. We'll have to do a whole episode on it because there are a lot of nuances. I walked this journey with one client and almost did the traditional mortgage or a reverse mortgage of sorts, and we chose not to do the mortgage. So, there's some places for innovation here.
WHICH RULES SHOULD BE USED FOR THIS INHERITED IRA?
Okay. That was a long one. Now I got a short one, and this comes from Thaddeus.
"Roger, looking for clarification, my mother passed away in December 2019, but we did not inherit her IRA until March of 2020.
Do we follow the pre 2020 IRA withdrawal rules or the current 10-year rule for IRAs? Which one?"
Taylor: This is like a CFP test question here.
Roger: It does sound like it, doesn't it?
Taylor: So, yeah, so the rules just tie back to date of death, right? So, date of death of that person would be December of 2019. So, you would use the pre 2020 IRA rules for this situation.
So, everything ties back to date of death, whatever's on the death certificate.
Roger: We just recently got some more clarification from the IRS related to this, because the next question, now that we know that is in your case, it's prior to secure act. So, you're just going to follow the normal stretch rules.
Okay.
So, actually all the secure act stuff doesn't apply to you. So, I just answered my own question. I was going down the secure act because I've been reading that lately. And so that's where my mind is. So, you had it pretty easy there from this perspective. You just can stretch it out over normal life expectancy.
WHY SHOULD I DO A ROTH CONVERSION IF I DON'T WANT TO?
All right, next one is from Anthony related to Roth conversions.
" Yo, Roger my question."
He didn't actually say “Yo, Roger” but I like that. I think that's how Anthony talks. I know an Anthony who talks that way.
"I know the advantage of Roth conversions that you recommend doing as many conversions as you can and paying the taxes, preferably from our savings.
My question is, why should I do a Roth conversion, even though I know that when I pass, my two kids can easily pay the taxes themselves when they inherit my traditional IRAs? I don't want to do Roth conversion paying taxes from my IRA distribution itself. I think as long as I am alive, I will pay taxes on whatever RMDs I have."
He goes on to say my wife and I are 60, 67 and receive monthly pensions.
Well, one, I would argue before I throw this back to you, Taylor, is I don't say, yes, you must and should really do Roth conversions. I think it's a tool that you should evaluate. But it sounds like from Anthony's perspective, it's like, I don't want to pay all these taxes, my kids can handle it. How do you approach this subject?
Taylor: Yeah, I think last time I was on, we had a Roth conversion question. We're sure to emphasize that look, Roth conversions can be great. It's a way for you to optimize your plan. It's not going to make or break your plan. So, if you skip Roth conversions, fine, you know, I'm sure you'll be just fine. If you do some Roth conversions where it makes sense, it could put you in a better position.
At the end of the day, to me, just like, let's set the kids aside for a moment, a Roth conversion is paying taxes on your terms versus the IRS's terms. So, is it cheaper to start to pay some of the taxes now? By the way, I don't think you mentioned it, but I know Anthony has, he mentioned a 1 million IRA and he's 70 years old. His wife, I think is 67, 1 million IRA. Is it better, is it cheaper to start to pay some taxes now on that money, convert it to Roth, or do nothing, wait and pay some of the taxes at age 73 when Anthony is forced to start to take required minimum distributions, will your effective tax rate be higher at age 73 and beyond than it is today?
To a certain extent, you have to make some assumptions here, right? We don't know exactly what things are going to look like in the future. There's no guarantee, but that's the question to ask yourself is, am I in a better tax situation today? Or can I get some money out at a lower rate today than where I'll be in the future? That's just an exercise that I think everybody should go through to determine if there's an opportunity there.
Now, going back to the kids, because I think he's asking a really good question. This comes up a lot.
First off with Anthony, with your pensions and social security and the fact that you only have three more years before your RMDS begin, it's highly unlikely that you'll be able to convert all 1, 000, 000, at least I think, like, I don't have all the information here, but that's a lot of money to convert in a short period of time when you have other income sources. So maybe push that to the side that you're not going to convert all 1, 000, 000. Again, it might still make sense to do a Roth conversion analysis and determine maybe you can get a little bit of money out. Maybe it's just 50, 000 per year for the next three years. That could still be a win.
Back to the kids. Yes. Your kids can likely easily pay the taxes themselves when, and if they inherit this IRA, the inability to pay the tax bill is not usually the primary driver of this approach. The reason that, at least our clients, the reason that they consider their kids when doing a Roth conversion is for two reasons.
One, their kids will likely be in their peak earning years when that IRA is inherited, and two, the client, again, we're not going to make this prediction, but the client believes has a strong opinion that taxes will be higher in the future than they are today. So, if my kids are going to be in their peak earning years and taxes are going to be higher in the future, the parents are saying to themselves, well, I can pay 22 percent or 24 percent of the IRS today, or my kids might have to pay 37 percent or higher on a potentially larger balance in the future. So that's really what I hear from clients. It's not like I'm worried they won't be able to pay the tax bill, so I'll pay it for them.
It's like, no, I, I don't want the IRS to get a bigger chunk of this money than they really deserve.
Lastly here, also it's rare in my experience for someone to do Roth conversions just for the benefit of their kids. It's usually a mix of a few different things.
One, clients wants to pay tax rates on their terms at favorable rates.
Two, getting money into a Roth provides some flexibility and tax diversity in retirement.
Then finally, it might be something like, yeah, I don't want my kids to inherit a tax burden or I don't want the IRS to collect a bigger check in the future so I want to get some money out of there today. I want to pay it at more favorable rates today so my kids don't get stuck with this giant tax bill and the IRS collects a bunch of money.
It's usually a mix of these things. It's not just I'm going to do this for my kids.
Roger: Yeah. A good friend, Michael Kitsis says, and I think it's the best way to think about taxes is it's never a question of avoidance, it's always just a question of timing. You're going to pay the tax, whether it's this year, next year, or your children pay it.
Taxes will be paid. It's just really a matter of timing. So, if you think of a couple of quick steps you could go through, Thaddeus is number one, create a, let's just call it a three-year cashflow estimate for you and your wife. What is your income going to be by source over the next three years? That's step one.
Step two, you say you're not taking money from your IRA. If you don't take money from your IRA, just throw a 5 percent growth rate on it. What will that grow to, your required minimum distributions, you go on to an online calculator and figure out what your first year and beyond R. M. D. estimates are. Now that's going to be income that you're going to be forced to take out that will be added to your other income sources and see as Taylor was saying, does this move me from the 12 percent to the 22%? Or from the 22 to the 24 or whatever they are after 2026. Like you were saying, Taylor, do I have the opportunity of taking 20, 000 and paying 12 percent this year, rather than waiting and paying 23 or 24 or whatever it is.
That's really the low hanging fruit on all is give me a burger today rather than two tomorrow. I know I can pay 12 percent on some portion of it and maybe there isn't any opportunity. So that's usually a healthier way to approach this.
Taylor: That's well said. It is a timing decision. Another one of our mutual friends says, Hey, we want to pay the IRS their fair share, we just don't want to leave them a tip, right? So, let's not just be lazy here and do nothing or I don't want to pay this tax bill for my kids, right, and just not do anything. Then all of a sudden, like you are leaving the IRS a tip. The IRS is winning in this situation.
Be proactive, crunch the numbers, make an educated and informed decision. Yes, we don't know the future. So, to a large extent, we are making educated assumptions here to try and make the best decision possible for us and our financial plan.
Roger: Okay. You said a mutual friend. I don't know who this person is. I want to confirm that I'm actually friends with them. Who is this?
Taylor: I'll tell you offline.
WHAT CAN I DO WITH MY SMALL ANNUITY?
Roger: Our last question, Taylor is from Brent.
"My question is as follows.
My wife has been a teacher for 31 years. She plans to retire in three years at age 58. When she started teaching all these years ago, we fell for the sales pitch and opened a variable annuity for her. When I came to my senses, I stopped contributing money to the annuity and opened up a Roth IRA, which has a balance of 250, 000. The annuity has a balance of 14, 000. What can I do with the annuity?
Can I somehow get the money into a Roth? Can I plan on retiring in December and I have Roths in my name also?"
I think the good thing here is it's 14, 000. It's not the majority of your nest egg. So how you manage out of this annuity is really just looking at the fact set of what are my options, right?
How would you approach this?
Taylor: Yeah. I was almost wondering if there was a typo in the question, like it's a really good question about the annuity and what do I do with this thing, but you know, it's only 14, 000. I don't want to make assumptions here about what that 14, 000 means to this person, this couple, yeah, the balance, at least in compared to the other 250 that's been saved, it's relatively small so even if you paid the taxes and paid whatever penalty you're still walking away with some money there. Maybe it doesn't require a large analysis.
However, let's say that that 14 grand means a lot to you. You want to make the smartest decision you can with that 14, 000.
One is just understanding if there's any surrender fees on this annuity so most annuities have some sort of surrender period. You need to wait seven years or 10 years before you can liquidate it without penalty or move it without penalty. So, you might just want to understand what those surrender fees are when that schedule ends. Maybe it's already ended. It sounds like you did this quite a while ago.
Then from there, it is pretty simple. He didn't share what type of account the annuity is held in. Annuities can be held in retirement accounts, IRAs. They can be held outside of retirement accounts and just your traditional brokerage accounts are in the name of a trust, but let's just assume that it's pre tax IRA account type. So, if the annuity is out of surrender, there's no more fees. That 14, 000 is yours to do something with, well, you can just move it to another pre tax traditional IRA and invest in how you see fit, maybe do some Roth conversion, since he mentioned trying to get it into a Roth, you could also move it to another annuity if annuity seems to be fitting for you, but once you're out of surrender, you can kind of do whatever you want with it.
You could just treat it like any other account type, any other traditional IRA that you might have. So, there's a few things maybe understand there to ensure that you're not. Surprised by fees or penalties, but it is pretty simple once the annuity is out of surrender.
Roger: I think a key to this is thinking through it in an organized way, Brent, rather than, obviously you're not an annuity fan from your experience just with the verbiage that you used in your question. But you also want to make sure that you're not giving up a valuable benefit that you're not even aware of. That you might not recreate.
So similar to Taylor, have a feasible plan and just think about this as a financial asset. Table stakes is having a feasible plan. This is a tactical decision of what do I do with this one piece of my financial assets in the context of the bigger plan of what's important to you. Then when you're looking at this, is it in a surrender charge? What are the costs? What are potential benefits that were in there that you may not even realize were in there because you've had it for so long? That could be a long-term care benefit. It could be an accelerated death benefit. It could be, you just know, it doesn't matter whether you like it or not, just know what they are. Then once you have that information, what are the options? I could buy another annuity, and maybe there are better annuities that have things that you care about now. Long term care with limited underwriting, perhaps. Or you could turn it into cash. If you turn it into cash, is it an IRA?
Just thinking through it like a decision tree will help you get to your best judgment, because there's likely not going to be a slam dunk answer. That's true for most things.
Taylor: Yeah, really well said. I should have mentioned that every annuity is different, right? So, it might be called a let's say variable annuity, but every variable annuity is different. Even variable annuities at these insurance companies that have the same name actually are different. They roll out different variable annuities under the same name all year long with different I. D. Numbers. So anytime we're dealing with an annuity, new client comes on board. We call the insurance company directly, and we're on the phone with that annuity company for at least 30 minutes, asking them a lot of questions about that specific product and learning as much as possible about that specific product to then decide how we are going to move forward with this annuity. Not all annuities are the same.
Be very careful, and I think you listed out some great questions and things to understand to know how you want to move forward with this bucket of money.
Roger: It's like wine that way. It could be the exact same name, but a different vintage year to year, right?
Taylor: That's a really good analogy.
Roger: Thank you. All right. I'm going to throw a curveball at you.
ARE CLOSED-END FUNDS GOOD OR BAD?
Here's another one actually, this was asked in the Rock Retirement Club and I promised I would ask it on the show.
"A good friend asked me to read a book by a former financial advisor promoting actively trading in closed-end funds to enjoy large and growing distributions during retirement. Then do you have any thoughts on a few closed-end funds?"
They gave me a couple symbols.
So, the symbols they gave me were essentially equity, dividend equity portfolio in the structure of a closed-end fund, not the traditional fixed income closed-end funds that we talked about, but I think the two key questions here are one, closed-end funds, good or bad or worthwhile investments?
Two, really what the guy was promoting, which is actively trading closed-end funds to capture dividends and be protected in all markets was somewhat of the pitch when I went and checked out the book.
I don't want to recommend it because I think it's hoo ha but I wanted to talk about actively trading in terms of getting growing distributions in retirement. Is that a good strategy? What are some of the maybe advantages or disadvantages?
Taylor: It's timely. I just did a whole four-part series on dividend investing on the state wealthy retirement show this last month.
I cover everything you could possibly imagine on dividends and dividends investing and kind of exploring a lot of these concepts and what I would call myths that are out there about chasing yield or chasing investments that kind of promise these distributions. So, if you want to learn more, go there and listen, pushing aside the investment product, right, closed-end fund versus ETF versus mutual fund versus separately managed account, whatever, like. Push the product type aside, your retirement needs and goals, your income needs, your retirement timing, your needs and goals should drive how you invest your money based on what I need, based on what I'm going for, what my goals are. Here's how I need to invest my money.
From there, then determine, okay, what's the best way to go and implement this investment portfolio, it might be closed-end funds. It might be mutual funds. It might be ETFs. It might be a mix of all these things. At the end of the day, when it comes to choosing investments or yield, you get in a situation where you end up taking a lot more risk than you probably think.
I think the simplest way to frame this is the global stock market. So, US stocks and international stocks. The global stock market, the current yield of the entire global stock market right now is like about 3%. So, if the global stock market, the yield of the global stock market is 3%, and there is an investment out there, again, I don't care if it's a closed-end fund, if it's a mutual fund or an ETF, there's an investment out there that says we're spitting out a 6 percent yield, double that of the global stock market. All you need to tell yourself is I'm taking more risk than the global stock market to go and get that 6 percent yield that 6 percent yield doesn't come out of nowhere. You don't just get like more yield for the same amount of risk. There's more yield there for the reason that that portfolio that closed-end fund contains junkier companies that are paying higher yields. You need to accept more risk by getting those higher yields.
I don't really care so much that it's a closed-end fund, although closing funds certainly have some issues. I just care about luring investors into these products that on the surface appear like they're great solutions, but these investors not really realizing how much risk they're taking by buying these investments.
I would just be very, very, very careful. Hopefully that illustrates just really simply how to think about the risk when buying some of these funds.
Roger: Yeah. One thought on how we think about dividends, but I want to question and perhaps a pushback on something you said is thinking about the dividend yield. I mean, dividends are nice, right? It's nice to get paid. The price will go down by the amount of the dividend, but behind income strategies is that we think of retirement planning like our parents did, that we're going to live off interest rather than thinking in a total return strategy.
I think the idea of just living off the income of portfolio throws off for 99 percent of us, that's not going to work, and it can lead you down some of these strategies where a more thoughtful retirement process can help you.
I wanted to question you on the junky company comment. I think of companies who have free cash flow, right? They have to decide what to do with it. They can reinvest it in the company. They can buy back stock, which is more popular than ever, or they can distribute to the owners. There are obviously more options, but those are the main three.
Not all companies that Decide to pay back a portion of their free cash flow or profits to the owners are junky. The ones that the higher the yields, the more aggressive they might be. But I don't know if it's always.
Taylor: Absolutely. It's certainly not always. Maybe we'll back up and we'll say one of the common reasons that companies pay dividends is to show potential investors that they're healthy. They're so healthy that they have some excess profits that they can share with you, right? They don't need that money to fuel the future growth of the business. We're doing so well that we can share some of these profits with you, our investors.
Now, it's not necessarily true that it's just because they pay a dividend doesn't mean they're healthy, but that's kind of what they're signaling to investors is that they have some excess cash. They're healthy. Therefore, you should invest in them.
The other thing to note is most companies pay a dividend. I think it's like 75% of all US companies, they pay some sort of a dividend. It may not be 6%, it might be 1%, it might be 3% or 2%, but most companies do pay a dividend. So yes, there are great companies that pay dividends.
To your point about looking at the total return of your investment versus just the yield, that's the important part. You've got a great company like, I'll pick on AT&T, for example, AT&T is long paid a nice dividend. But if you look at the total return, and I haven't looked at AT&T specifically, but most of these great dividends paying kind of blue-chip stuff.
Roger: AT&T is about 6%.
They're my doghouse because they've released all my information, but they're about 6 percent right now.
Taylor: If you look, I haven't looked at the total return chart, but most of this kind of like blue chip stable dividend paying stocks, you look at the total return compared to just the S&P 500, and they significantly outperform even with the dividends included.
So, yeah, it's a stable company that spits out a nice dividend, but on a total return basis. Your investment returns are significantly lower than just owning the global stock market, and so no, not a junkie company, but you should expect lower returns from these dividend yielding or high dividend yielding securities.
My comment about junkie companies is when you go chase a portfolio that has 6 percent yield, you are owning some junkie companies that are going to drag down the future returns of that company. You are increasing the risk in the portfolio and you will likely have lower future expected returns.
So no, they're not all junkie companies that are great companies that pay dividends, but just very simply, there's no free lunch.
Roger: I'll check out your series. I didn't realize you did that.
The other part of this question, Taylor, which I have a big issue with, is this idea that there's a trading strategy that's active in trading these instruments or any instruments that can somehow participate in the upside and protect you in the downside, which is what this book is arguing and well, I'll say promoting.
I think that is a recipe for disaster in that it's all about the execution, not just now, but consistently. I think that's a recipe for disaster for someone to try to go into retirement thinking they're going to have a trading strategy to pay for their life for the next 20, 30 years.
Taylor: Yeah, I think we're in agreement. They're actively trading. I mean, again, all the data is out there, all the research is out there that actively traded investment products largely underperform just your passive low cost, simple solutions.
It all sounds good. The marketing sounds great, but you should expect lower future returns from that product that's actively trading things.
Now you might get lucky and choose the right manager at the right time, and it happens to work out but on average, over long periods of time, these actively traded strategies typically underperform. Now, I will say some of these, they are very good strategies run by incredibly smart people and it's not that the strategy is bad, but these actively traded strategies cost more money than your low-cost kind of passive, plain vanilla solutions. Those additional fees reduce the rate of return. So, it's not that the manager doesn't know what he's doing or she's doing, or it's a bad strategy. It's just like the fees that are embedded, they take away all the excess return that that manager generated.
Just on average, over a long period of time, you know, 85, 90 percent of these active strategies underperform. Maybe you get lucky and you choose the 10%, but that's a really hard thing to do.
Roger: Charles Ellis, Winning the Loser's Game, investment classic. If you're going to learn the investment strategy and take it on yourself, then yes, you're saving the cost of paying someone else to do it, but now you're paying in a lot of other costs. You're paying in taxes. You're paying in time. You're paying and execution risk goes up through the roof in terms of, you've got to do it exactly the same way every single time and not outthink it. Even then it might not work. Even if it has a bad period, you have to stick with it, even if it was a valid strategy in the first place. It sort of sets you up for a lot of future difficult decisions.
Taylor: I agree. I always say the best investment strategy is the one that you can stick with and what I find when people come across these too good to be true type investments that they want to go and implement themselves, they go and they try it for a year or two. It doesn't work out how they had thought. So then they jumped to something else and they never really give this thing the long term hold that it needs to be successful. It's really hard to stick with things.
No matter what strategy you choose, you're going to go through a period of underperformance. You're going to go through a period where you hate this strategy that you have. Could be dividend investing. It could be small cap value investing. Could be this closed-end fund actively managed strategy. It's going to go through difficult time periods, but you have to stick with it. You need to own it for a long period of time, and that's really challenging to do on your own.
I think you brought up the real point, which is like, is that really how you want to spend your time in retirement day trading, actively managed closed-end funds? Like most people would say no.
Roger: I don't. So, I am going to check out your dividend series on Stay Wealthy Retirement Podcast. Didn't realize that you did that. That's awesome. Thanks for hanging out with me, buddy.
Taylor: For what it's worth I did see one other question come through.
Roger: Did I miss one? Okay. You read the question.
Taylor: Okay. I'll play Roger. I'll play Roger today.
PENSION OR THE LUMP SUM?
All right. Question.
"Bit of a background. I retired last year at 52 from the corporate world in order to scratch my entrepreneurial itch. It's been a goal of mine for years, but the golden handcuffs and multiple college bills for kids prevented me from doing so. After doing some calculations, I determined that I was financially independent. I pulled the plug."
This person has 6 million net worth, not including their home equity, and they have an option to take their pension from their company as a lump sum or in monthly payments. The monthly payments would be about 3, 500 per month starting in 2032. So, six years from now. So, he's 52 today. Six years from now, he'll be 58 and that's when he could start to take 3, 500 per month from his pension. That's one option. Or he could take the cash value. Now he could take the 400, 000 lump sum, roll it into an IRA and invest it how he sees fit. He mentioned that he also has another pension that will be paying 1, 100 per month, starting in 2028. That one cannot be taken as a lump sum so he's just accepted that. Then also both of these do not have cost of living adjustment increases. So, no COLA on either of these pensions. In other words, It's 3, 500 per month and that's it. It's not changing in the future. Inflation will slowly erode or eat away at the purchasing power of that 3, 500 per month.
Lastly, he said he's leaning towards taking the lump sum after doing some calculations, but wanted to see if he was missing anything. He just figures he could invest the 400, 000 now and have more flexibility down the road than this fixed monthly payment that does not grow with inflation.
So, what should he do?
Roger: Okay, so it actually starts in eight years, not four years. I think you said four or six years, right? Starts in 2032. So that'd be eight years.
Taylor: Oh, I'm sorry. Eight years. Yeah. So, age 60.
Roger: Okay. So, you're asking me that question. I'm going to answer this first. All right.
So, one, it sounds like we have a feasible plan. You are likely overfunded. I'm going to make that assumption based on the numbers you gave. Right, Taylor?
Taylor: Right.
Roger: Okay. So, you're overfunded. This is an optimization question. Do you take the 400, 000 today or 3, 500 a month starting in 2032? We can make some assumptions on what the 400 would grow to.
One question is, do you have to make the decision now? Some pensions will allow you to defer that decision. Sometimes the pension amount in terms of the monthly income could grow by deferring it. So, we would want to know that because perhaps you could not choose one or the other and then choose 4, 000 a month, four years from now, you have to check with your pension on that.
Just using the 400, 000 in today's dollars that's about a 10 percent payout, which is attractive, but we have the foregone growth on that 400, 000 if the pension is locked in the way we talked about it. So, we do want to know that.
I think this is a little bit of dealer's choice in what do you want? The advantage of taking the money is going to be that you can hopefully grow that longer. You're so overfunded that you're building a bigger pie for family later on. The disadvantage is you're going to have a higher need from your financial assets because you don't have this guaranteed income source.
Not with those facts presented. I would likely take the pension.
Taylor: Interesting.
Roger: We need to know whether that, what might grow later between now and 2032. That's really the wrinkle for me. I think Taylor, assuming you got that 40, 000 a year today, I would rather get the social capital as guaranteed payments and that will allow you to be one, more aggressive, potentially with the rest of your assets, because there's less of a demand for them and it'll also be, make your future self, their life a lot easier potentially.
The other factor is if you take the pension, you may have a bigger window to do Roth conversions and things like that because we have the time. I would say 80, 90 percent of the time, because this is one of the most answered questions, Taylor, that we get, The pension is usually a really good option. So, this is not a recommendation to you, but this is, as I think through it, you're never going to recreate that pension if you were trying to buy annuity later on.
What do you think, Taylor?
Taylor: So yeah, it's interesting where you landed with that. There are a few other things that came to mind for me here. So one is, yeah, so this 400, 000, well, the way I took it in his question was the 3, 500 per month in 2032 to me, I took it as like, he already has that number from the company that if he waits until 2032, that's going to be the amount. So that's the way I read it. So, it's, I can take the 400, 000 now or wait and get 3, 500 per month, eight years from now.
The first part for me is, okay, I take the 400, 000 now and I invest it, so what's that going to grow to eight years from now? I'm just going to make a number up and say it's 550, 000.
Roger: 590. Pretty good.
Taylor: So conservatively, again, let's just say 400, 000 turns into 450, 000 conservatively at the end of eight years, 3, 500 per month divided by that 550, 000, it's getting close to like a seven, 8 percent distribution rate.
On the surface that sounds pretty darn good, right? We all know the 4 percent rule. So, this pension company is basically saying, we'll pay you seven or 8%. I don't calculate the numbers in front of me here, but we're paying you 78%. That sounds pretty enticing. However, there's no COLA increases. So, it sounds good today. This is pretty typical with pensions that don't have COLA. It sounds good today, but inflation is going to start eroding your purchasing power. 3, 500 a month, 10 years from now is not the same as it is today. So, the math is all making sense to me.
The other thing, COLA is a big one for me. If there's no COLA, I'd say 99 percent of the time that the client's not taking the pension, they're going to roll.
Roger: Interesting. We're very different on that one.
Taylor: Yeah. Well, here's the bigger kicker for me, and we don't know this information. He did mention kids, college bills. I know he has kids, so he seems like he's very well taken care of financially that he's over saved for retirement. So, what are his intentions and goals for his heirs, his kids, if he takes the pension and he passes away, that money's gone, right? The kids don't inherit that pension. If he takes the 400 K and invests at how he sees fit and grows that 400, 000 to a million dollars by the end of life, his kids now inherit a million dollars. So, I think that's an important consideration here is what does this bucket of money mean to you and your legacy goals?
Then second to that, again, there's a lot more to understand here, but I'm not sure if he's married. I know he has kids, but I don't know if he's still married or not and how his wife plays into all this as well. There are some different pension options, you know, spousal benefits. Also, sometimes you run into, let's say he plans on taking the pension eight years from now, in some cases, if he passes away before that pension begins, it's gone. If he doesn't make his election and start that pension and he passes away, that whole bucket of money is gone. She doesn't get the 400, 000. She doesn't get the pension. So, it's not until he starts to take that pension income and if he elects an option that includes a spousal benefit, that she would be entitled to it.
That's something to factor in as well as how does my spouse and the benefits from my spouse play into this decision, and we just don't have enough information there. So, a few more things to consider, but the lack of a COLA is a real big one for me, especially since he doesn't really sound like he needs this income.
Is it better to take the money and grow it yourself?
Roger: Yeah, I think the key thing is 6 million net worth likely doesn't need the income. Lack of COLA doesn't bother me nearly as much as it does you.
Now this is interesting because I think Taylor is one of the smartest retirement planners I know, and I try to be, and we have some differing views on approaching this, and it goes back to sort of that annuity question is, and this is frustrating for you. It's frustrating for us is almost all of these questions become our judgment calls based on financial numbers, but also personal preference, and that's okay.
Although that is frustrating, it'd be great to have clarity. So when you're dealing with judgment calls is have all the information, so we understand exactly how the pension works, what your feasible plan of record is, so you can work through it in an organized way to make a judgment call that you can at least feel confident that you didn't wing it.
Thanks for grabbing that question, Taylor.
Taylor: Sorry, there's one more thing that we totally glossed over here. Taxes.
So, if he takes a pension at age 60, he's essentially triggering a tax bill, and again, we're assuming his financial situation, he's over saved for retirement. He doesn't need this money. He doesn't need this income yet. He's taking this income and creating a tax bill that he doesn't really need.
Now, I don't know enough about the situation. Maybe that tax bill is not a big deal. But if you take the pension, you're also accepting a tax bill on income that sounds like you don't need at that time.
If you instead rolled that money over to an IRA at age 60, well, you would do it today, but you would have from today until age 75 to deal with the tax bill. So, you would have more control over the timing of your taxes by rolling it into the IRA and dealing with it either through Roth conversions on your terms between now and age 75, or maybe RMD is at age 75 and beyond are more tax efficient for you than clipping 3, 500 per month today, starting or starting to age 60, 15 years ahead of RMDs. So, 15 years of income that you don't need. Again, I don't know what that does to his tax situation, but that's a really important piece of this puzzle.
Roger: See, we could banter around this all day. Then I'm thinking, yeah, you know, qualified charitable distribution for you at age 70. This is what we do for a living.
Taylor, thanks for hanging out with me today and thinking thoughtfully on helping people take little baby steps to get to judgments they're comfortable with.
I appreciate it.
Taylor: Yeah. Thanks for having me on. I always appreciate chatting with you. Yeah. You want to check out the show? Stay Wealthy Retirement Show. It's ahead of Roger's in the charts. Appreciate you listening.
TODAY’S SMART SPRINT SEGMENT
Roger: Now it's time to take a baby step you can take in the next seven days to not just rock retirement, but rock life.
All right, in the next seven days, I'm going to be honest with you. It's summertime. People are on vacation. It's hot. It's hot. We don't always have to be doing stuff all the time. So, feel free to take the week off on any little baby steps. Just be with your family.
But if you want a baby step, this is not extra credit. You don't get extra credit, but if you want a baby step, here's what I would challenge you with. Ask yourself, what are one or two things in your life? It can be financial and non-financial that you're doing more talking about it than being about it.
I just recently had a DEXA scan, which measures body fat, visceral fat, bone density, lean mass, all that. I'm about a year in to doing them and I have done three so far. It gave me a lot of information that was not comfortable to see. My body fat percentage stayed the same or went up, my visceral fat went up, my lean mass went down. It really made me challenge myself.
Now obviously some of this is genetic and a lot of things are going on there. I don't discount that. But, reflected back to me some things that I talk about that I'm not really being about near as much. I'm not doing the things as much as I'm talking about the things when it comes to health, and I'm talking about my internal conversation, perhaps conversation with friends and family.
That's a good reflection, even though it's uncomfortable, if you use it in a productive way. I'm not shaming myself as a result of this, I'm using a flashlight. It's like, Oh, why am I not congruent with what I'm talking about? I'm working on installing a few habits to start walking the talk and also deleting a habit or two so I can be more congruent.
This is a journey. We're all going to find those things. But if you want to maybe feel uncomfortable or maybe say, Hey, I got it going on. That's awesome.
CONCLUSION
A couple of weeks ago, we had a discussion of advisor certifications and there are a couple that I am not familiar with. Kevin Lyles is, and he says the CRPC is the retirement planning component of the CFP.
I didn't even know that had its own certification. I used to teach that component. I thought you just had to have those five in order to go on to the CFP. So, it doesn't have any coaching related education. People who get the CRPC would get this RICP or the RMA, which I have as a graduate degree. I didn't even know that one existed.
The retirement coaching designations. CRC, Certified Retirement Coach, which Kevin Lyles has, and the CPRC, Certified Professional Retirement Coach. So those are going to be more coaching designations, not professional in the sense of advisory designations. So, thanks Kevin Lyles, one of the smartest, sweetest people I know.
With that, I hope you have a wonderful day.
The opinion's voice in this podcast is for general information only and not intended to provide specific advice or recommendations for any individual. All performance references, historical and do not guarantee future results. All indices are unmanaged and cannot be invested in directly. Make sure you consult your legal, tax or financial advisor before making any decisions.