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Retirement Is a False Finish Line

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The hard work of budgeting, saving and investing to accrue assets to retire is only the first step in an ongoing planning process. Retirement itself is an intermediate goal. It is an artificial finish line. Retirement is the culmination of the first phase of the journey and marks the entrance to the second phase. The retiree might ask, “Now how do I use these assets I worked so hard to accumulate to effectively create cash flow?”

Part of the answer is to review, monitor, calculate and project. Much of this is similar to the first phase, when the person was building wealth.

On Arrival

Envision arriving at retirement as gradually winding the spring in a clock, building energy and storing it for the future as we build assets. Now, however, we must apply several different, critical, integrated planning techniques to guide the clock spring to unwind as efficiently as we can — to continue to protect this mechanism while it returns the energy to us that we put into it. In the same way that clocks have complex mechanisms to regulate this process, those complexities exist for your assets, as well.

Cash Flow

The second phase of your planning now must generate cash flow from the assets you have accumulated. Many people will have accounts that are taxed in different ways. IRA distributions, having minimum distributions required at age 70-1/2, are taxed as income. Roth IRA distributions are not taxed at all. Regular accounts are taxed depending on dividends and capital gains, some of which may be at favorable tax rates.

If you liquidate those securities to provide retirement cash flow, the accumulated dividends and capital gains will impact the basis and subsequent tax liability of the payments you receive. The assets in all of these different accounts should be structured to provide tax efficiency. In some years, relocation of an asset from one type of account to another may be an incredibly valuable tool.

Let’s assume you retire at age 67 and have deferred Social Security to age 70 to obtain the 8%-per-year delayed credits. Your age 67 year may be an ideal time to relocate assets from an IRA to a Roth IRA.
Once you reach age 70 and receive Social Security, and then 70-1/2 and start required distributions, your tax structure will probably change dramatically. Those years between retirement and age 70 may be ideal years for Roth conversions.

Four Pillars

How do we integrate the ownership of assets with the specific assets themselves? For example, an asset that has a large growth potential, if held in an IRA, may be taxed at potentially higher income rates when distributed, effectively converting tax-favored capital gains into ordinary income.

The second phase of retirement involves the art and science of locating the correct assets in the correct accounts depending on the amount of cash flow necessary. Maximizing tax-efficient cash flow is done by employing the “four pillars” of interest, dividends, capital gains and principal.

Interestingly, from a strictly tax perspective, “spending the principal” is a valuable technique for generating tax-favored retirement distributions, as long as you fully understand the strategy that is being employed. This is analyzed not only by type of account, but by the assets located in the accounts. This analysis is further enhanced by fully understanding the potential tax efficiency gained by relocating assets to different accounts. When asset relocation is employed, the holdings of all the accounts must be reviewed as well as the tax consequences.

Downside Risk

Lastly, crossing the retirement “finish line” creates a different relationship between portfolio risk and reward. Investors who accumulated their assets over a lifetime of being a “risk-taker” and are rebalancing to a fixed portfolio asset allocation may find the rules about accepting portfolio volatility have changed once they are withdrawing systematic payments from their portfolio.
If you experience a serious bear market early in your retirement, you risk having your financial plan destroyed, even if you eventually earn the average returns you forecasted for your life expectancy. It is not the average return that matters post-retirement. Instead, it is the order of the returns you earn and the amount of volatility in your portfolio. Managing downside risk becomes more crucial once you stop earning a paycheck and depend on your portfolio for cash distributions.

All of the above should be reviewed annually so that your retirement assets are most efficiently releasing their usefulness as they are being unwound into cash flow.

While achieving the financial ability to cross the threshold to enter retirement is an outstanding accomplishment, it is not the checkered flag. It may be financially healthier to view that step as a transition into the next phase of retirement, as there is still much ongoing work to be done.

 

Kelly Wright is director of financial planning for Pinnacle Advisory Group, in
Columbia. He can be reached at kwright@pinnacleadvisory.com.