Make informed decision about retirement assets
February 4, 2015 by Gary Boatman
This past week, I was meeting with a new couple to discuss their retirement. They were regular readers of this column and they were surprised about some of my concerns about their asset allocation. They suggested that I cover this topic so that other Valley residents could make better informed decisions.
Unfortunately, this is something that I observe way too often. Because of this, I am going to discuss asset allocation in the next two columns.
Everyone, whether they are preparing for retirement or not, needs to have some emergency funds. Often, advisors will suggest six to nine months of living expenses as the amount needed. Some of these expenses may be covered by unemployment benefits if you lose your job.
Emergency funds are to cover all of the surprises that life throws at us. This may include a transmission that breaks or some other unexpected auto repair. It may be that the hot water tank suddenly stops working, an unexpected school expense or many other non-budgeted expenses.
Increasingly, it is likely to be a medical deduction or co-payment for a newly diagnosed aliment.
This money needs to be very liquid and readily accessible. That means it is probably in the bank or credit union.
You will not be earning much interest, but you can get the money in a moment’s notice. Emergency money should not be in the stock market because a sudden negative market shift could consume the funds.
Next, you have to understand the three types of your assets as viewed by the IRS – qualified, non-qualified and Roth. Each type has a different tax treatment and a different best use because of this treatment.
Qualified money includes IRAs, 401(k)s, 403(b)s, deferred compensation and other such assets. What they all have in common is that Uncle Sam is your partner. When you saved these funds, you got to deduct this income from your tax return. The money grew faster because you were not paying taxes on the yearly gains. There is a 10 percent penalty if you withdraw these funds before you reach age 59½. When you take disbursements from any of this money, you must report it as income and pay taxes at ordinary rates. That means that you are paying at the same rate as your paycheck. Since you owe the government taxes on these funds, you need to start taking required minimum distributions at age 70½.
This money is intended to be retirement money. That is why there is an early distribution penalty. When deciding how to use these funds toward retirement, their best use is to fund future income needs. This is usually clear for several reasons. You get to take advantage of tax deferral during your lifetime. You will earn more because you are not paying taxes on growth until you take the money out to spend or cover required minimum distributions.
This money is also your most expensive to access. This is because you must pay taxes on withdrawals. This extra income may push you into a higher tax bracket. If you need $10,000 to cover a certain expense, you may need to withdraw $12,000 to cover the taxes and net the needed funds. Also, the best financial vehicles to generate long-term income may not be the most liquid to access.
There is no perfect financial product where you can get the highest return, no risk and instant liquidity. That is OK as long as your future needs are understood and planned for. You need a balanced approach and the knowledge to understand each product.
There is only one type of financial product that can guarantee you a lifetime income. That is an annuity. There are good annuities and bad annuities. While annuities might be a good consideration for lifetime income, they can be terrible for short-term liquidity. Almost every week, I see where annuities were used in questionable places. Usually these are variable annuities used for non-qualified funds. Non-qualified funds are money in which Uncle Sam is not your partner. This may be money that you saved from your paycheck after paying your bills. It may have been received as a gift or inheritance. It may be from the sale of your house or other property. You only owe taxes on the earnings, not the principal.
Why do I believe variable annuities are often inappropriately used in these cases? First of all, while most have a 10 percent free withdrawal after one year, you may have to pay a surrender charge to access more of your own money. Liquidity is a major concern. Variable annuities are very similar to mutual funds in an annuity wrapper. It is not unusual to see fees of 3 to 3 1⁄2 percent on variable annuities. If you liked these funds, you could own the same funds without these extra charges. If you owned mutual funds in a non-qualified account, you would be taxed at capital gains rate instead of the higher earned income rate. The income taken out of variable annuities is taxed at the higher ordinary income tax rate. Why would you want to pay more taxes than necessary?
In a qualified account, tax rates are not a problem because you are already required to use the earned income rate. This is an important reason to use them for income purposes. You do not need liquidity to the same extent on qualified money and the taxes they generate when you access them are an important consideration. This is why a low fee annuity may be a good fit.
Why are variable annuities so misused? Registered reps love them for the fees they earn. These reps work for broker dealers who encourage their sale. The lack of liquidity means that they can keep control of your money. While there may be an exception to every rule, be very careful when considering this choice.
Annuities can be very efficient in providing a lifetime income from an income rider. Both variable and fixed index annuities have income riders. Often a good fixed index will beat a good variable because they have lower cost, better payout options and no market risk. Be sure that you review all of your options, not just the first thing that you are shown.
Next week, we will look at other asset allocation considerations that could impact your financial future.
Gary Boatman is a certified financial planner and local businessman who is president of the Monessen Chamber of Commerce.
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