Perhaps the single most important issue on the minds of retirees today is how to maximize income during their golden years. However, in this period of financial repression, this task seems as difficult as convincing Jack Sparrow to quit drinking. With interest rates at historic lows, yields are compressed, leaving many struggling. Even so, there are a few hidden treasures out there if you have the right map. In this article, we will look at creating the structure for an income stream, owning rental property, secrets of the Social Security system, reverse mortgages, qualified retirement plans and annuities. Let’s begin with step one: Creating the structure.
Creating the Structure
There are two primary approaches to establishing an income stream during retirement. One involves the receipt of dividends and interest; and the other, the establishment of an income account. Both are quite common, and both have their benefits. With the dividend method, all income is derived from interest and dividends of stocks, bonds, REITs, etc., including funds. However, as the principal value fluctuates, so does the income stream.
In the income account method, cash and an individual bond ladder would be used. For instance, you would place one year’s worth of income in a cash account and buy a laddered portfolio of bonds with maturities of one to five years. Depending on the size of the account, the interest from the ladder and dividends from the more growth-oriented portion of the portfolio could be used to maintain the cash account. Then, when the first bond matures, it would simply be rolled into a bond with a five-year maturity to maintain the ladder.
The length of the ladder would depend on the slope of the yield curve and the prospects for growth investments. The income account strategy is what many pension plans use to immunize their future income needs against a large drop in stock prices. In essence, if a large crash were to occur, the growth investments could be left untouched until they recover.
Rental property is often overlooked by advisors due to the strong emphasis placed on asset gathering. However, owning rental property can provide a significant source of income with great diversification benefits. Also, with depressed real estate prices today, high unemployment and a glut of housing inventory, there is significant opportunity here. There are basically two types of rental property: residential and commercial.
Residential. Rental property can provide a great source of income for individuals who enjoy being a landlord. For property to be classified as “residential rental property,” more than 80% of its revenue must be derived from dwelling units (i.e., house or apartment).
One of the chief benefits associated with rental property is the ability to claim a depreciation deduction on your federal income tax return. Depreciation is a non-cash expense which reduces the value to approximate the wear and tear on a property. Property acquired after 1986 is subject to the modified accelerated cost recovery system (MACRS) and is depreciated over a 27.5 year recovery period.
Assume Bob bought a residential rental property valued at $250,000 on June 30. He must depreciate this property over a 27.5 year period and use the half-year convention when the recovery period begins. Each year, as Bob claims depreciation, his adjusted tax basis would be reduced by the amount of depreciation taken. Bob’s depreciation benefit in the first year would be $4,545 (half of a full year). In the second year through the 27th, it would be $9,091. The final half-year depreciation would be $4,545 for a grand total of $245,455. At this point, his basis would have been reduced to $4,545. If Bob sold the property at that time for $500,000, he would be subject to tax on a gain of $495,455 ($500,000 - $4,545).
After 27.5 years, Bob would have exhausted his depreciation benefit. This would be a motivating factor to dispose of the property. If Bob could find someone with a similar property, they could trade. In this case, Bob would elect a 1031 exchange, which would delay the tax and start a new depreciation period. A 1031 exchange requires that Bob exchange his property with another property of “like kind.” The specific nuances of this technique are beyond the scope of this article.
Using the above example, assume Bob put 20% down ($50,000) and financed the rest ($200,000) at a 5% rate for 15 years. His annual loan payment would be $19,268. If he rented it for $2,000 per month, Bob would report the income, but would be able to offset it by applying all allowable expenses incurred plus the amount of depreciation each year. The result is his net rental income (NRI). It’s quite possible Bob could reduce his NRI to zero because of depreciation. His rental yield would be approximately 9.6%, which is calculated by dividing the total rent by the value of the property ($24,000/$250,000).
If the property grew at a 3% annual rate (not unrealistic from where we are today), it would be worth over $500,000 at the end of the recovery period. This would put Bob’s total return over the period at more than 12%. If you, as the advisor, could add value to Bob’s real estate endeavor through ongoing analysis, then a reasonable fee may be warranted.
Income from rental activity is considered passive income, and as a rule, only passive losses can be used to offset passive income. However, if you actively participated in a passive rental real estate activity, you may be able to claim up to $25,000 in losses each year to offset non-passive income. However, this is phased out as your MAGI exceeds $100,000. Unused passive losses can be carried forward to the following year.
Commercial. Commercial property is treated in similar fashion with one notable exception being the recovery period. Instead of 27.5 years, commercial rental property has a recovery period of 39 years. There is also a tremendous tax benefit available for commercial property called cost segregation, which allows for accelerated depreciation. I wrote a detailed article on this subject in the April 2008 issue of Investment Advisor magazine (see “Wedge Issue,” Investment Advisor, April 2008).
When Social Security began in 1935, the average life expectancy was much lower than it is today. Moreover, it was common for people to work until death as the concept of retirement was not yet entrenched in society. Because life expectancy is much longer today, and the expectation of a period of “golden years” is pervasive, the Social Security system is under great pressure to continue meeting its obligation. The Great Recession and lack of Congressional action has only exacerbated the problem.
Hidden within our massive tax code are some rather obscure provisions pertaining to Social Security that could help many taxpayers maximize their retirement benefits. The resulting strategies are: file and suspend; collect some now, more later; and retirement do-over.
File and Suspend. This works well if one spouse has substantially higher earnings than the other. Under this method, spouse A (the highest income earner) reaches normal retirement age (see Figure 1, page 61) and files for a retirement benefit. Then, spouse B files and collects a benefit based on spouse A’s earnings. Spouse A would immediately suspend and delay his benefit until a later age, while spouse B continues to collect. Yes, you may collect a benefit on your spouse while he is alive.
Collect Some Now, More Later. This strategy works best with career couples. Spouse A reaches her NRA and files for a spousal benefit, delaying her own benefit until a later age (i.e., age 70). Then, at 70, spouse A files for her own benefit which is much higher.
Generally, a benefit that begins at NRA or sooner would have to grow at an annual rate of at least 8% to equal the benefit due by waiting until age 70. Because existing Social Security benefits increase with the rate of inflation, and since inflation is much lower than 8%, this strategy can provide a real income boost. However, you cannot do this until you reach your NRA.
Retirement Do-Over. Even if you are already receiving a Social Security retirement benefit, you can take advantage of this strategy. Let’s assume spouse A began receiving Social Security at age 62 and is now 70. He can simply pay back the amount he’s received, without penalty or interest, and start over with a higher benefit. Of course, spouse A would have to live a certain number of years to break even.
Defined benefit pension plans pay a monthly benefit based on a pre-determined formula. At decision time, prior to retirement, the employee must elect one of the available payout options such as life only, joint-and-survivor annuities, etc. One strategy to maximize the payout is to elect the life-only option, which pays the highest benefit, and replace the survivor’s benefit with life insurance. To use this strategy, the retiree should be relatively healthy. Here’s how it works: Assume the life-only option pays the retiree $2,000 per month and the joint-and-50% survivor annuity pays $1,600. If the joint-and-50% option was chosen, the survivor would receive $800 per month (50% of $1,600) at the death of the pension holder.
The relevant question is, “What lump sum is required to replace the $800 monthly benefit for an assumed number of years?” If the monthly premium is less than the difference in benefits ($2,000 - $800 = $1,200), it may make sense to maximize the initial payout and replace the survivor’s benefit with life insurance. Here’s another consideration: If the joint-and-50% option was selected and the couple deceased at the same time, or close to the same time, all benefits would cease. If the same event occurred and this strategy was in place, then the life insurance would pay out to the contingent beneficiary. It should also be mentioned that it’s best to use a permanent policy since the date of death is uncertain.
TV commercials touting the benefits of reverse mortgages are flooding the airwaves. Are they really that good? A reverse mortgage is an agreement between you as the homeowner and an institution acting as the buyer. Just as the name implies, you are selling your home to the other party, so instead of paying a mortgage payment, you will receive one. In short, it is a method to generate an income stream based on a portion of your home’s equity. You should be aware that these arrangements are typically more expensive than a traditional mortgage. To qualify, you must be at least 62 years of age, and, according to the IRS, this cannot be used with trailers.
Today is probably not the best time to enter into a reverse mortgage. Why? Because housing prices are depressed and interest rates are low. The result is that you will receive a lower monthly payment than if rates were high. This is a chief reason we are seeing such a deluge of reverse mortgage advertisements.
Qualified Retirement Plans
As most of you know, distributions from a qualified retirement plan or IRA prior to age 59.5 are subject to a 10% penalty plus income tax. However, if the distributions are in substantially equal installments, the penalty is waived.
There are three primary methods used to determine substantially equal periodic payments: the required minimum distribution method; the amortization method; and the annuitization method. Other methods may be available, but you would need a private letter ruling from the IRS.
Once you begin withdrawing, you must continue until age 59.5 or for five years, whichever is longer. You may also change your method one time, per Revenue Ruling 2002-62. Lastly, there are no penalties if your account is depleted before the required period ends.
You should consider dividing your IRA prior to making this election. By doing so, you will not encumber the remaining IRA assets. First, determine your desired payment. Then, using a 72(t) calculator, determine the lump sum needed to create this income stream. Finally, create a separate IRA with this amount.
Required Minimum Distribution (RMD). You must begin withdrawing from your retirement plan (excluding Roth IRAs) in the calendar year you turn age 70.5. Therefore, if you turn 70.5 prior to July 1, you must make your first RMD that same year. If your birthday falls after June 30, your first RMD is the following year. You may delay your first RMD until April 1 of the year following the year you turn age 70.5. However, if you delay, you will need to make a second withdrawal that same year. Here’s one exception to the rule: If you work past age 70.5, you will not be required to withdraw from your 401(k), profit sharing or other defined contribution plan until you separate from service, no matter the age. No such exception exists for IRAs.
Failure to comply with the required minimum distribution will result in a 50% excise tax on the “under distributed” portion. For instance, if your RMD was $25,000 and you only withdrew $15,000, you would pay an excise tax of $5,000 ($10,000*50%).
There are two tables used to calculate the RMD: the Uniform Lifetime Table (ULT) and the Joint and Last Survivor Expectancy Table (JLSET). When the sole beneficiary is a spouse who is 10 years or more younger, the JLSET is used. Everyone else uses the ULT.
If you have multiple retirement accounts, you may aggregate their value as of Dec. 31 of the year proceeding the RMD year. Then, if you wish, you may withdraw the entire amount from one account, as long as the total RMD is met.
The RMD withdrawal percentage increases each year (see Figure 2, right). Therefore, the account should continue to grow until about age 83 when it will continue to decline as the withdrawal percentage becomes more dominant.
Although annuities come in many flavors, we’ll focus on immediate annuities. In general, a traditional immediate annuity converts a lump sum into an income stream with guarantees. However, in today’s low interest rate environment, you would be locking in a relatively low benefit. It would be best to do this when rates are high, not when they are low. The income stream is calculated based on an internal rate of return (IRR). Therefore, if you could earn more than the IRR, you should invest the funds yourself; otherwise, an annuity may be a suitable option.
In this era of financial repression, finding ways to maximize income has become a top-shelf issue. Until such time as interest rates rise and traditional CDs are back in vogue, today’s retirees are forced to venture out of the box to find solutions. The moral? Don’t venture too far out of the box. As the pirate Jack Sparrow would say … savvy?