Weighing the options for retirement income planning

Clients who are close to retirement (or already retired) and thought they were in safer investments need to look at other, less traditional approaches. While not advocating any of the following, I think these approaches should be considered.

? Take out a home equity loan: The equity value of a client’s home can be turned into retirement income. The client can take a home equity line of credit to get through tough times (with a plan to repay the loan if and when the market rebounds). This may be better than turning a “paper loss” into a real loss. A home equity loan also allows the client to hold onto currently under-performing assets.

? Take out a conventional mortgage: The funds from a conventional mortgage can be used for income and to replenish investment accounts by buying quality assets on sale, as I noted above.
Interest rates remain quite low.

At least for now, mortgage interest (for most people) is tax-deductible. Should clients pursue this approach, make sure they have a proper plan to cover the debt service so they don’t lose their house while attempting to maintain their retirement life style.

? Take out a reverse mortgage: This is a direct means of turning home equity into income. Clients should explore this option carefully, with the advice and consent of financial advisors, accountants and attorneys.

? Secure a life settlement: The client’s permanent life insurance death benefit can be converted into far more cash than the policy’s cash value. Term policies, too, are eligible for life settlements. In either case, the internal rate of return on the death benefit can be significant. If the client needs cash (or cash flow) now, the death benefit can be sold. Again, carefully investigate this option and its tax consequences.

? Leverage the life insurance death benefit: Life insurance death benefits enable a retiree to invade principal for retirement income knowing the principal will be replaced at death for a surviving spouse and/or for children and grandchildren. Remember, the client can buy life insurance inside a profit-sharing plan, 401(k) or solo(k) plan (not an IRA) using tax-deductible dollars for the premiums.

Even though this coverage is included in the taxable estate, with a $3.5 million death tax exemption ($7 million for married couples with properly titled assets and estate planning documents), federal estate taxes are not an issue for most people. But don’t forget about state inheritance taxes.

? Use cash value as a “Roth look-alike” account: Clients can contribute after-tax dollars that accumulate tax-deferred and can be accessed tax-free. The top income tax bracket remains at 35%. Clients who expect their income tax rate will increase during their retirement years should consider the tax benefits of this option.

? Do a Roth conversion: If clients’ adjusted gross income is less than $110,000 in 2009, they can convert a tax-deferred retirement account to a Roth by paying the income taxes now instead of later, potentially at a higher rate. In 2010, under the current plan, the AGI limit is waived, enabling everyone to convert. But note: The client needs to have sufficient funds in taxable accounts to pay for the income tax cost of converting to a Roth.

? Allocate assets among different accounts: I am a strong proponent of asset allocation for retirement income planning. Most investors spread their assets across four account types: 1) qualified retirement accounts, funded primarily with corporate bonds; 2) taxable accounts, funded primarily with large cap value stocks (very tax efficient); 3) fixed annuities and variable annuities with lifetime benefit riders, funded aggressively (with large, small cap and international positions); and 4) life insurance death benefits (for principal replacement and/or “stretch” Roth funding) and cash value (Roth look-alike) to hedge against the possibility of higher income tax rates during some retirement years.

Herbert K. Daroff, J.D., CFP, is a partner at Baystate Financial Planning, Boston, Mass. His e-mail address is [email protected].