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Retirement Planning > Retirement Investing

Retirement with dignity, part 2

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Last week, we reviewed several obstacles, like inflation, that can stand in the way of your client enjoying a retirement with dignity. Now, let’s see if we can illustrate a simple yet extremely powerful planning technique. This is a lifetime income planning option, because it involves mathematically allocating assets in a way that gives a person what may be the best chance for generating an income that he or she can’t outlive.

Here is a hypothetical situation where there is $250,000 of available savings, the client is age 70, and he has the following objectives:

  • Needs $12,000 of annual income.
  • Wants that income adjusted for a 2 percent rate of inflation.
  • Wants to be certain, if possible, he will never run out of money (income will never stop).

With a multiple fund retirement planning approach, the client would divide the $250,000 into three amounts or funds.

The first fund will hold money and distribute income for a period of five years. During this period we will assume that the money in this fund earned a 4 percent rate of return. The money in this and the other funds can be invested in anything that the client prefers, but that investment must earn a 4 percent rate of return in order to make this example valid. 

The second fund will hold money (grow without distributions) for a period of five years and then the money in this fund will be used to provide income for another five years (total of 10 years). Like the first fund, the money in fund #2 can be invested in anything, but that investment must earn a 5 percent ROR in order for this example to be valid. 

The reason we are assuming that fund #2 will earn more interest than fund #1 is because it will be held for a longer period of time 10 years as opposed to five years.

The third fund will hold money (grow without distributions) for a period of 10 years and then the money in this fund will be used to provide income for another five years (total of 15 years). Like the first and second funds, the money in fund #3 can be invested in anything, but that investment must earn a 6 percent ROR in order for this example to be valid. 

The reason we are assuming that fund #3 will earn more interest than fund #1 or #2 is because it will be held for a longer period of time 15 years as opposed to five years for fund #1 or 10 years for fund #2.

Based upon the objectives of the client in this hypothetical example and the rates of return that we have assumed for the three funds, the client would need to place $53,422 of his total money ($250,000) into fund #1; $46,214 of his total money would go into fund #2; and the remaining $150,364 of his total money would be allocated to fund #3.

Again, we have allocated the money to these three accounts or funds because each will be designed to do a specific job. He still has the same total amount of money $250,000.

The $53,422 in fund #1, earning a rate of return of 4 percent, should be able to provide an annual income of $12,000 (the client’s objective) if both interest and principal were used for the distributions. The concept behind this strategy is that by the end of five years there would be no money remaining in fund #1. His fund is completely liquidated because over this five-year period all of the earnings and principal were used to provide the $12,000 of annual income.

Because a large portion of the $12,000 of income received by the client was a return of his principal, only a small percentage (the amount from earnings) is considered taxable income. Depending on this client’s specific circumstances, this might have the effect of reducing his current income taxes.

Not only might it reduce this client’s taxable income, it might also have the effect of reducing the portion of Social Security income that could be subject to income taxes. Instead of more of their Social Security benefits going to Uncle Sam, in some circumstances, more of their Social Security income might be able to stay in their pocket.

Let’s go back to the plan.

Remember that it is now five years later and there is no remaining money in fund #1. Now where will this person’s income come from?

During these first five years the money in fund #2 was being left to accumulate so its balance was growing. At our assumed rate of return of 5 percent, the $46,214 that was initially allocated to this fund would have grown to $58,983 by the end of this five-year period. This $58,983 can be used to figuratively “refill” fund #1.

With $58,983 now in fund #1, it should be able to generate an annual income of $13,249 over a second five-year period of time. Again, this level of income is based on the assumption that this money will be fully liquidated over these five years: $13,249 is the equivalent of the $12,000 of income that the client initially wanted, after it is adjusted for a 2 percent rate of inflation. As before, this $13,249 income is made up of both interest and principal.

Because a greater portion of the income over the second five-year period is made up of interest earnings, a greater portion will be subject to income tax. But keep in mind that any income that is considered a return of the client’s principal is not taxable income. This means that a large percentage of the income is nontaxable. After five more years (10 years from the start) there is no remaining money in fund #1 or fund #2.

However, during this initial 10-year period the money in fund #3 has been left to accumulate and has grown. Assuming a 6 percent rate of return, the $150,364 that was originally deposited into this fund has grown to $269,272 by the end of 10 years. Consider that this is a greater amount than the $250,000 that the client started with. Not only does he have more money than he started with but he also received a relatively large amount of income over the 10 years. Part of the reason that he was able to accumulate this amount in this third fund is because our calculations assume that this money had been growing on a tax-deferred basis. This makes perfect sense because we knew that the client would not need to use any of the earnings from this fund during the initial 10-year period. We knew this because we had allocated money to the first two funds to provide the income that would be needed.

It doesn’t seem very smart to pay taxes on earnings until the time comes when your client needs to spend those earnings, does it? How can you client defer these taxes? Simple, they can use a deferred annuity to hold this money. With deferred annuities they don’t pay tax on the earnings until they are withdrawn. Deferring taxes can make a big difference in how quickly their money will grow.

To illustrate this important point, let’s take a quick look at how many years will be required for the money in two different accounts to grow.

  • The earnings in the first account are taxed each year even though they are left to accumulate, just like what happens in bank CDs and other accounts.
  • The earnings in the second account are tax deferred. This could be accomplished with an annuity but it is important to say that we are using hypothetical rates that do not reflect the rates paid by a specific annuity.
  • We will assume that each account grows at the hypothetical rate of 6 percent.
  • And that the hypothetical account owner pays taxes at the rate of 28 percent.
  • After current taxes his net after-tax rate of return would be only 4.32 percent.
  • At this net rate it would take over 16 years for his original deposit to double.
  • But with the tax-deferred account it only takes 12 years for his money to double. He has twice his money but after only 12 years instead of 16-and-a-half years.

Now it’s true he will have to pay taxes on his earnings when he starts taking distributions, but even after he paid those taxes he would still end up with more money, assuming his tax rate didn’t go up. When used properly, deferring taxes can be a great way to increase the level of security your client is able to enjoy in the future.

Now with the money that has accumulated in the third fund, your client can figuratively “refill” fund #1 with enough money to provide an income for another five year period. There would still be enough money left to also “refill” fund #2. As before, this second fund could grow for five years and then its balance could be used to provide income for another five-year period.

And, there should even be money left in fund #3. This money could be left to accumulate, tax-deferred. 

In fact, based on these assumptions, there should now be enough money in all three funds so that the entire process can be repeated over another 10-year period. And after that, this person could do it all again for 10 more years. Unless the assumptions changed or his needs changed, these funds could continue to provide him an income for rest of his life…no matter how long he might live.

The foundation of enjoying a retirement with dignity is built upon a lifetime income.

For more from Lloyd Lofton, see:


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