9 Smart Strategies for Handling RMDs


After decades of squirreling away money in tax-advantaged retirement accounts, investors entering their seventies have to flip the script. Starting at age 70½, Uncle Sam requires taxpayers to draw down their retirement account savings through annual required minimum distributions. Not only do you need to calculate how much must be withdrawn each year, you must figure and pay the tax on the distributions.

There’s no time like the present to get up to speed on the RMD rules. Once you know the basic rules, graduate to smart strategies that can whittle down these taxable distributions and make the most of the money that you must withdraw. Uncle Sam may not give you a choice on taking these distributions, but you do have options for handling the money. “Retirement income planning is as much about managing distributions as investment income,” says Rob Williams, vice president of financial planning for the Schwab Center for Financial Research.

RMD Basics No. 1: When is your First RMD Due?

First, let’s start with the basics. Original owners of traditional IRAs are subject to required minimum distributions when they turn 70½. The RMD is taxed as ordinary income, with a top tax rate of 37% for 2019.

You must take your first RMD by April 1 of the year after you turn 70½. The second and all subsequent RMDs must be taken by December 31.

An account owner who delays the first RMD will have to take two distributions in one year. For instance, a taxpayer who turns 70½ in March 2019 has until April 1, 2020, to take his first RMD. But he’ll have to take his second RMD by December 31, 2020.

To determine the best time to take your first RMD, compare your tax bills under two scenarios: taking the first RMD in the year you hit 70½, and delaying until the following year and doubling up RMDs. “It’s important to look at whether [doubling up] will push you into a higher tax bracket,” says Christine Russell, senior manager of retirement and annuities for TD Ameritrade, and whether it will subject you to higher income-related Medicare premiums. Doubling up could be the right strategy, however, if you’re retiring in the year you turn 70½ and your wages plus the first RMD would push you into a higher tax bracket.

RMD Basics No. 2: How to Calculate RMDs

To calculate your RMD, divide your year-end account balance from the previous year by the IRS life-expectancy factor based on your birthday in the current year. For most people, the appropriate factor is found in Table III toward the end of IRS Publication 590-B. Let’s say an IRA owner with an account balance of $750,000 as of December 31, 2018, turns 72 in 2019. The RMD for 2019 will be about $29,297. (Calculate your 2019 RMD right now.)

If you own multiple IRAs, you need to calculate the RMD for each account, but you can take the total RMD from just one IRA or any combination of IRAs. For instance, if you have an IRA that’s smaller than your total RMD, you can empty out the small IRA and take the remainder of the RMD from a larger IRA.

A retiree who still owns 401(k)s at age 70½ is subject to RMDs on those accounts, too. But unlike IRAs, if you own multiple 401(k)s, you must calculate and take each 401(k)’s RMD separately. A retired Roth 401(k) owner is also subject to RMDs from that account at age 70½, though the distributions would be tax-free.

You can take your annual RMD in a lump sum or piecemeal, perhaps in monthly or quarterly payments. Delaying the RMD until year-end, however, gives your money more time to grow tax-deferred. Either way, be sure to withdraw the total amount by the deadline.

RMD Basics No. 3: Penalties for Missing RMD Deadlines

What happens if you miss the deadline? You could get hit with one of Uncle Sam’s harshest penalties—50% of the shortfall. If you were supposed to take out $15,000 but only took $11,000, for example, you’d owe a $2,000 penalty plus income tax on the shortfall. “Fifty percent is a hefty price to pay,” says Williams.

But this harshest of penalties may be forgiven—if you ask for relief. “Fortunately, the IRS is relatively lenient, as long as once you realized you missed it, you take your RMD,” says Tim Steffen, director of advanced planning at Robert W. Baird & Co. You can request relief by filing Form 5329, with a letter of explanation including the action you took to fix the mistake.

One way to avoid forgetting: Ask your IRA custodian to automatically withdraw RMDs. At Fidelity Investments, “about 50% have chosen to automate” RMDs, says Joe Gaynor, Fidelity’s director of retirement and income solutions.

RMD Strategy No. 1: Work Waiver

Now that we’ve covered the basic RMD rules, it’s time to look at all the options for minimizing those required distributions.

First, check to see if you have an RMD escape route. Every rule has an exception, and the RMD rules are no different. There are a number of instances where you can reduce RMDs—or avoid them altogether.

If you are still working beyond age 70½ and don’t own 5% or more of the company, you can avoid taking RMDs from your current employer’s 401(k) until you retire. You must still take RMDs from old 401(k)s you own and from your traditional IRAs.

But there’s a workaround for that: If your current employer’s 401(k) allows money to be rolled into the plan, says Kelly Famiglietta, vice president and partner of retirement plan services at financial-services firm Charles Stephen, “you could roll in the other accounts to postpone all RMDs.” And, voila!, you won’t have to take any RMDs until you actually retire.

RMD Strategy No. 2: Roth Rollovers

For those who own Roth 401(k)s, there’s a no-brainer RMD solution: Roll the money into a Roth IRA, which has no RMDs for the original owner. Assuming you are 59½ or older and have owned at least one Roth IRA for at least five years, the money rolled to the Roth IRA can be tapped tax-free.

Another Roth solution to say goodbye to RMDs: Convert traditional IRA money to a Roth IRA. You will owe tax on the conversion at your ordinary income tax rate. But lowering your traditional IRA balance reduces its future RMDs, and the money in the Roth IRA can stay put as long as you like. “It’s something to consider, particularly now that tax rates are lower,” says Scott Thoma, principal at Edward Jones.

Converting IRA money to a Roth is a great strategy to start early, but you can do conversions even after you turn 70½. You must take your RMD first. Then you can convert all or part of the remaining balance to a Roth IRA. You can smooth out the conversion tax bill by converting smaller amounts over a number of years.

“Roth conversions are a hedge against future increases in taxes, and they provide flexibility,” says Williams. For instance, while traditional IRA distributions count when calculating taxation of Social Security benefits and Medicare premium surcharges for high-income taxpayers, Roth IRA distributions do not. And if you need extra income unexpectedly, tapping your Roth won’t increase your taxable income.

RMD Strategy No. 3: Carve Outs

About five years ago, a new option known as the qualified longevity annuity contract, or QLAC, arrived. You can carve out up to $130,000 or 25% of your retirement account balance, whichever is less, and invest that money in this special type of deferred income annuity. Compared with an immediate annuity, a QLAC requires a smaller upfront investment for larger payouts that start years later. The money invested in the QLAC is no longer included in the IRA balance and thus is not subject to RMDs. Payments from the QLAC will be taxable, but because it is longevity insurance, those payments won’t kick in until about age 85.

Another carve-out strategy applies to 401(k)s. If your 401(k) holds company stock, you could take advantage of a tax-saving opportunity known as net unrealized appreciation, says Russell. You roll all the money out of the 401(k) to a traditional IRA, but split off the employer stock and move it to a taxable account, paying ordinary income tax on the cost basis of the employer stock. You’ll still have RMDs from the traditional IRA, but they will be lower since you removed the company stock from the mix. And any profit from selling the shares in the taxable account now qualifies for lower long-term capital-gains tax rates.

RMD Strategy No. 4: Younger Spouse

In the beginning of this story, we gave you the standard RMD calculation that most original owners will use—but original owners with younger spouses can trim their RMDs. If you are married to someone who is more than ten years younger, divide your year-end account balance by the factor listed at the intersection of your age and your spouse’s age in Table II of IRS Publication 590-B—rather than Table III—to calculate your RMD. Table II factors in the younger spouse’s longer life expectancy, reducing your required distribution.

For instance, if you are 72 and married to a 59-year-old, Table II tells you to use a factor of 27.7. If your IRA was worth $500,000 at year-end 2018, you’d take out about $18,051 in 2019. That’s about $1,480 less than if you used the calculation that didn’t take into account your younger spouse’s life expectancy.

RMD Strategy No. 5: Pro Rata Payout

If you can’t reduce your RMD, you may be able to reduce the tax bill on the RMD—that is, if you have made and kept records of nondeductible contributions to your traditional IRA, says Steffen. In that case, a portion of the RMD can be considered as coming from those nondeductible contributions—and will therefore be tax-free.

Figure the ratio of your nondeductible contributions to your entire IRA balance. For example, if you contributed a total of $200,000 to your IRA and $20,000 was nondeductible, 10% of a distribution from the IRA will be tax-free. Each time you take a distribution, you’ll need to recalculate the tax-free portion until all the nondeductible contributions have been accounted for.

RMD Strategy No. 6: Re-invest

If you can’t reduce or avoid your RMD, look for ways to make the most of that required distribution. You can build the RMD into your cash flow as an income source. But if your expenses are covered with other sources, such as Social Security benefits and pension payouts, put those distributions to work for you. After all, “the IRS isn’t telling you to spend the money,” Williams says. “It just wants the tax dollars from you.”

While you can’t reinvest the RMD in a tax-advantaged retirement account, you can stash it in a deposit account or reinvest it in a taxable brokerage account. If your liquid cash cushion is sufficient, consider tax-efficient investing options, such as municipal bonds. Index funds don’t throw off a lot of capital gains and can help keep your future tax bills in check.

If you’re selling investments to satisfy your RMD, review your portfolio’s allocation. “You could use the RMD to reallocate,” says Gaynor. Meet the RMD by selling off investments in overweighted categories, and you’ll rebalance your portfolio back to your target allocations at the same time.

RMD Strategy No. 7: Transfer In-Kind

Remember that the RMD doesn’t have to be in cash. You can ask your IRA custodian to transfer shares to a taxable brokerage account. So you could move $10,000 worth of shares over to a brokerage account to satisfy a $10,000 RMD. Be sure the value of the shares on the date of the transfer covers the RMD amount. The date of transfer value serves as the shares’ cost basis in the taxable account.

The in-kind transfer strategy is particularly useful when the market is down. You avoid locking in a loss on an investment that may be suffering a temporary price decline. But the strategy is also useful when the market is in positive territory if you feel the investment will continue to grow in value in the future, or if it’s an investment that you just can’t bear to sell. In any case, if the investment falls in value while in the taxable account, you could harvest a tax loss.

RMD Strategy No. 8: Give to Charity

If you are charitably inclined, consider a qualified charitable distribution, or QCD. This move allows IRA owners age 70½ or older to transfer up to $100,000 directly to charity each year. The QCD can count as some or all of the owner’s RMD, and the QCD amount won’t show up in adjusted gross income.

The QCD is a particularly smart move for those who take the standard deduction and would miss out on writing off charitable contributions. But even itemizers can benefit from a QCD. Lower adjusted gross income makes it easier to take advantage of certain deductions, such as the write-off for medical expenses that exceed 10% of AGI in 2019. Because the QCD’s taxable amount is zero, the move can help any taxpayer mitigate tax on Social Security or surcharges on Medicare premiums.

Say your RMD is $20,000. You could transfer the whole $20,000 to charity and satisfy your RMD while adding $0 to your AGI. Or you could do a nontaxable QCD of $15,000 and then take a taxable $5,000 distribution to satisfy the RMD.

The first dollars out of an IRA are considered to be the RMD until that amount is met. If you want to do a QCD of $10,000 that will count toward a $20,000 RMD, be sure to make the QCD move before taking the full RMD out.

Of course, you can do QCDs in excess of your RMD up to that $100,000 limit per year. “A QCD can be your RMD, but it doesn’t have to be,” says Steffen.

RMD Strategy No. 9: RMD Solution

You can also use your RMD to simplify tax payments. With the “RMD solution,” you can ask your IRA custodian to withhold enough money from your RMD to pay your entire tax bill on all your income sources for the year. That saves you the hassle of making quarterly estimated tax payments and can help you avoid underpayment penalties.

Because withholding is considered to be evenly paid throughout the year, this strategy works even if you wait to take your RMD in December. By waiting until later in the year to take the RMD, you’ll have a better estimate of your actual tax bill and can fine-tune how much to withhold to cover that bill.

Social Security: Why Claiming Early Could be…..

Despite a permanently reduced monthly benefit, here’s why more workers could opt to take their payout as early as age 62.

Whether you realize it or not, you’re probably going to be reliant on Social Security for a portion of your retirement income. According to data from the Social Security Administration (SSA), 62% of current retirees lean on the program for at least half of their income, with just over a third reliant on Social Security for virtually all (90%-plus) of their income.

This more or less corroborates surveys conducted by Gallup of retired and non-retired individuals. Of the retirees, just 1 in 10 aren’t reliant on their Social Security income in any way. Meanwhile, more than 4 out of 5 non-retirees expect to lean on their retirement benefit as a major (30%) or minor (54%) income source.

All of this data leads to one conclusion: Your claiming age is extremely important.

A Social Security card standing up on a counter, with the name and number blurred out.


Your claiming age can have a huge impact on your monthly benefit check

As a refresher, there are four factors that have a high bearing on what you’ll be paid by Social Security during retirement, assuming you’ve earned the required 40 lifetime work credits to receive a benefit. The first two factors are intertwined: your work history and earnings history.

When calculating your retirement benefit, the SSA will take into account your 35 highest-earning, inflation-adjusted years. If you have any hope of maximizing what you’ll receive from the program, you’ll want to work at least 35 years to avoid any zeros being averaged in for each year you didn’t work.

The third factor, which we have absolutely no control over, is your birth year. The year you’re born determines your full retirement age, or the age at which you become eligible to receive 100% of your retirement benefit. Put simply, claiming benefits prior to your full retirement age will result in a permanent reduction to your monthly benefit of as much as 30%, whereas claiming after your full retirement age can boost your payout by as much as 32%, all depending on your birth year.

The final factor is your claiming age. Retirement benefits can be claimed as early as age 62, but the SSA gives people incentives to wait by increasing their payouts by 8% per year, up until age 70. Assuming you were looking at two identical individuals (i.e., same work history, earnings history, and birth year), the one claiming at age 70 could receive a monthly payout that’s up to 76% per month higher than the individual claiming as early as possible at age 62.

So, everyone obviously waits then, right? Well, not exactly.

A hand filling out a Social Security benefits application form, which sits under a pair of glasses and a calculator.


Expect a claiming-age trend reversal next decade

Historically, a majority of Americans claim benefits prior to reaching their full retirement ages. Whether that’s because they need the money or simply don’t understand their options isn’t clear. What is clear is the data, which showed that 60% of retired workers in 2013 took their benefits between ages 62 and 64, with another 30% claiming at ages 65 or 66 (age 66 was the full retirement age in 2013). Comparatively, just 1 in 10 retirees took their benefits after their full retirement age.

However, there has been a modest reversal of this trend in recent years. Data from the SSA finds that more people are waiting to take Social Security, albeit very few are still waiting until after their full retirement age. At last check, 57% were claiming prior to their full retirement age, with 34.3% signing up at age 62. Of course, this data also includes those folks receiving a disability payout and is therefore not an apples-to-apples comparison to the 2013 data.

This push to a later claiming age is certainly preferable, especially with the average American living longer than their parents or grandparents and potentially needing more income for a longer period of time. But as time passes, my suspicion is we’ll again see this trend reverse, with more retirees choosing to claim earlier rather than waiting.

The reason? A forecasted cut to Social Security benefits, as highlighted in the 2018 Trustees report.

Scissors cutting through a hundred dollar bill.

Benefit cuts could be coming, and retirees will want to stay ahead of the curve

According to the Trustees report, Social Security will face an inflection point this year. In other words, it’ll expend more than it collects in revenue for the first time since 1982. This might not seem like a big deal, but this net cash outflow is expected to rapidly grow in size beginning in 2020 and beyond.

By the time 2034 rolls around, the program’s $2.89 trillion in asset reserves is expected to be completely gone. Should this happen and Congress fails to generate additional revenue and/or institute expenditure cuts, a projected across-the-board cut to benefits of 21% would be needed to sustain payouts through 2092.

There are two considerations to make here. First, there are a lot of Americans who incorrectly believe that Social Security running out of its excess cash means the program is insolvent. In fact, more than half of all millennials surveyed by Pew Research Center in 2014 believed they wouldn’t receive a red cent from Social Security by the time they retire. This fear of Social Security going bankrupt (which actually can’t happen) is probably one driving force for early claimants.

The other consideration here is the notion that benefits could be slashed by more than a fifth come 2034. Workers who come of claiming age in the next five to 15 years are probably going to give serious consideration to taking their benefits sooner rather than later and reaping the rewards of a check that isn’t reduced by up to 21% (even if claiming early will itself result in a permanent monthly reduction).

A man holding up a large sign in front of his head with multiple question marks drawn on it.


Is this the right move?

But is it the right move? The honest answer is, no one knows. Congress could allay these concerns by passing a bipartisan fix to the program that doesn’t result in a huge benefit cut in less than two decades’ time, which would make early claimants none-too-pleased.

We also (thankfully) don’t know our expiration date, which means that we can never be certain that we’re making the best possible claiming decision. And by “best possible,” I mean the decision that results in the highest amount of lifetime benefits being received.

What I do believe is that the longer Congress waits to act and the larger Social Security’s cash shortfall becomes, the more likely it is that we’ll see aged beneficiaries making earlier claims.

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How soon can I retire?

Reposted from “How Soon Can I Retire?”

TIME FOR SAVINGS. Watch and coins copy space concept for saving fund, financial, banking, investment, money or other your content. Malaysia coins. – How soon can I retire? June 1, 2017

 NEW YORK (CNNMoney) — “How do I calculate the earliest possible date I can retire — my “take this job and shove it!” date — beyond which working is my choice and earnings are gravy?” — Jason, New York

Like Jason, many of us are counting down to the day we can say “shove it!” to a job we hate and pursue our own interests. But most people wrongly assume that day won’t come until our 60s or 70s. Lots of people are taking the concept of “early retirement” to new extremes by becoming financially independent in their 50s, 40s, or even 30s.

While the concept of “retirement” may sound boring to some people, early retirement guru Brandon of the Mad Fientist blog prefers to call it “freedom.”

“Retirement makes you think of [old people] moving to Florida,” he says. “But really, retirement is freedom. Freedom to do what you want to do with your time, freedom from jobs you don’t like, freedom from bosses you don’t like.”

Brandon, who only uses his first name for privacy reasons, is part of an online movement of early retirement enthusiasts who preach that retirement is attainable for anyone at almost any age. It’s just a matter of calculating how much it costs for you to live, and saving up enough to support yourself for the rest of your life.

First, understand the math.

There are many schools of thought on how to calculate your number, depending on your spending and age.

“Traditional late-retirement advice aims to maximize lifetime consumption and what people therefore look at is either saving a million dollars or saving 10-15% of all income over some 40 years on the job,” explains Jacob Lund Fisker, author of the book and website Early Retirement Extreme.

But for those who want to retire much sooner than age 65, he says, that conventional advice does not apply.

“The goal [for early retirement] is to save 25-35 times one’s annual expenses. Once this goal is reached, one is financially independent and working is a choice.”

The early retirement rule is simple: For every $1,000 you spend a year, you need to invest $25,000 to $35,000.

The more money you save, the more you’d have to spend. Similarly, and key to many young retirees, the less money you spend each year, the less you have to save and the sooner you can retire.

This breaks down to spending, Fisker says. “The easiest way to find $1,000/year in the budget is to start the few largest expenses — namely, housing, driving, and eating. It’s easier to make a few decisions about a few big items than constantly make decisions about many small items.”

But how do you make the money last for decades? A common rule of thumb is what’s known as the “4% rule.” “This equation multiplies your spending by 25 to give you how much you need to save. If you need $40,000 per year, multiply that by 25 a year, you get a million bucks,” explains Fisker, “$40,000 is 4% of a million.”

But that assumes your money consistently earns at least 4% a year. Some experts think the rule is flawed and could cause some early retirees to run out of money.

Fisker takes an even more conservative approach with his equation: Annual expenses should be less than 3% of your invested savings. So for that same $40,000 a year in income, you’d need $1.3 million invested. (Fisker also has other tips on calculating how much money you need to retire.)

And of course, it never hurts to start planning early.

“Less than a decade of delayed retirement savings can cost someone $1 million in forgone savings,” says financial adviser Barbara O’Neill. “People who start saving at age 34 and accumulate $1 million at age 67 could have saved $2 million had they started at age 25, assuming an 8% average annual return.”

Or, they could have just retired much sooner.

Second, figure out when you’ll get there

So now that you have a general idea of the amount you need to call it quits, it’s time to figure out how long it’ll take you to get there.

A million dollars may seem like a big number, but the more you can save, the faster you’ll reach your goal. Say you’re 25 and you want to retire by 45. Investing $1700 a month will get you to a million in 20 years, assuming an 8% return. Too steep? Learn to live on less and you won’t need a full million. Or be less ambitious about your retirement age. Saving $675 a month will get you there by age 55. This CNNMoney calculator can help you figure out how long it’ll take.

Or try the FI Tracker on the Mad Fientist blog. This online app allows you to track your progress toward financial independence by calculating your net worth, expenses, savings, and countdown to retirement.

If this all feels too overwhelming, you can always find a Certified Financial Planner to walk you through the steps and coach you through your best path toward retirement.

“My best advice to someone trying to figure out if they can retire is to spend some time with a CFP to help them make one of the biggest decisions in their life,” says financial planner Howard Pressman. “You really only get one shot at this and it’s worth doing it right.”

Copyright 2017 Cable News Network. Turner Broadcasting System, Inc. All Rights Reserved.

Choosing Between Roth and Traditional IRA’s

Among the most important decisions investors make is their choice of location for assets within the various alternatives available for retirement (tax-advantaged) accounts. Allocating between a traditional IRA (a pretax, tax-deferred account) and a Roth IRA (a post-tax, tax-free account) can have a pronounced impact on retirement outcomes, given the $14 trillion in tax-advantaged retirement account assets at the end of 2015.

David Brown, Scott Cederburg and Michael O’Doherty contribute to the literature on retirement asset location with their June 2016 paper, “Tax Uncertainty and Retirement Savings Diversification.”

The modeling approach they adopt accounted for investor age, current income and taxable income from outside sources in retirement, as well as the highly progressive income tax regime now in place. The authors point out that “the marginal rate for a single taxpayer with inflation-adjusted income of $100,000, for example, has changed 39 times since the introduction of income taxes in 1913 and has ranged from 1% to 43%.” This creates considerable uncertainty.

Because risk-averse investors (and most investors are risk averse; it’s generally only a matter of degree) dislike uncertainty, this should create a preference for Roth accounts, as they “lock in” the current rate, eliminating the uncertainty associated with future changes.

On the other hand, a traditional account, which offers retirement savers the benefit of deducting current contributions, allows investors to “manage their current taxable income around tax-bracket cutoffs, which is valuable under a progressive structure.”

Another benefit of traditional accounts, the authors write, is that “the progressive tax rates faced in retirement provide a natural hedge against investment performance. Investors with poor investment results and little wealth in retirement will pay a relatively low marginal tax rate, whereas larger tax burdens are borne by investors who become wealthy as a result of good investment performance.” This creates tension between the traditional and Roth options.

Who Should Use The Roth Structure?

The authors state: “Roth accounts are primarily useful for low-income investors who can lock in a low marginal rate by paying taxes in the current period.” They add that because “future tax rates are more uncertain over longer retirement horizons” and their analysis of historical tax changes suggests “that the rates associated with higher incomes are more variable,” eliminating “exposure to tax risk is particularly attractive for younger investors with relatively high incomes and correspondingly high savings.”

The authors continue: “Despite high current marginal tax rates, and contrary to conventional financial advice, these investors benefit the most from the tax-strategy diversification offered by Roth accounts.”

Brown, Cederburg and O’Doherty concluded: “Whereas conventional wisdom largely supports choosing between traditional and Roth accounts by comparing current tax rates to expected future tax rates, the hedging benefits of traditional accounts and the usefulness of Roth accounts in managing tax-schedule uncertainty are important considerations in the optimal savings decision.” They note that, for wealthy investors, their analysis shows “tax-strategy diversification is particularly attractive, despite their high current marginal tax rates.”

The authors also examined their findings’ economic implications: “Our results are of practical importance to employers and regulators who determine the retirement savings options available to employees. In particular, broadening access to Roth versions of workplace accounts would provide investors with important tools for managing their exposures to tax risk. Given that these accounts are available under current regulations, encouraging the widespread adoption of, and education about, employer-sponsored Roth plans could substantially improve investors’ welfare.”

What the authors found provides investors with the proper framework to make informed decisions regarding the asset location of their retirement savings and the diversification of tax risk.

This commentary originally appeared July 27 on

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

4 Benefits of Holding Stocks for the Long Term By David Dierking

Originally posted on

Many market experts suggest holding
stocks for the long term. The Standard &
Poor’s (S&P) 500 Index has experienced
losses in 10 of the 40 years from 1975 to
2015, making stock market returns quite
volatile in shorter time frames. However,
investors have historically experienced a
much higher rate of success over the
longer term.

In an ultra-low interest rate environment,
investors may be tempted to dabble in stocks to boost short-term returns, but it makes more
sense to hold on to stocks for the long term.

Better Long-Term Returns

An examination of several decades of historical asset class returns shows that stocks have
outperformed most other asset classes. Using the 87-year period from 1928 to 2015, the S&P
500 has returned an average of 9.5% per year. This compares favorably to the 3.5% return of
three-month Treasury bills and the 5% return of 10-year Treasury notes.
While the stock market has outperformed other types of securities, riskier equity classes have
historically delivered higher returns than their more conservative counterparts. Emerging
markets have some of the highest return potential in the equity markets, but also carry the
highest degree of risk. Short-term fluctuations can be significant, but this class has historically
earned 12 to 13% average annual returns.

Small caps have also delivered above-average returns. Conversely, large-cap stocks have
been on the lower end of returns, averaging roughly 9% per year.

Opportunity to Ride Out Highs and Lows

Stocks are considered to be long-term investments. This is partially because it’s not unusual
for stocks to drop 10 to 20% or more in value over a shorter period of time. Over a period of
many years or even decades, investors have the opportunity to ride out some of these highs
and lows to generate a better long-term return.

Looking back at stock market returns since the 1920s, individuals have never lost money
investing in the S&P 500 for a 20-year time period. Even considering setbacks like the
Great Depression, Black Monday, the tech bubble and the financial crisis, investors would
have experienced gains had they made an investment in the S&P 500 and held it
uninterrupted for 20 years. While past results are no guarantee of future returns, it does
suggest that long-term investing in stocks generally yields positive results, if given enough

Investors Are Poor Market Timers

One of the inherent flaws in investor behavior is the tendency to be emotional. Many
individuals claim to be long-term investors up until the stock market begins falling, which is
when they tend to withdraw money for fear of additional losses. Many of these same investors
fail to be invested in stocks when a rebound occurs, and jump back in only when most of the
gains have already been achieved. This type of “buy high, sell low” behavior tends to cripple
investor returns.

According to Dalbar’s 2015 Quantitative Analysis of Investor Behavior study, the S&P 500 had
an average annual return of roughly 10% during the 20-year period ending Dec. 31, 2014.
During the same time frame, the average investor experienced an average annual return of
just 2.5%. Investors who pay too much attention to the stock market tend to handicap their
chances of success by trying to time the market too frequently. A simple long-term buy-andhold
strategy would have yielded far better results.

Lower Capital Gains Tax Rate

An investor who sells a security within one calendar year of buying it gets any gains taxed as
ordinary income. Depending on the individual’s adjusted gross income, this tax rate could be
as high as 39.6%. Those securities sold that have been held for longer than one year see any
gains taxed at a maximum rate of just 20%. Investors in lower tax brackets may even qualify
for a 0% long-term capital gains tax rate.

Guide to Retirement Planning

Guide to Retirement Planning

Section 1: Determining How Much to Save and Spend

Estimating a Retirement Spending Amount

If you are 10 years or less away from retirement, you may be able to estimate retirement spending based on your current spending. Be sure to exclude expenses that may not continue in retirement, and remember to include expenses that may be higher in retirement. In determining how much of these expenses need to be funded by your portfolio, subtract any income you’ll receive in retirement from Social Security or pensions.

If you are more than 10 years away from retirement, it may make sense to estimate retirement spending as a percentage of your current pretax income. A starting point you can use is to assume that 50 percent of your pretax salary needs to be funded from your portfolio. While 50 percent may seem low, keep in mind that in addition to this level of spending, you’ll likely have Social Security or pension income on top of this. In addition, after retiring, you no longer have to save for retirement or pay FICA taxes.

Estimating How Much to Save

If you are 10 years or less away from retirement, we recommend working with a financial advisor to develop a savings plan using Monte Carlo analysis. Monte Carlo simulation is a statistical method for analyzing issues that involve randomness, like the returns of different asset classes. The inputs used in the simulation include the return, volatility and correlation of the asset classes. The simulator provides thousands of “versions” of each year in the future, and then reports back how the portfolio held up in each of these versions of the future. This simulator can help determine when you can retire and how much you’ll need to save for retirement.

If you are more than 10 years away from retirement, Monte Carlo may not be as useful due to uncertainty surrounding retirement expenses and the limitations surrounding the number of years you can run a Monte Carlo simulation. This simulation is useful for up to about 30 years, but analyses that are run much longer than that become unreliable. As a replacement, you can use the table below:


Savings Schedule


The rows of this table are your current age while the columns are how much you have saved for retirement. The percentages show the pretax income you should save annually. The assumptions behind this chart are a 50 percent replacement rate, a retirement age of 65, a 30-year retirement and a 60-40 portfolio. As an example, if you are 35 years old and you’ve saved 1x your annual salary (as indicated by the shaded box above), you would need to save 10 percent per year going forward. The table, which was created by Professor Wade Pfau, looks at a worst-case scenario using historical data back to 1871.

Plan for Potential Early Retirement

The above chart assumes a retirement age of 65, but it is wise to plan for the possibility that you might retire earlier than planned. There can be positive and negative surprises. For example, the investment returns you experience may be higher than expected, your earned income may be higher than expected or you may receive a large unexpected inheritance. On the other hand, you may retire earlier than expected due to negative surprises. For example, you may have a health issue that forces you into early retirement. It is important to have a “Plan B” for this possibility, which could include reducing annual spending or downsizing your home.

Section 2: Portfolio Management

Deciding on an Asset Allocation

Selecting an appropriate asset allocation is largely a function of your ability, willingness and need to take risk.

Your ability to take risk is largely a function of your time horizon. The longer your horizon, the greater is your ability to wait out the virtually inevitable bear markets. In addition, the longer the investment horizon, the more likely equities will provide higher returns than fixed income investments.

Your willingness to take risk is determined by the “stomach acid” test. This is the degree to which you’ll be able to stick with your plan during bear markets.

Your need to take risk is determined by the rate of return required to achieve your financial objectives. We discuss estimating future returns in the next three subsections.

Do Not Assume Constant Rates of Return

When planning for retirement, it is common to plan for the average returns you hope to achieve. However, actual returns will vary from one year to the next. Even if you could predict the actual average return in your retirement, the sequence of returns is also very important when it comes to retirement planning.

For the period of 1926–2014, a portfolio invested 70 percent in the S&P 500 and 30 percent in five-year Treasuries returned an average of 10.1 percent. In real terms (adjusted for inflation), the return was 7.0 percent. You might conclude that it would be possible to withdraw $70,000 per year from a
$1 million portfolio and maintain the same real income over the long term, increasing the $70,000 by the future rate of inflation.

The problem with this approach is that inflation rates and investment returns vary each year. If you retire before the start of a bull market, you may be able to withdraw 7 percent per year and maintain a portfolio in excess of $1 million. However, retiring at the beginning of a bear market can produce very different results.

For example, an individual who retired in 1972 and withdrew 7 percent of his or her original principal and adjusted that figure each year for inflation would have run out of funds within 10 years, or by the end of 1981. This is because the S&P 500 Index declined by approximately 38 percent in the
1973–74 bear market.

Systematic withdrawals during bear markets exacerbate the effects of the market’s decline, causing portfolio values to fall to levels from which they may never recover. For instance, if you withdraw
7 percent plus 3 percent for inflation in a year when the portfolio declines by 20 percent, the result is a decline in the portfolio of 30 percent in that year. A 43 percent increase is then required the following year just to return to the previous value.

Given the possibility that a market decline might occur at a very early stage of your retirement (when it tends to cause the most damage to long-term portfolio outcomes), consider remaining conservative as you determine how much money you can withdraw annually and still minimize the risk that you outlive your assets. We recommend consulting with a financial advisor who uses a Monte Carlo simulator to determine a prudent spending rate in retirement.

Estimating Equity Expected Returns

There are two primary ways of estimating expected returns, either using historical averages or using current valuations to forecast returns.

From 1926–2014, the annual average real return on the S&P 500 was 8.9 percent (not compounded). If you use current valuations, you can use the dividend discount model (which uses dividend yields), the Shiller CAPE10 model or a combination of the two. As of June 30, 2014, the Gordon model yields a real return estimate of 4.5 percent. The Gordon model is calculated using the dividend yield on the MSCI All-Country World Index (2.5 percent) plus an estimate of future growth of 2 percent. The Shilller CAPE10 model yields an estimate of 5.1 percent by taking a 60 percent U.S., 30 percent developed international and 10 percent emerging markets weighted average of the CAPE10 ratios and then multiplying by 1.075 to normalize for growth in earnings.

As you can see, the various methods can yield very different results. Further, all methods of calculating the expected return have flaws. Historical returns are subject to survivorship bias and changes in valuations. The dividend discount model doesn’t account for alternative ways of getting cash to shareholders. Also, not all firms pay dividends, and this model uses current dividends as a proxy for future dividends. As for the Shiller model, it doesn’t account for changes in accounting practices.

We generally prefer to err on the conservative side for these estimates, so we use an average of the result from the Gordon and Shiller CAPE10 models. If you plan for returns that are higher than what actually occur, this could result in you falling short of your goal.

Estimating Fixed Income Expected Returns

On the fixed income side of the portfolio, you are also able to use historical averages or current valuations in the form of current yields.

From 1926–2014, the average real return on five-year Treasuries was 2.5 percent. In looking at current valuations, the yield on a five-year TIPS is 0.2 percent.

Again, the method you use can yield very different results. We prefer to use long-term TIPS rates for determining the highest real return you’d be able to earn over the period. For example, if your horizon is 20 years, we’d recommend using the yield on a 20-year TIPS as your real return estimate on fixed income.

Equity Portfolio Construction

The first step to building a solid equity portfolio is to invest in a globally diversified portfolio. Investing in international stocks, while delivering expected returns similar to domestic stocks, provides the benefit of diversifying the economic and political risks of domestic investing. There have been long periods when U.S. stocks have performed relatively poorly to international stocks. The reverse has also been true.

The logic of diversifying economic political risks is why you should consider allocating at least
30 percent and as much as 50 percent of your equity holdings to international equities. To obtain the greatest diversification, your exposure to international equities should be unhedged from a currency perspective.

Fixed Income Portfolio Construction

The main role fixed income assets play in a portfolio is to reduce its volatility. Therefore, we generally recommend investing in high-credit-quality fixed income. This can include AAA/AA rated corporate bonds or municipal bonds, bank CDs under FDIC limits, agency bonds or bonds issued by the U.S. Treasury. Along the same lines, short-term and intermediate-term bonds have the benefit of less volatility and lower correlation to equities than long-term bonds. As a result, we think most individual investors are best served by avoiding long-term nominal bonds.

Section 3: Risk Management

Long-Term Care Coverage

According to the U.S. Department of Health and Human Services, roughly 37 percent of people turning age 65 today will need long-term care in a nursing home or assisted-living facility. The average cost of a private room in a nursing home is $229 per day or $83,580 per year. The average cost of a room in an assisted-living facility is $3,293 per month or $39,516 per year.

These costs are quite high and many people have turned to insurance to protect against the risk of needing long-term care. The process for determining whether you need long-term care can be complex. We recommend consulting with a financial advisor to determine if it is appropriate in your situation.

Protecting Against Longevity

It is important to consider the “risk” of living longer than expected. This “longevity risk” is the risk that you outlive your financial assets. In certain cases, it can make sense to buy a form of insurance against longevity risk.

This insurance is either a single premium immediate annuity (SPIA) or a deferred income annuity (DIA). In a SPIA, you pay an upfront premium to an insurance company in return for an income stream that starts immediately. This income stream can be either fixed or adjusted for inflation. In a DIA, you pay an upfront premium to an insurance company in return for an income stream that starts at some date far into the future. For example, you could buy the DIA at age 65 in return for income starting at age 85.

The process for determining whether you should insure against longevity risk or self-insure is complex, and we recommend consulting an advisor to determine if it is appropriate in your situation. We generally prefer deferred income annuities over immediate annuities because we’ve found the deferred option leads to higher levels of success in Monte Carlo simulations.

Section 4: MaximizING Social Security Benefits

According to the Social Security Administration, Social Security benefits represent about 40 percent of the income for the elderly. Social Security benefits are essentially guaranteed income that:

  • Is adjusted for inflation
  • Is free of investment risk
  • Is protected against longevity risk
  • Comes with a death benefit for married and qualifying divorced individuals

These benefits often are a significant source of retirement income and unlike any other income or investment vehicle. It is important to know how to optimize lifetime benefits. Benefits are determined by birth year, retirement age and lifetime earnings. Once workers reach full retirement age (FRA), they are eligible for full retired worker benefits, also known as the primary insurance amount.

Workers who claim benefits prior to reaching FRA will receive a reduced benefit of up to 25 percent of the primary insurance amount. Delaying a claim until age 70 results in a benefit of up to
32 percent more than the primary insurance amount due to cost-of-living adjustments and delayed retirement credits.

The optimal strategy for claiming Social Security benefits might not be obvious because of various rules for how those benefits are paid. For instance, a husband who earns high wages but does not expect to live long may still want to delay filing because, at his death, his benefit will go to his lower-earning wife. If he claims early, she will have a lower benefit for the rest of her life.

Strategies for claiming Social Security benefits can get incredibly complex, so we recommend consulting a financial advisor to help you make this decision.

Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.