Lynn Brenner's Family Finance

Is My Inherited IRA Subject to EstateTax?

Q: My mom passed away in November 2010. She was a New York resident and left an IRA with two beneficiaries, myself and my sister. Is that IRA considered an asset for the purposes of New York State estate taxes? The bank has already completed transfer of the IRA distributions. I’ve rolled my portion to a new IRA to avoid tax liability, and my sister took her portion in cash. I live in another state and I’ve been advised that this IRA wouldn’t be considered a taxable asset if mom had lived here. But I need to know if it is in New York. –DM

 

A: No matter what state you live in, your estate is the value of everything you own at the time of your death -- and that means everything, from your tax-deferred retirement accounts to the loose change on your bedside table. But not all states have an estate tax; and even the ones that do have an estate tax don't tax every estate.

New York taxes estates whose value is greater than $1 million. Let's say your mother’s total estate – including her IRA – was worth $1.2 million. In that case,  a New York estate tax is due on the $200,000 excess. If her estate was worth less than $1 million, there's no New York estate tax. (In case you're wondering, in 2010 there was no federal estate tax. In 2011 and 2012, federal estate tax appies only to estates worth more than $5 million.)

Don’t confuse estate taxes with income taxes. These are two entirely different sets of taxes, with different rules, tax rates, and exemptions!

Regardless of whether your mother’s estate was taxable, you and your sister will owe income taxes on the money you take out of her IRA. If the IRA is worth $200,000, for example, and you take a $10,000 distribution, that $10,000 is added to your taxable income for the year.

Your sister took her portion in cash. If she took it in 2011, she’ll owe income taxes on the amount of her cash distribution in April 2012.

You say you transferred your share into a new IRA to avoid tax liability. As I explained in an earlier post, that new IRA must still be titled in your mother’s name to preserve its tax-deferred status. Your name can be on the account too, but as its beneficiary, not its owner.

If you’ve done this transfer correctly, you’ll only owe income taxes on your annual IRA distributions. (You must take a minimum yearly distribution from the IRA based on your life expectancy.)  But the balance of the account will continue to grow tax-deferred.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

Lousy Timing Is a Major Investment Risk For Retirees

Q: You’ve written about studies showing you should use a 4% annual spending rate if you need your money to last for up to 30 years. Can you use a higher spending rate if you only have a 15 to 20 year horizon? --DA via email

 

A:  Financial professionals say you’re probably safe using a 5% annual spending rate if you have a 15 to 20 year horizon; but they warn that if you exceed a 6% rate, you run a serious risk of outliving your savings.

In other words, cutting your horizon from 30 years to 15 years doesn't mean you can prudently double your annual spending rate.

Why must you be so cautious? A major but little-understood reason is that all retirees are exposed to what I think of as the Terrible Timing risk.

Here’s what I mean:

Even in a 15 year period, there’s a very good chance that you'll live through more than one bear market. (In the last 15 years, we have experienced two horrific bear markets: 2000-2002 and 2008-2009.)

The question is, when will these bear markets occur?

To explain why this matters so much, Parsipanny NJ financial adviser Mark Cortazzo tells a story about three imaginary brothers whom we’ll call Andrew, Bob, and Charlie.

Each brother retires with a $1 million nest egg invested in Vanguard’s S&P 500 Index Fund.  Each brother uses a 6% annual spending rate, withdrawing $5,000 a month ($60,000 a year) from his portfolio. (To keep things simple, there are no inflation adjustments in their withdrawals.)

Andrew retires on January 1, 1997. Bob retires on January 1, 2000. And Charlie retires on January 1, 2003.

Their starting balances, investments, and withdrawal rates are identical -- but by July 2010 there’s a dramatic difference in their portfolio balances.

Andrew still has almost $1 million; his balance is $999,310. Charlie has $1,008,561. And Bob -- who had the bad luck to retire just as the stock market tanked -- has only $261,884 left.

The moral: If you happen to retire at the start of a bear market, your money won't last nearly as long as it will if you retire at the start of a bull market.  

So what can you do about this?

You can't control future market cycles, so there's no sense in wasting sleep about them. Instead, focus on what you can control:

Trim your annual living expenses (and that includes paying down credit card debt and minimizing investment-related fees).

Maintain a well-diversified portfolio to reduce the risk that all your investments are hammered at the same time.

Maximize alternative sources of retirement income (like Social Security and part-time earnings).

And spend your nest egg at a conservative annual rate!

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

 

How to Turn a Retirement Portfolio Into Income (Part 3)

It’s a real shock to learn how little you can withdraw from your savings every year after you retire without running out of money.

A healthy 65 year-old can now expect to live into his or her 80s or 90s. In other words, your savings must last for 20 to 30 years. Even if you invest wisely and limit your annual withdrawals, that takes a huge pile of money.

Very, very few people can save enough to live on their savings alone for two or three decades. Fortunately, few of us have to. On average, Americans aged 65 and older receive 40% of their income from Social Security; 25% from wages and self-employment income; 20% from retirement accounts and pensions; and about 13% from non-retirement investments.

So how much can you take from your savings every year?

Studies using past financial data show a retiree must limit annual withdrawals to an inflation-adjusted 4% to 5% of his portfolio’s balance at the start of retirement if he wants to be reasonably certain his portfolio will last as long as he does -- i.e., a portfolio worth $1 million on the day you retire can probably produce a constant $40,000 to $50,000 a year until you die. That assumes at least 50% of the portfolio is invested in stocks. It also assumes you don't count on leaving anything for your heirs.

This stark conclusion flies in the face of longstanding conventional assumptions. The typical response is: Why can’t I earn a 10% average annual return on my investments, withdraw 6% of my savings each year, and leave my survivors a nice legacy?

We've all seen handsome illustrations that show big stocks and small stocks have respectively earned 10% and 12% average annual returns since 1925. Unfortunately, as William J. Bernstein explains in The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between-- a brilliant and wonderfully readable book -- you cannot have those returns. In real life, no investor has ever had those returns: They exclude investment fees, transaction costs, and taxes. They also assume that all gains were reinvested for 80-plus years.

Last and most importantly, writes Bernstein, the historic numbers reflect a reality that no longer exists: "We cannot go all the way back to the end of 1925, when U.S. stocks yielded 5 percent." The current dividend yield on the U.S. stock market is about 1.7%. Why is this important? Because almost half of the historic return on stocks comes from their reinvested dividend yield, not from rising stock prices.

But even if you could earn a 10% average annual return, there is a huge difference between an average annual return over a 20 year period, and actual returns in each of those 20 years. The average airbrushes out all the annual volatility. In bad years your investments will earn less than the longterm average -- and in awful years, they'll lose money. Meanwhile, inflation will steadily erode the purchasing power of the dollars you withdraw to pay your annual expenses. In two decades, a modest 3% annual inflation rate cuts the value of a dollar in half.

The upshot is that if you want your money to last as long as you do, your annual spending rate has to be well below your optimal longterm average annual investment return.

An analysis of 75 years of market data by Bill Bengen, a California fee-only financial planner -- one of many studies to reach similar conclusions -- found that a retiree with a 30 year horizon couldn’t safely withdraw more than about 4% of his initial portfolio every year, plus annual inflation. (In a future post, I'll address whether you can boost your spending rate if you have a shorter horizon.)

The Bengen studies and others are based on the past. They can design hypothetical portfolios and trace what would have happened to them using real market returns, inflation and tax rates. Obviously, predicting the future is a different matter. But forward-looking numbers-crunchers using ‘Monte Carlo’ simulation software to compare the impact of hundreds of possible future market scenarios on multiple combinations of assets have reached the same conclusion: Your savings are unlikely to last for two or three decades unless you start with a huge portfolio or adopt a very modest spending annual spending rate.

If you want to run your own portfolio through such calculations, your best recourse is to go to a fee-only financial planner – i.e., someone who charges for advice, but doesn’t earn money selling investments – whose software program lets you put in your own assumptions. With online calculators, you must accept built-in assumptions, which aren't always revealed and are often over-optimistic.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

How to Turn a Retirement Portfolio Into Income (Part 2)

 

Q: What's a good way to withdraw annual retirement income from an investment portfolio? --DA, via email

 

A: I like the two-bucket method. It has the virtue of simplicity, and it makes sense both emotionally and fiancially.

But the caveat I cited in my last post applies here, too: It won't work well if you don't have enough money.

Here's the idea:

When you retire, you divide your nest egg into a Cash Flow Bucket and an Investment Bucket.

Fill the Cash Flow Bucket with enough money to cover your living expenses for two years. Keep it in a money market fund.

Fill the Investment Bucket with a mix of stock and bond funds. The most appropriate mix depends on factors like the size of your portfolio, your other sources of income, your life expectancy, your assumptions about future market returns and inflation rates, and your appetite for risk. My own best guess is that a healthy 65 year-old shouldn’t have a stock/bond mix more aggressive than 65/35 or more conservative than 50/50.

Clear so far?

Okay, let's look at an example.

Let's give you a $1 million nest egg, and say you want to withdraw a constant $45,000 a year (i.e., $45,000 after inflation) to cover your living expenses. In other words, your annual spending rate will be 4.5% plus inflation. In effect, you've turned your portfolio into an inflation-adjusted annuity. These $45,000 withdrawals will supplement your monthly Social Security benefit and any other income you may have, such as a pension or earnings from a part-time job.

You'll put $90,000 into your Cash Flow Bucket. Every month, you'll write yourself a money market fund check for about $3,800.

Think of this as your paycheck.

The remaining $910,000 goes into the Investment Bucket's mix of stock and bond funds. Once or a year you'll rebalance this portfolio back to your original allocation. When you rebalance, you'll also transfer enough money out of Investment Bucket into the Cash Flow Bucket to bring its balance back up to $90,000.

What if you don't need to rebalance the Investment Bucket that often because your allocation hasn't changed?

In that case, when there's less than a year’s worth of expenses remaining in the Cash Flow Bucket, you'll examine the contents of the Investment Bucket to identify what to sell to replenish your Cash Bucket. Remember, you want to sell shares of funds that are doing well. You should avoid selling an investment that is experiencing significant losses; you want to give it the time to recover.

Sell enough of an investment that is doing well to provide the money to bring the Cash Flow Bucket balance back to $90,000. Don't forget to rebalance the Investment Bucket after you've done this.

Okay -- but what if nothing is doing well in the Investment Bucket? What if all your investments are losing value? A bear market in both stocks and bonds lasting longer than a year is unlikely, but not impossible. In that case, you replenish your Cash Flow Bucket by liquidating some of your most conservative bond holdings, says Harold Evensky, the fee-only financial adviser who pioneered the two-bucket method. He recommends that your Investment Bucket contain about three years worth of living expenses in short-term, high quality bonds.

In other words, this approach gives you liquidity enough to cover up to five years' worth of withdrawals: two years in the Cash Flow Bucket, plus three years in the Investment Bucket.

The beauty of this system is that it’s relatively simple. It's comfortingly familiar because it preserves the psychological distinction between your checking account and your investment portfolio. It offers some protection against having to sell stocks at the worst possible moment. And it helps provide emotional stability: you're less likely to agonize over market volatility if you know you have enough cash on hand to cover a couple of years’ worth of living expenses.

But it’s no coincidence that financial planners and columnists so often use a $1 million portfolio to illustrate such strategies: You need that big a nest egg if you want to withdraw $45,000 a year, adjusted for inflation, for up to three decades of retirement. In fact, if your annual, inflation-adjusted withdrawals exceed 5% of your initial portfolio, you run a serious risk of outliving your savings.

In my next post, I’ll explain why that is.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved