Editor’s note: While advisors watched the development of new tax law this year with high interest, they were also especially focused on client service and financial planning. Of the more than 500 articles published this year, our members found this one to be among the best.
One reason Social Security resonates so strongly with baby boomers is that after years of thinking it wouldn’t be there for them, it turns out to offer exactly what they need at the end of a long working career: guaranteed income. Without examining details or semantics, Social Security picks up where the paycheck leaves off, allowing (at least some of) the bills to get paid.
As you know, in this industry we avoid using the word “guaranteed” wherever possible, including as it applies to Social Security, because technically Social Security represents a promise by the U.S. government—a promise that could be revoked at any time. Because we don’t think there are enough lawmakers willing to commit political suicide, we are assuming Social Security is here to stay and that the lifetime inflation-adjusted income is as close to guaranteed as you can get.
Baby boomers tend to start the retirement income planning process with Social Security because, compared to other sources of retirement income, it’s a relatively known quantity. First they want to see how much they’ll get from Social Security. Then they’ll figure out how much income they’ll need from other sources. Putting a pencil to it, most clients find that Social Security will supply somewhere between 20% and 70% of their income in retirement.
Working until age 70 is the easiest way to keep “guaranteed” income flowing after stopping work (not that a paycheck is guaranteed either, but clients usually think of it that way). At 70 the paycheck gets traded for the maximum Social Security check. Gaps are identified and filled in with withdrawals from retirement accounts. The uncertainty of how much to withdraw while being assured of never running out of money is at least partially resolved by the IRS, which tells you exactly how much you must withdraw from your retirement accounts starting at age 72.
If you did nothing more than collect Social Security and take RMDs, you’d have a pretty solid retirement income plan—one which didn’t require a lot of thought or discipline, and one that would (probably) never run out. All that’s needed would be sufficient assets in the retirement accounts so that the RMDs, in addition to the Social Security, would meet the client’s spending needs (or else a flexible enough lifestyle to make it fit the available income).
If Social Security + RMDs are insufficient, non-retirement assets can be evaluated for their income potential and perhaps converted to a form better designed to generate monthly income, such as an annuity. Now the client would have three layers of “guaranteed” income: Social Security, RMDs, and annuity income. (The amount of the RMDs is not guaranteed, of course, but the fact of the RMDs is assured, as long as any assets remain in those qualified accounts.)
How it works
Say you have a client couple with $5,000 in monthly Social Security income and $800,000 in IRAs. Based on the Uniform Lifetime Table, their first RMDs would total $800,000 ÷ 25.6, or $31,250, which is $2,604 per month. This gives them pretax monthly income of $5,000 + $2,604 = $7,604.
Next year, at age 73, the RMD divisor would be 24.7. The $800,000 IRA got reduced by $31,250 from the first RMD, but let’s say the account grew by 5%. Now the IRA is worth $807,187 and the second RMD will be $32,680, or 4.5% higher than the first one. The Social Security will be a bit higher too, due to the COLA. Let’s say the Social Security is now $5,100. So their age—73, monthly income will be $5,100 + $2,723 = $7,823, which is 2.88% higher than the previous year’s income. If the IRA again grows by 5%, it will have recovered the RMD and then some, making the following year’s RMD a bit higher to go with the COLA-adjusted Social Security.
So as long as the IRA keeps growing at a reasonable rate and Social Security pays a cost-of-living adjustment, the client’s income will keep up with inflation for the next 20 years. It is not until the client’s mid-90s that the RMDs take such a bite out of the IRA that the account starts declining in value and the RMDs fail to keep up with inflation. Meanwhile, over more than two decades the client has received enough income to pay the bills without having to think too much about how to obtain that income. Social Security hit their bank account monthly, and the IRA custodian made sure the RMDs were delivered in accordance with the law.
To keep all of this simple, rather than trying to figure out the after-tax portion of each income source, we just take the pretax amount (the full RMD plus 85% of the Social Security), estimate total taxes and enter that as a budget item along with housing, food, Medicare premiums, and other expenses. For a couple filing jointly, the tax on the $31,250 RMD and the $51,000 in taxable Social Security income, assuming the standard deduction and no other income, would be about $6,460 for the year. Figured monthly, this gives them a line-item expense for federal income taxes of $538. In other words, after taxes they’ll have $7,066 ($7,604 - $538 = $7,066) available for living expenses.
A simple place to start
This very simple retirement income plan will work just fine for a lot of clients. It’s at least a starting point. First see what you can get from Social Security (after maximizing it by claiming at 70), add in RMDs, and there’s your retirement income. For those retiring before age 70, you’ll have to impute the RMDs (just divide the IRA by something close to the RMD divisor, like 25) and also pull the Social Security equivalent amount from available assets, perhaps utilizing financial products like annuities during the bridge period.
Retirement income planning is only tricky for people retiring before age 70. Then you have to find enough income to serve as a bridge to the Social Security claiming age of 70. But once Social Security starts at 70 and RMDs start at 72, it’s pretty clear sailing, barring unforeseeable events such as a lengthy illness or the need for long-term care, which can be planned for separately through hybrid products or setting aside sufficient assets in reserve.
Clients who don’t have enough assets to give them that bridge to age 70 would be better off continuing to work. Those whose IRAs are not large enough to generate sufficient RMDs may need to adjust their lifestyle. Those who have converted all or most of their traditional IRAs to Roth IRAs won’t have to worry about taxes, but without the RMD schedule to calibrate withdrawals, they will have to do the math themselves, taking enough to live on without running the risk of depleting the account. The regular RMD schedule, though not required, can serve as a guide.
References and further reading