How Much Can We Spend if We Retire Tomorrow?
Tim walks through a case study of a couple's retirement plan emphasizing tax planning, guardrails, and a war chest while stressing the importance of considering healthcare costs in retirement.
Today I'm going to talk about a couple that has about $2.7 million in investable assets. They are 62 and 58, and they want to know how much they can spend in retirement if they were to retire right now.
One thing that they're concerned about is a big concern of most people that want to retire before 65 and get Medicare. They want to know how much their insurance is going to cost in those years between when they retire and Medicare, and can they afford it?
They're in a pretty good situation. I show the details in our big picture planning software. Their net worth is actually $3.1 million because they have a $400,000 house that's paid for.
About 85% of their assets are tax deferred. Typically, if I see a large tax deferred asset or holdings, that means that Roth conversions are probably going to be something that we can use. That's not always the case.
If people have everything in a Roth already, or if they have a large joint account or a taxable individual account, then you can't even do Roth conversions. You can only convert from a pre-tax account like an IRA or a 401(k).
We see large tax deferred accounts often because you've been told to put your money in a tax deferred account for the last 30 or 40 years or so by your advisor or your company. That's not always the case, but it's what we often see.
I'm gonna walk you through what I look at in our planning software to determine whether or not Roth conversions might be something for you. Of course, you could always reach out and we can go through that together.
I used the names Charlie and Lucy Brown again for this scenario. Charlie is 62 and Lucy is 58, and the lion's share of their assets is in Charlie's 401(k) with almost $2.2 million. He also has a Roth IRA started with about $83K, which is nice, and they have a joint checking account with about $100K and a joint brokerage account about $150K. Then of course, the primary home is $400,000 and Lucy has an IRA and a Roth IRA as well.
Do We Have Enough to Retire?
The first primary question is, do we have enough to retire. Well, they told me they're going to probably spend around $8,500 per month in retirement, so they're in pretty good shape. The plan is actually showing them finishing with a moderate growth portfolio which is about 8.5 % a year on average. We can raise that and lower that based on conversations with our clients or prospective clients.
They're in really good shape actually. Spending that, they could finish with about $15 million if they live to age 90. So they've got a lot of room to work here.
Monte Carlo Simulations
I don't like to use Monte Carlo probabilities. We pay attention to them, but if people see a 97% probability of success, a lot of times they think, hey we're in really good shape. But sometimes it makes people actually underspend what they could.
If you're at about a 50% probability of success, that means you have about a 50% chance of being good and a 50% chance of running out of money, but that's never really going to happen because this is just a probability of success.
So I don't like to use Monte Carlo simulations with my clients. If they've got $2.7 million, I can say, you know what, I can safely send you about $145 or $150,000 a year out of that nest egg for the next 30 or 40 plus years, if we follow a few rules. We call that our guardrail portfolio, which is usually between 5% and 6% that we can send clients out of their nest egg.
Cash Flow
So with their cash flow summary, they said they could spend $8,500 a month on living expenses. Then I added in $12,000 apiece per year for healthcare until they are 65 and get Medicare. This might actually be a little bit high when you factor in healthcare subsidies, but I like to be a little bit conservative with the number.
The cash flow for Charlie and Lucy is inflation adjusted. Then the healthcare portion goes down when Charlie hits age 65, and again when Lucy turns 65 and her Medicare kicks in.
Roth Conversions
Now let's go back to their tax deferred situation. This couple looks like they're in pretty good shape as far as having enough to spend and live comfortably in retirement.
Let's see what we can do with their lifetime tax liability because they have that large tax deferred account that's not all theirs. A big chunk of that belongs to Uncle Sam. So what we're going to try to do is thread that needle and lower lifetime tax liability over their lifetime.
First of all, let's take a look at withdrawal sequence. People don't realize how big a difference this can make. But just withdrawing from the proper account at the proper time over their retirement is going to enable them to save $1.3 million in taxes just by doing that.
Then on top of that, let's look at Roth conversions in the software. So we look at filling up the 10% tax bracket with Roth conversions, then the 12% bracket, then the 22% bracket. By filling up the 22% tax bracket and withdrawing from the proper account at the proper time, they can save $2.3 Million in taxes.
That's a lot, right? That's a big deal. Now, there comes a point usually when it's counterproductive to do Roth conversions. Let's say we fill up the 24% tax bracket. That shows less tax savings than just filling up the 22% tax bracket. Knowing this is great, right because we don't want to pay Uncle Sam any more than we have to.
Doing Roth conversions over time is going to also have this couple have a higher net worth in addition to paying less in taxes.
We also look at Medicare parts B and D premiums, which are based off your adjusted gross income. If your AGI gets too high, then you're going to have to start paying more for your parts B and D premium.
In this situation, filling out the 22% bracket between retirement and RMD age is going to be the best scenario for Lucy and Charlie. So we're definitely going to be able to do some good tax planning for them.
Withdrawal Rate
As I mentioned, we want to keep most people between 5 and 6% for a withdrawal rate. We can go a little bit higher than that for a few years, but in general, we want to keep people between 5 and 6% throughout their lifetime.
This couple is in good shape at 5.5% the first few years because they're having to pay higher health care costs out of pocket. Then the withdrawal rate drops down as Social Security kicks in, and then Medicare starts covering more medical costs.
In this situation, with them spending $8,500 a month and covering their expensive health care costs until Medicare kicks in, they're going to still finish with quite a bit in their plan, about $15 million. So they could retire tomorrow and still be in really good shape.
Increasing Expenses in Retirement
What if you actually want to kick this up? Let's see what happens. Let's say we take it to $13,000 a month. The biggest thing is this gives people peace of mind knowing, hey, look, I CAN do this. So even if we kick that up to $13,000 a month, it's still showing them finishing with about $5 million in assets.
So these guys are in great shape for retirement, which of course is the biggest concern. They are higher health care costs in the meantime between when they retire and Medicare, if they're retired right now.
The biggest thing is, yes, they are able to retire. Again, I'm not big on the Monte Carlo probability of success because basically what that's saying is, if you're at 100%, then that means that you're probably definitely under spending what you could in retirement.
And if you want to spend more to be happy, then do it. If you're at 50%, then you have a 50% chance of running out of money and a 50% chance of not spending enough. So you want to thread that needle, and we're going make adjustments along the way.
Guardrails
Another reason that I like to use our guardrails as opposed to probability of success, let's say out of your $2.7 million, we can give you $145,000 a year to last 30 or 40 plus years. But if, or when, the market goes down by 30, 40, or 50 percent, well, rather than just saying, your plan has failed, you're not going to make it, we're just going to say we're going to have to take a 10% haircut on what we're sending you. We're going to have to tighten our belts a little bit while we let the stock market bounce around and come back up.
And that's why we have a war chest for all of our clients. But them saying, hey, we're going to go from spending $145,000 a year to $130,000. Well, at least that allows them to say, oh, okay, yeah, I can tighten my belt a little bit if the economy goes down or my investments go down.
It still gives them something to look at, something tangible to think about. $130,000 is easier to understand than saying a 60% probability of success. What is that?
Bottom Line
So anyway, long story short, Lucy and Charlie have done great. They have a $2.7 million nest egg. A large part of that is tax deferred. So we're going to be able to do some great tax planning for them.
We'll save them over a million dollars in taxes and also allow their net worth to be a couple million dollars higher at the end. They are in great shape. They can retire tomorrow and in all likelihood have a great retirement.
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