Wednesday June 18, 2014

Case Study – Early Retirement Plan Distributions – When Does it Make Sense?

When Does it Make Sense to Take Retirement Plan Distributions Before You Have to?

The primary reason one takes Retirement Plan Distributions prior to the mandatory age of 70 ½ is financial necessity. The distributions are needed to supplement income and cover one’s basic expenses. I will not be discussing that situation in this post. I will be covering the situations in which the person or household has the resources and income to cover their lifestyle without dipping into their retirement savings until the Required Minimum Distribution age mandates they do so.

In this example I will be using an actual client case in which the individual retired quite early (age 55) with sufficient income streams and a relatively large amount in Qualified Retirement Plans – Pension, 401(k) – and substantial cash savings.

Here is the scenario:

  1. Client is age 59 1/2, his spouse is 58. His Company downsized him and many of the higher paid senior and mid-management employees 4 years ago. They will continue to pay for his family’s major medical insurance until his age 65. His wife worked enough over the years to qualify for Social Security but was primarily a homemaker during this time.
  2. There is 1.2 million in his Retirement Plans – 900k in a 401(k) and 300k in a Pension Plan.
  3. There is 700k+ Cash Reserves in CD’s and Money Market accounts.
  4. They own 3 annuities totaling $330,000. We determined that it would make sense to annuitize one with a balance $143,000 to pay out over 11 years at $18,000 per year (mostly tax free return of principal) to supplement income and avoid using their Cash Reserves. The 11 year payout period was set to end with the Client’s attaining 70 ½ when he must begin taking Required Distributions
  5. A Social Security Analysis was performed and determined that he would defer his SS Benefit until age 70 in order to leave his wife with a much larger monthly benefit after his death. She will begin her SS at age 62, switching to Spousal Benefits at age 69. He will take a Spousal Benefit at his age 66 (½ of his wife’s benefit amount) and switch to his at age 70.
  6. They have been diligent with their debts, all mortgages and other loans have been paid off.
  7. They own 4 rental properties from which they receive $36,000 per year in rental income. Their income needs are modest at around $50,000 per year.
  8. The wife just inherited an IRA from her deceased father and is taking the distributions over 5 years – $28,000 per year.
  9. With the tax deductions available from the rental properties and other itemized expenses – depreciation, maintenance, insurance, taxes, charitable donations, etc., their Adjusted Gross Income is only $48,000 per year. This places them in the 15% Federal Tax Bracket.

His Retirement Plan Accounts – 401(k) and Pension – totaling $1.2 million today will grow substantially between now and his age 70.  He saw no need to take a lot of risk with the portfolios and we rolled the balances into three IRA accounts. $900k was placed into two Fixed Index Annuities with uncapped earnings strategies, but with the guarantee of no losses in down markets. The remaining $300k was invested in the Stock Market in a portfolio of low-cost Exchange Traded Funds representing various market indices – S&P 500, Mid Cap, Small Cap, and International.

We assumed a very conservative overall return on his IRA Accounts of 5% compounded over the next 11 years. This would bring the total IRA balances at age 70 ½ to just over $2 million. The Required Minimum Distribution at his age 70 ½ would be just over $75,000, increasing a bit each succeeding year.

Now let’s look at their Current Income and Tax Brackets.

  1.  At their current Adjusted Gross Income of $48,000 they fall into the 15% Fed Bracket. The 15% Bracket goes up to $73,800 for couples filing jointly before moving to the 25% Bracket.
  2. At 70 ½ the Required Minimum Distribution of $75k+ would effectively use up the entire 15% Bracket. Their additional income from the Rental Properties and other probable inherited IRA’s (from his aged father) would then move those amounts into the 25% Fed Bracket. Of course some of their income is in the 10% Bracket ($18,150), so there would be about $30k in the 25% Federal Bracket. In this I’m making the assumption that their other income remains consistent at about $48,000
  3. Today they have the room to take another $25,800 of income and still remain in the 15% Bracket. $73,800 – $48,000 = $25,800.

Question: What is worth more – $1 taxed at 15% or $1 taxed at 25%. Simple, it’s 85 cents versus 75 cents.

Taking IRA distributions now through age 70 ½ in an amount that lets them fully take advantage of the 15% Federal Tax Bracket makes a lot of financial sense. It’s a guaranteed 10% increase in the value of those distributions.

Taking those distributions now will also lessen the amounts they will be required to take at age 70 ½ by lowering the IRA balances.

Just because they will be taking these distributions of around $25,000 per year for the next 11 years doesn’t mean they will have less Retirement Income later. They can reinvest these distributions into a Growth Portfolio, convert to Roth IRA’s, add to their Cash Reserves, buy cash value Life Insurance, any of which they can use later in a much more tax favored manner.

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