Your starting retirement portfolio balance is a small fraction of your lifetime wealth. When you understand that a $4M IRA at age 60 will likely have $16M ramifications, you start to understand how investment, income, and tax decisions all carry significant consequences.
Small decisions extrapolated over a long period become enormous decisions.
If you and your friend are driving in the heart of Houston and have to choose between heading north on I45 or heading east on I10, it’s not that big of a difference for the first 5-10 miles. If you choose different paths, you’re still relatively close to each other.
But 4 hours later, you’re in Dallas, and your friend is in New Orleans. Ten hours later, you’re in Wichita, and your friend is enjoying the Florida panhandle (no disrespect to Wichita!).
Understanding this idea is critical with your investments and retirement income plan. You might retire with $3M (or $1M or $10M). But your future income stream (and tax bill!) will be drastically higher than your starting asset amount.
In one of my February newsletters, I alluded to the fact that your starting assets in retirement will likely end up producing four times that amount in lifetime income + remaining principal.
If you retire with $5M, your future income stream, taxable income, and legacy assets could reach $20M. Even crazier, the last century has produced several periods where the starting $5M reached $30-$40M+.
The Basics: The 4% Rule
Let’s start with a fundamental “rule” in retirement planning. Bill Bengen came up with the famous “4% rule.” He recently updated it to the 5% rule. If you’re not familiar with the 4/5% rule, here are the basics:
- You can take 4-5% of your portfolio balance as a starting annual income in retirement.
- Have $3M? Bengen says to start with $150,000 per year.
- After the first year, Bengen’s model assumes you increase your yearly income by 3% each year (for inflation).
- Bengen’s portfolio consisted of 50-60% US stocks and 40-50% bonds.
Other interesting facts:
- Why 4-5%? Bengen picked 4% (later 4.5%) because 4.5% with subsequent inflation increases survived the worst 30-year period in the last century.
- 7% was the average safe withdrawal rate over the past century
- Several 30-year periods in the last century would have accommodated a 10%+ starting withdrawal rate.
Can we improve the “4/5% rule” with essential financial planning tools? Yes, here are a few:
- Start with a diversified equity portfolio. International may or may not outperform US stocks. But they have different annual returns. This leads to the next point…
- Utilize a dynamic withdrawal strategy. Simply put, when one part of the equity market struggles (i.e., US Small Caps), don’t take from that part of your portfolio. Let it recover for a few years.
- Utilize a rising equity glide path. Whether you start with a 50/50 or a 75/25 stock/bond split, this can be helpful. What is a “rising equity glide path?” It’s when you take from your bonds first (especially during a sustained market downturn) to allow your stocks to recover.
- During sustained market downturns, pause your annual inflation increases.
- Take it to the next level: create an upper and lower band for your portfolio. If the portfolio hits the ceiling band, increase your income. If the portfolio hits the floor band, decrease your income.
- Employ the dozen+ tax planning strategies to lower future taxes.
- Be mindful of investment fees! If you’re paying 2% in all-in fees (yes, many people are–even if they don’t know it), this reduces the income you can take.
A central theme in the above ideas is flexibility. When you employ the above strategies, you can take more income from your portfolio. 6-7% instead of the usual 4% is possible with proper management.
Retiring From Large Oil & Gas Companies
As we’ve written before, retiring from an Oil & Gas company creates unique financial challenges and opportunities relative to most retirees. You typically have more assets–thanks to higher employer contributions via 401k & pension. And you typically own the vast majority of those assets in pre-tax retirement plans–creating unique tax challenges.
The result: Oil & Gas retirees typically have a lower withdrawal rate than the average American. While we certainly let our clients know how to spend 6-7%, a common retirement income plan might look like this:
- $5M in assets
- 80%+ in retirement plans
- Expenses around $12,000/mo
- $200,000 annual withdrawals more than cover life expenses and any associated tax bill
If this retiree properly manages their portfolio, retirement distributions, and navigates tax oportunities (NUA, Roth conversions, etc.), they can likely take $200,000 every year + a 3% annual inflation increase. Over a 35 year retirement, this is over $12.5M in lifetime income.
And thanks to the low withdrawal rate, it’s likely that the principal has continued to compound. Just like Bengen’s research shows, the portfolio (that produced over $12M in income) will retain the $5M principal even in some of the last centuries worst stretches. In many cases, the $5M reaches $10M-$15M+
This is how a $5M portfolio can surpass $20M+ in lifetime income plus the remaining balance that passes on to heirs.
Why You Need to Understand This
Back to the analogy at the beginning: a small mistake at the beginning of a trip results in a massive problem over a long time period.
A small investment mistake or a small tax mistake isn’t always a big deal on its own. But if you mess up at age 60–and live to age 95–that can create some serious problems.
Investments and Inflation
Simply put–you cannot time the market. Just don’t do it. It’s tempting to make your portfolio much safer as you approach retirement. And you do need to have a “war chest” (five years of fixed income) to provide for future years.
But getting too safe can ruin your retirement plans. Most people are afraid of a market crash. When you know that markets correct almost every year, and crash every 5-7 years, you realize you can’t be afraid of these things. You will likely live through 30 market corrections and six market crashes in retirement.
The far bigger risk to your financial life is that inflation erodes your purchasing power. You must invest in assets that have a reasonable chance of beating inflation. The last 35 years haven’t been high-inflation years. Still, almost everything in life is at least 3x more expensive than it was in 1990.
What if inflation gets really bad over the next 20 years? Starting with an overly safe portfolio with low interest rates (bond returns will be low) is VASTLY riskier than having significant exposure to diversified equities.
We’re ecstatic about owning equities over the next 20 years. There has arguably never been a better time to own and operate a business. Financial planning requires that we provide for income in the short-term–but long-term growth is a must.
The first risk of mismanaging income distributions is the obvious one: if you spend too much too early, you increase your risk of running out of money later in life.
But there’s another factor we like to make our clients aware of: you might regret spending too little!
You typically have more ability for travel and activities before age 80 than after. In the example above, we would let that family know that they can take significantly more each year. If you have children and grandchildren, taking everyone on an annual vacation costs a lot of money–but you should absolutely do it.
What is the purpose of money if you can’t spend it on deepening your relationships? What is the purpose of retiring if you don’t spend your time doing that?
I don’t want to exaggerate, but this understanding that your starting retirement balance will be 4-5x over your lifetime is critical for tax planning. It’s is why tax planning can have seven-figure ramifications. In my last newsletter, I tried to answer the question, “What tax rate will your IRA/401k be subject to?”
You will face multiple tax rates. Here is a rough estimate:
- 15% of your IRA lifetime distributions + remaining principal will face the 12% tax rate.
- 65% of your IRA distributions + remaining principal will face the 22-24% tax rates.
- 20% of your IRA distributions + remaining principal will face the 32-37% tax rates.
Note: These are our current tax brackets. The above tax rates could certainly go up.
If you have less than $3M, it might be a little better than this. If you have more than $5M, it might be a little worse than this.
But let’s go back to our example: a family retiring with $5M. If they don’t do any tax planning, it’s not 20% of $5M that will be subject to high tax rates. It’s 20% of their lifetime income + legacy assets (remaining balance). Exposing 20% of the larger $20-$25M results in a $4-$5M total tax bill.
If you utilize NUA, Roth conversions, deduction planning, etc. in the early retirement years, you can largely avoid the highest tax brackets later in life. Partially converting a portion of your IRA to Roth in the first 5-10 years of retirement often means those conversions are taxed at 12%-24%. Paying 12% now (on the smaller balance) instead of 37% decades from now (on the larger balance) is a big deal.
But remember, you can’t do a whole lot of tax planning after age 72. Required minimum distributions will eat up the lower tax brackets. Thanks to the SECURE Act, your heirs will likely be exposed to a larger tax bill as well.
- Your starting retirement balance will likely 4x over the course of your life between retirement income.
- If inflation is equal to or worse than the last 30 years, you may need it to 4x to provide for rising costs in retirement.
- Proper portfolio and withdrawal management is critical. Investment or income mistakes can have substantial consequences later in life.
- Tax planning during your first few years of retirement is critical. Paying a 12% tax rate for partial Roth conversions of $1M over the first 7-8 years of retirement costs $120,000. But it saves you from having $4M exposed to 35% rates years later.
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