The last two posts (Here is the first post.) discussed how Patti and I want to our spend money in the time we have left.

 

 

I then thought about our spending and made a list of where I dislike or even HATE to spend money. “Money equals value equals opportunities.” I need to prioritize the value I get from spending: I focus on large dollar expenditures. I don’t sweat the small stuff.

 

Each year I’m presented with opportunities to spend A LOT of money that I judge as REALLY LOW value: I don’t consider them as routine Basics; Patti and I get little or NO JOY from the spending; no Help now for our family; no Help to others. Here’s the list, and I’ll describe what it is I am doing about these expenditures.

 

 

==== 1. Will NOT PAY normal Investing Costs ====

 

The top thing I DON’T WANT TO PAY is Investing Costs. I think the typical retiree pays out well over one percentage of their nest egg per year in these costs, while Patti and I are spending less than one-twentieth of that.

 

 

Every time you spend you are making a choice. Many retires choose the opportunity – the alternative – to pay high investing costs. Patti and I would get NO JOY from high investing costs. If we paid them, they would be the largest component of our Basics; they’d easily exceed all our utilities and cable TV, internet and phone. A cost of $10,000 per year will accumulate to several $100,000s in terms of lower value of your nest egg in time. I’d call that negative value from those costs. (See Chapter 6, Nest Egg Care or input different Investing Costs into FIRECalc.) Patti and I will always choose other opportunities – alternatives – that align with what we want to spend.

 

Patti may need some financial help if (when) I die first, (Recalculating her Safe Spending Amount (SSA); rebalancing her portfolio) but she’d be much better off to pay $400 per hour for what she needs than to pay normal fees based on Assets Under Management (AUM.)

 

==== 2. Plan to Avoid taxes ====

 

I’ve mentioned these increases in taxes in recent posts (here and here). As nesteggers, we always plan for the worst; the assumption of horrible future financial returns drives our Safe Spending Rate (SSR%) to a low level. But at normal, expected returns for stocks and bonds, our retirement portfolio will continue to grow: the expected return rate for your retirement portfolio is greater than your RMD percentage for many years. Your portfolio will peak when you are in your early 80s. Your RMD percentage increases each year and therefore your RMD dollar amount will increase. At normal returns, it will be twice the amount you took in the year you turned 70½. In turn, this means two things:

 

1) You’ll have greater taxable income and continually get closer to income thresholds that trigger greater Medicare Premiums. Each threshold costs an individual about $1,000 per year. The first four thresholds add to $4,000 per individual. Double that for a couple who are both on Medicare.

 

2) Those with healthy retirement accounts when RMD kicks in at age 70½ can be pushed into the 32% tax bracket in future years. Some could find 40% of their total, lifetime retirement income taxed at 32%. UGH.

 

I have been oblivious to these potential increases in past years. I did a poor job of thinking about how to avoid these taxes. I’m going paying attention from here on out. We can avoid the impact of these two with proper planning. As I refine my planning process for 2019, I’ll keep you posted.

 

My general actions are clear: 1) convert some of my Traditional IRA to Roth; use Roth judiciously so I can spend more but not cross a Medicare Premium threshold; and 2) I’ll consider much higher donations to a donor advised charitable fund – prepaying future donations in effect. This action lowers the value of our retirement accounts; that lowers RMD and therefore the chance of getting hit with those higher taxes.

 

==== 3. Pay some home costs differently ====

 

I’ve gnawed at these expenditures before, and this year I finally did something about it.

 

Over past several years, I’ve spent money to repair stonework on a patio, and we had to replace our furnace in December. Each of these cost more than $5,000. They were necessary (especially the furnace!), but I don’t consider these as part of our routine monthly spending for the Basics. They really were capital expenditures to maintain the value of our home, and Patti and I will never tap that value.

 

Patti and I also pay more than $5,000 of property taxes each year. These taxes add NO JOY.

 

As I think about the opportunity cost of these expenditures, in total they easily equal one trip to Europe per year for us. Is this the way we want to spend our FUN money? I think it’s fair to consider these two options; I use the furnace as the example:

 

1) Take the money from our annual Safe Spending Amount (SSA) and spend it on the furnace. That means we don’t take a trip to Europe that year. Or, since we don’t spend our total SSA in a year, spending it on the furnace means we won’t give gifts to family members’ retirement accounts; and the amount we gift this year may compound to a factor of perhaps eight (three doublings following the Rule of 72.

 

or

 

2) Pay those expenses from my Home Equity Line of Credit (HELOC). Pay monthly interest only. Never repay the loan. The principal is repaid on the sale of our home after we are dead. With inflation at 2% over the next decade, $10,000 now will shrink to about $7,500 in today’s spending power. That’s really a small nick off of the equity value that will be realized on the sale of our home after we are dead.

 

==== Happy HELOC ====

 

I’ve had a Home Equity Line of Credit (HELOC) for a number of years. The loan balance at the end of December was $0. Last month I transferred an amount from the HELOC to our checking account equal to our recent capital improvements and this year’s property tax.

 

I’ll pay about $40/month in interest expense. That’s peanuts when compared to our SSA and other routine Basic expenses. The interest won’t be tax deductible because Patti and I will use the $27,000 standard deduction in calculating our taxable income. Also, interest from HELOC now is only deductible for capital expenditures for your home; I’ll keep track of the amounts that are for capital expenditures as distinct from property taxes in case we ever cross the $27,000 of deductible expenses.

 

 

Conclusion. We all have thoughts as to how we want to spend our money in the time we have left. I think it’s a good idea to think through priorities and write them down. Next, look at all that you spend. I think you’ll find some expenditures that just don’t align with the list of what you really want to spend. Patti and I will avoid Investing Costs like the plague: NO value (actually negative value) for us. We’ll use our HELOC for capital expenditures that maintain or improve the value of our home; we’ll pay back the loan principal after we are dead.

How do we want to spend our money in the time we have left? Last week I wrote that Patti and I have four big priorities, detailed here. Last week’s post discussed 1) The Basics and 2) What it is we ENJOY most. This week’s post discusses the other two: Help family and Help others.

 

 

==== Help Family====

 

 

We all want our family to be happy and successful. How money plays in that equation is not always clear, but Patti and I think assume some reasonable amount of money can make folks happier and more successful. Deciding on when our family gets our money is simpler for Patti and me to decide than for most. We don’t have children.

 

We want to help siblings, nieces and nephews. Patti has several siblings and about 14 nieces and nephews we’d like to help. None is expecting to inherit anything from us, so that’s not something we think about. A few can use the help now.

 

It’s easy for us to decide that it’s better to help them now than later – perhaps in 15 years when we are dead. We don’t have any thoughts about deferring help now to then leave the biggest pile of money possible to them. If you follow the plan in Nest Egg Care, it’s easier to think about giving money now than later. These factors help:

 

• We’ve all had the benefit of good market returns over the last four years – really it’s been over the last ten. Patti and I took our first withdrawal for our spending in December 2014, so it’s easy for me to track what’s happened since then. (Here’s the description and calculation sheet from last November 30). We had two good years (2016 and 2017) and two not-so-good years (2015 and 2018). The good years outweighed the two not so good.

 

• I recalculate our Safe Spending Amount (SSA) each November 30. Our first SSA was at the rate of $44,000 per iniital $1 million Investment Portfolio. (See Part 1, Nest Egg Care.) Our SSA for 2019 is $55,500 – 20% more in real spending power. We’re not spending 20% more. This means near the end of each year our thoughts will turn to gifting what we have not spent.

 

• We’ve taken out four years of Safe Spending Amount (SSA). That’s 188,000 in four years relative to a reference of $1 million starting Investment Portfolio. Right before the withdrawal in December for this year’s spending, we have $1.04 million measured in the same spending power as four years ago. We aren’t depleting our nest egg. You haven’t either if you follow the plan in Nest Egg Care. (See Parts 1 and 2.) However, over time we expect our portfolio to be less: we’re taking a greater SSA; we’re putting more stress on our portfolio; we have fewer years and don’t need the same size of nest egg. Patti and I are fine with that.)

 

==== Help we provide ====

 

If family members visit we like to help with travel expenses. Airfare is an obvious one. We like paying for meals when they visit. We generally also pay for all meals out if we’re visiting them.We also like to help with tuition expenses and health expenses.

 

Beyound those needs, Patti and I agreed on a target amount we would like to give each niece and nephew over a five-year or so period. With 14, you can guess that the amount per individual won’t be huge, but it may be significant depending on when they spend our gift: I always think of these gifts in terms of the Rule of 72: our gift now will compound to something much greater later. We like giving them money that they don’t immediately spend. Here are three options we like.

 

==== Gifts to IRA accounts ====

 

We gave gifts to them for their Traditional or Roth IRAs in 2017. Some had not started to save for retirement. (Patti and I were pack rats at their age; we understood the Rule of 72, and I don’t think it’s imprinted in their heads yet.) If we can encourage them to save more in addition to our gift, they’ll be MUCH better off in the future. Some already had an IRA account at Fidelity; we asked the others to open their new IRA accounts there.

 

==== Gifts to 529 plans ====

 

We also like giving to 529 plans for great nieces and nephews. Their parents –our niece or nephew – opened accounts at our request, and we give a gift to each every December. Our nest egg is at Fidelity. Their 529 plans are at Fidelity; this is very low-cost plan with a wide range of investment options. Vanguard also has a very low-cost plan. I’m sure there are others as low cost, but you can’t go wrong with these two.

 

In 2017 we also opened 529 plans with Patti as the owner (The legal term is participant.) – not the parents – with the same children as beneficiaries. We opened the accounts that way, because in a pinch, Patti can always withdraw from those accounts, paying tax only on the growth. I view the total amount we contributed as part of our off-the-top Reserve. (See Chapter 7, Nest Egg Care.) The added benefit for Patti as the owner is that contributions to these plans are tax deductible in our state – Pennsylvania – so 3% of our gift cost nothing.

 

==== Gifts to Health Savings Account (HSA) ====

 

This is an option that I have only recently considered. Those who have a high deductible medical insurance plan are eligible. This gift is a better investment option than a gift to a Traditional or Roth retirement plan. It’s a better because the contribution is not taxed (It’s deducted from income.), and the withdrawal is not taxed when used for eligible medical expenses and premiums. WOW. I’ll write more about this. Here’s a good article.

 

==== Simple mechanics for gifts ====

 

We make the gifts to each IRA or 529 account by using Fidelity’s bill pay system. I’ve stored their account as a payee; each gave me their account number. In all but one case, the check goes from my Fidelity account payable to Fidelity Investments for the specific account. Making those gifts just takes a few minutes.

 

Our nieces or nephews then log in and invest the proceeds. All but two of the great nieces and nephews are under the age of six. I’ve advised the parents that the money should be in FSKAX. The oldest is 12, so at the end of this year I’ll advise the parents to start shifting toward a mix that includes much more bonds than stocks five years from now – when they will first tap these accounts for college expenses.

 

==== Help others in need====

 

 

Patti and I are on the same wavelength on this priority. We want to help those who need most help. We use the filter shown above for our gifts. As I mentioned in this post, about 88% of our total donations in 2018 met this priority. The 12% that didn’t were to universities and cultural organizations. We’ll continue to judge as to how much to support them in the future.

 

Mechanics: Patti and I are both over age 70½, and it always a tax benefit to donate first using Qualified Charitable Distributions (QCDs) from our retirement accounts.

 

 

Conclusion. We all have thoughts as to how we want to spend our money in the time we have left. I think it’s a good idea to think through priorities and write them down. Our priorities are to 1) spend on the basics; 2) spend on what we enjoy doing together and makes us happier; 3) help our families to be happy and successful; and 4) help to improve the lives of others.

Have you thought about these questions? Last week’s post talked about Opportunity Cost. “Money equals value equals opportunities.” Every time we spend money, we forego an alternative opportunity. The alternative we don’t pick is our Opportunity Cost. The point of the book – subject of the post – was that we often pick alternatives instinctively and based on emotion without thinking clearly about the value of the alternative opportunities.

 

This post discusses two of our priorities for the use of our money while we are alive. I wanted to write down our priorities (Here’s the detail.), because I find we spend money on some things that just don’t align with what we most value. I’ll discuss a few of those in an upcoming post. I generated this spreadsheet with four categories. On a long walk last weekend – training for our upcoming trip – I asked Patti what she thought were our priorities. She was in exact agreement and didn’t have the benefit of my spreadsheet to prime her thinking.

 

 

How would you describe what it is that you enjoy most? What is it that you want to do with your money in the time you have left? I’ll discuss our first two categories in this post, and I’ll discuss the other two next week.

 

==== The “Basics”  ====

 

 

I include spending for what we all need to live, although our basic is a comfortable basic. Heck, most of us who live in the US have a basic that is far above the average in the world.

 

Our home is nicer than average. We love it. It’s right-sized for the two of us, but I’m sure our utility bills are above average. Our cars are nicer than average although I think we’ve kept them longer than most folks; I have far less interest in driving a new car now. Since we live in the city, we don’t put many miles on them, and our operating costs are low.

 

==== ENJOY MORE. NOW. ====

 

This is a big one. I have three headings in this category.

 

 

Travel. We both use our credit card extensively and I keep track of key expenses in Quicken. By far our largest discretionary expense is travel: airfare, lodging, rental car; tour costs; I include the cost of the kennel for Dudley as part of our travel expenses. I don’t count meals and entertainment, since we’d have somewhat similar expenses at home.

 

Patti and I have enjoyed active, walking vacations for years. I really like knowing we have an upcoming walking trip. It’s an incentive for me to stay in shape. It’s almost always just Patti and me; we rarely go with groups. We have not rented a car for many years now. So, for most trips our daily costs are really not that much.

 

In years past, we’d walk a long distance path in England – maybe 100 miles or so in ten or so hiking days. Now eight miles is good for us; ten isn’t that enjoyable. We now like staying three nights in the same location. We’ve gone to the Lake District of England for the past four or five years now. We know the three towns where we want to stay, the room we want, and about six day-hikes we really like. Train, bus, and cabs work great, and we don’t have the headache or expense of a rental car.

 

 

Oh, boy. Patti is pushing to get as many of these trips in before we just don’t have the physical capacity to take them. My health is good, but at my age 74, that may not be too many years in the future.

 

We booked a self-guided trip to Portugal (Algarve coast) for next week. Self-guided trips are not expensive. This one is five hike-days and a total of about 40 miles. We’ll end with four nights in Lisbon. We have a similar five-day walking trip penciled in for Sicily in the fall, but we’ll stay longer and rent a car – unusual for us – to explore the whole island.

 

I now target to stay at above average places and book a better than average room.  That might add $75 per day to our trips and maybe $1,000 for the whole vacation. We find we really get more for that $75. Patti finally agrees with me on this added spending.

 

Here’s our big extravagance: we decided to fly business class for our long distance flights – generally those with five-hour time zone changes. We don’t sleep and are not comfortable in coach. The thought of uncomfortable, sleepless travel lessens the enjoyment of the whole trip. (I keep thinking of how much we don’t spend on Investing Cost relative to many folks we know. They’ve chosen the option – the opportunity – of high Investing Cost (for what?) and we’ve chosen the option of business class airfare. I like our choice.) Patti is a master at booking business class airfare at relatively low prices.

 

Extra help at home. I read this article almost two years ago now. It says money can buy you happiness, and a big component is to spend money to make your life easier – buy yourself time: don’t spend time on things you don’t enjoy. Most people fail to buy time.

 

We spend extra to avoid tasks that seem like chores. I used to like working in the yard and cleaning the sidewalks of snow in the winter. I dropped yard work a number of years ago: Doc takes care of the routine. Joe does the major spring and fall cleanups. This is the last year for snow removal for me. I’ve come to dread it. Maybe Doc can handle that for me next year. Cindy does a great job keeping the house clean. Steven is the greatest on window cleaning and getting the leaves off our roof in the fall. RJ does a great job planting the annual flowers.

 

At least once a week we don’t want to prepare dinner. We will take out or eat out. The Food Shoppe is less than ½ mile from here, and it has prepared main courses for $12 for the two of us. They grill two days a week in summer. I cook the vegetables or make a salad. We’ll toast nan bread or heat the rice medley I prepare. Fast. Healthy. Good. Patti is great on clean up. We can walk to about 15 restaurants. Bangkok Balcony, Dinette, and Kaya’s are favorites.

 

We both know we have to exercise if we are going to be active in the time we have left. We joined our local community center and go to exercise classes three or four times a week. We joined a country club years ago, and that’s another social network for us. I seem to have lost my passion for golf, though.

 

Other. The key one here is Patti’s PURE JOY when she buys something that she really likes at a deep, deep, sale price – especially shoes. “How do you like my new Sesto Meucci shoes? They’re sewn in Italy. They sell for $341, but they were marked down to $169, and then 50% off. I paid about $85. They are really comfortable. I love them.” “Yep, they look great. Terrific purchase!” Patti gets a LOT of happiness without spending a lot of money in the year.

 

 

Conclusion. We all have thoughts as to how we want to spend our money in the time we have left. I think it’s a good idea to think through priorities and write them down. Our priorities are to 1) spend on the basics; 2) spend on what we enjoy doing together and makes us happier; 3) help our families to be happy and successful; and 4) help to improve the lives of others.

I read this book last month, Dollars and Sense: How We Misthink Money …. I liked it. Chapter 2 discusses the concept of Opportunity Cost. “Money equals value equals opportunities.” Every time you spend – or invest – you always have alternate opportunities. You pick one opportunity and forgo at least one other. The one you forgo is your opportunity cost. In a world of only apples and oranges, when you pick the apple you forgo the orange; the orange is your opportunity cost. The point of the book is that we make spending and investing decisions on instinct or emotion. We don’t consider and weigh the alternatives. We don’t think through what we might value most when we decide.

 

The post discusses this concept in terms of our choices as to what percentage of our total assets we want in financial assets – invested in stocks and bonds – and what percentage we want in non-financial assets – our home and other real estate would be examples.

 

Many retirees are driven to move more and more of their money into non-financial assets: paying off the mortgage is clearly a goal of many. Have they properly weighed that decision? I think we retirees are far better off with much more of our assets invested in stocks and bonds than into real estate. Patti and I have less than 15% of our total in non-financial assets, and I think that’s about right. (See Chapter 1, Nest Egg Care.)

 

==== David and his rental condo ====

 

My friend David at age 68 decided to buy a condo near Bradenton, FL as an investment. What is he doing when he buys the condo? He is shifting money from his financial assets to non-financial assets. He’s trading one opportunity for another.

 

 

He told me he hopes to leave $1 million in real estate to his son and daughter. I assume that’s his goal from this condo, not adding his home, a condo nearby. David’s life expectancy is 16 years, so I interpret that is the time horizon that he’d like to have close to $1 million more than he does now. I’ll also assume he thought of those dollars in today’s spending power.

 

What did he invest? He made a down payment (let’s assume that was $100,000) and he told me that he now has negative cash flow of $4,000 per month or $48,000 per year. (!!!) That’s the net of rental income less his mortgage payment, condo fees, real estate taxes, and utilities.

 

What was his opportunity cost? The alternative was to leave the money in his investment account. He took money out of that account, selling stocks, for the $100,000. David told me he is continuing to sell stocks and bonds to get the $48,000 per year. He decided to forgo his return on that money in 16 years from his investment account.

 

What’s that cost? I’ll assume for his mix of stocks and bonds that his expected real return is about 6% per year – that’s assuming typical return rates and a typical sequence of annual returns. Let’s work that out for 16 years. That $100,000 down payment would compound to +$250,000 in today’s spending power. Let’s assume he cuts his cash outlay to $25,000 per year and that continues for 16 years. That compounds to +$640,000 in today’s spending power. The total is $890,000 in today’s spending power.

 

Now we can state his choice more clearly. He gave up the opportunity to make about $900,000 from his investment portfolio by putting that money in a non-financial asset with the hopes it grows to $1 million. Not much potential difference in my view considering other things he gave up:

 

• He gave up financial flexibility; in an emergency he can tap his financial assets, but he can’t tap his non-financial assets.

 

• I think he also bought anxiety. Paying $2,000 a month to something that I get no personal enjoyment from would not make me happy. I think it would drive both Patti and me nuts. We’d constantly be trading that off that $2,000 per month with opportunities for travel – something we really enjoy.

 

==== Sam and Julie and their HELOC ====

 

My friend Sam and his wife Julie are almost the exact same age as Patti and I. They have no children or heirs that they want to leave a lot of money to, and their heirs are not expecting anything. Sam told me that his plan is to “run out of money one half hour before we die.” I’d restate that to mean, “We plan to spend as much as we can to enjoy ourselves. We’re not holding back spending to benefit heirs.”

 

Sam and Julie remodeled their house last year. Sam got a home equity line of credit (HELOC) for $75,000 and pays about $300 per month interest only – about 5% annual interest. They have no other mortgage payment. He thinks his home is worth $450,000. Sam told me he HATES, HATES, HATES writing the check to pay that every month.

 

I look at that completely differently. I’d actually ENJOY paying $300 per month. I’d look at is this way:

 

I’d restate the 5% interest on the HELOC to adjust for inflation. Assuming 2% inflation, it’s really 3% real interest rate. It looks like $3,600, but it’s really $2,250 per year.

 

Lowering their Investment Portfolio by $75,000 translates to lowering their Safe Spending Amount by $3,550 per year. That’s also stated in real terms since it adjusts for inflation each year.  (Sam and Julie have the exact same 4.75% Safe Spending Rate [SSR%] as Patti and I. See Chapter 2, Nest Egg Care.) And in all probability that $3,550 will increase in real terms over time. On this basis, Sam’s at least $1,300 ahead each year.

 

I think Sam should say to himself every time he makes his payment: “I just paid $300 here, but over in my investment account I really just made $100 more than this. That’s going add to $1,000s over time. I think I should look at my investment portfolio and remind myself I have $75,000 more there than I otherwise would have.”

 

I’d also suggest that Sam look at the $75,000 in his investment portfolio and translate it to something concrete. I’d translate it into how many really great vacations that might be. For Patti and me, $75,000 would easily translate to five trips to Europe. I like that.

 

====

 

I don’t like investments in non-financial assets other than our home, which I view as a deep, deep emergency reserve. (See more on this in Chapter 1, Nest Egg Care.) At this stage of life, we want to maximize the financial assets that we can spend and ENJOY NOW.

 

 

Conclusion: Every time we decide to spend or invest our money we are always picking one item of value and not another. The one we didn’t pick is our opportunity cost. All of us make spending and investing decisions driven first by emotion, not rational thought. As a result, we can make decisions that simply aren’t in our best interest. Lowering our investments in financial assets to put more – or keep more – in non-financial assets doesn’t make a lot of sense to me at this time of life.

 

YES. And NOW. I’m 74 and I just opened my first Roth IRA account in December. I should have opened one years ago – more like 10 or 15 – and gotten money into Roth at lowest tax cost. This post explains why you want to have money in a Roth account and a bit of the mechanics of opening an account.

 

==== Traditional and Roth IRAs ===

 

I think you know the difference between the two. I wrote about this here. You pay no tax when you put money into Traditional but pay tax on the amount you withdraw. You pay tax before you put money into Roth but pay no tax on the amount you withdraw. Traditional and Roth have the exact same result in term of after tax proceeds if your marginal tax bracket at the time of your contribution equals your marginal tax bracket at the time of withdrawal. Here’s the example of Bob Roth and Suzie Traditional.

 

 

If you think your current marginal tax bracket is greater than the one you’ll be in at the time of your withdrawal for spending, you’d choose Traditional. (SEP-IRA, 401k or 403b plans are always Traditional.) If your view on marginal tax rates is the opposite (greater later than now), you’d choose Roth. (Roth is a great choice for younger savers in low tax bracket now.)

 

==== Your view of future taxes ====

 

Now that you’re retired or nearly so, you have a much clearer view of your future taxes. If you are 70½ and taking your Required Minimum Distribution (RMD), it will double from your initial amount when you are in your mid 80s if future returns are typical. That doubling results in two potential tax bites you would like to avoid.

 

 

1) Medicare Premiums increase as you cross income thresholds. The increases in essence are added taxes. A small amount of income that crosses a threshold could cost you more than $2,000 (I state this for married, joint filers). Some taxpayers will eventually rack up nearly $5,000 per year in increased Medicare premiums; some couples nearly $10,000 per year.

 

2) The 32% tax bracket. That 2X RMD means some would have a significant portion of their lifetime retirement income taxed in the 32% marginal tax bracket. In the example in the post, by age 90 the retiree had nearly 40% of lifetime retirement income taxed at 32%. 32% is 33% more tax than 24% tax. Not good.

 

The chance that you are hit by these two is a function of how much you have in your Traditional IRA accounts that is subject to RMD. The more you have in Traditional, the lower your ability to avoid these two taxes.

 

==== Shift money from Traditional to Roth ====

 

We can shift money from Traditional and therefore lower future RMD: we convert Traditional to Roth. When we convert, we pay tax now on the amount we convert. Paying more taxes now sounds crazy, but it makes sense. We pay tax now for the ability to avoid a much greater tax bite later.

 

I like to think of it this way: I NEVER* LOSE by converting to Roth. I WIN (keep more; pay less tax) when I use Roth judiciously to avoid a threshold that would result in greater tax.

 

Let’s assume I pay 24% marginal tax now when I convert and avoid 32% later. I always keep about 12% more of what I would have when I do this. You can think of immediately earning 12% of the amount your convert. That difference compounds to a larger increase in real spending power. In this example, I get +20% of the amount I originally convert. That’s one heck of a return for not a whole lot of work. (*NEVER assumes that future withdrawals from Roth are never in lower marginal tax bracket than when I converted.)

 

 

===== Why didn’t I open Roth before? ====

 

Most all our retirement contributions were to SEP-IRA plans and 401k plans that are Traditional plans: pay no tax going in; pay tax coming out. We were always consistent in contribution to annual IRA plans – the one that now is $6,000 per year, and we did most of that before Roth started in 1997 – or I should say the value of our Traditional IRA is largely from the compounding of contributions in the 1980s and the early 1990s.

 

Also, it was always (incorrectly) in my head to postpone paying taxes now. I did not understand the basic benefit of having Roth: lower the amount in Traditional to lower RMD; lower the chance of tipping into too high of marginal tax bracket and higher Medicare Premiums.

 

==== The best time to convert to Roth ====

 

The best time to convert traditional to Roth is before you are age 70½ – before the age you are first subject to RMD – and if you are retired and have years of lower taxable income. You’ll have the greatest flexibility in the amount that you can convert. You’ll be in a lower marginal tax rate than you will after you start taking your RMD.

 

==== Mechanics of my new Roth account ====

 

I opened a Roth account in December at Fidelity. All our nest egg is there. I converted $100 total (!) from my traditional IRA to the new Roth account. I did not convert more since I did not have a handle on my Modified Adjusted Gross Income (MAGI) for 2018. I have a preliminary tax plan for 2019 now. I’ll convert a lot more near the end of the year when I have a really good handle on our 2019 MAGI.

 

It took me less than ten minutes to open the account online, designate beneficiaries (Patti is primary), grant Patti full trading authority, and to nickname the account “T’s Roth Account;” that reminds me what it is when I look at the display of all my accounts. I could have funded the account online, but I chose to call Fidelity. The rep helped me put a total of $100 into the account: shares worth $70 of FSKAX and $30 of FTIHX. That took less than five minutes.

 

Patti had to complete the online task of verifying her identity to complete the authorization of full trading authority. I remember this was a straightforward process when we granted full trading to each other on all our accounts several years ago. Patti may not have remembered from before. This was not smooth as silk for her, and I think it took her about 15 minutes to complete this task.

 

As reference, I liked this series of articles on converting Traditional IRA to Roth. An article explains the detail of a five year aging period from the start of your Roth account for all gains to by untaxed at the time of withdrawal; you can withdraw the amount you convert at any time without tax consequences. 

 

 

Conclusion: We all should have a portion of our IRA in a Roth account. You NEVER* LOSE by converting Traditional to Roth. You WIN when you judiciously use your Roth for spending and avoid higher taxes. You keep more of your money.

We Nest Eggers always plan for the worst: we assume we’ll be faced with the worst sequence of financial returns ever and that assumption determines how much we spend and how we invest. This post shows that your Required Minimum Distribution (RMD) doubles in real spending power for expected future returns. (Expected is the same as the long-run average return rate: 7.1% real per year for stocks; 2.3% for bonds.) That’s REALLY good news. That really good news can also translate to greater taxes than we would like as described here and here. Those posts showed we can act now to lower the chances that we’ll pay those greater taxes. We and our heirs can keep more of what we have.

 

A Retirement Withdrawal Calculator (RWC) like FIRECalc also tells you that you can expect good news. (Also see Chapter 2, Nest Egg Care.) An RWC also shows that returns can vary widely from expected for long periods. My use of a constant annual return rate for expected returns for this post is not as rigorous a result as one would get from FIRECalc, but it’s not possible to vary the annual withdrawal rate – the increasing annual RMD percent – in FIRECalc or any other similar RWC I find..

 

==== Expect RMD to double in ~13 years ====

 

Your RMD from your Traditional retirement accounts increases over time when stock and bond returns are close to their long-term, expected returns. That’s because of two factors:

 

1) The expected return from your mix of stocks and bonds is greater than the RMD percent for many years; your IRA grows for many years.

 

2) Your RMD percent is increasing year after year: it starts in the table I show for this post at 3.65% (That starting percent depends on when your birthday falls in the year.) and increases to 6.13% 13 years later. That’s nearly a 70% increase.

 

I use a real return of 6.15% as the base case for this post. You can see I could have used a range of returns.

 

 

This table you can download shows your RMD doubles in real spending power in 13 years. Even though you are withdrawing a greater RMD each year, at age 83 your IRA is 26% greater than in your first year ($1.26 M compared to $1.0 M). At age 90, you’re RMD is about 2.8X than your first RMD ($102,000 compared to $36,500), and your IRA at the end of the year you turn 90 is 13% more than your initial amount.

 

 

==== RMD will double at lower returns ====

 

I input the range of expected returns for the different   mixes of stocks and bonds shown in the table above. The table below shows the years for RMD to double or the peak value of your IRA does not change much over the range of returns based on expected returns for stocks and bonds. The value of your IRA at age 90 changes most with the change in return. At a lower mix of stocks, your IRA decreases in real spending power by age 90. At a greater mix of stocks the value of your IRA increases by about 19%. The difference in the two is about 25%.

 

 

Conclusion: You can expect your RMD to double in real spending power in roughly 13 or 14 years from your first year if stock and bond returns roughly equal their long-term average. This holds true over a wide range of mix of stocks and bonds. A greater mix of stocks, however, results in about 25% more for you or your heirs at age 90 than a low mix of stocks.

 

We’re consumed about Never Running Out of Money when we’re retired. We always spend and invest thinking we will hit the worst sequence of returns in history. But we may have a different – but nice – problem if returns are average: we’ll have a growing retirement portfolio that can kick us into a 32% tax bracket and unnecessarily eat the amount we can spend and enjoy. And the problem could be bigger if future returns are better than average

 

I never thought I’d be thinking about this because that 32% marginal rate kicks in at a very high threshold: about $348,000 of Normal (Ordinary) Income (MAGI) for joint married filers and about $174,000 for single filers (half that of joint). For most of us, this is not a concern. But my discussion with my friend John convinced me that at least some of us should be taking action now to avoid that tax bracket. This post discusses how that bracket can come into play and what we might do now to avoid that bigger tax bite.

 

==== 32% is a big jump from 24% ====

 

I discussed this in this post: we basically pay taxes on two kinds of income: 1. We pay 15% tax on Capital Gains Income. 2. We pay tax using a tax table on Normal Income; accountants call it Ordinary Income.

 

Here’s the tax table for Normal Income for 2019 based on MAGI – Modified Adjusted Gross Income; it assumes the taxpayer takes the Standard Deduction. I show this for married, joint filers, both over age 65. (The start of a bracket would be half that shown for a single filer.) The brackets adjust for inflation each year, so we can think about what can happen in the future by thinking Real.

 

 

We have a long run of Normal Income from about $106,000 to about $348,000 where we get to keep either 78% of 76% of each additional dollar of Normal Income; that’s the range for 22% or the 24% marginal tax brackets. But after $348,000 there is a jump of 8 percentage points: we keep 68%, not 76% of each additional dollar of Normal Income; that’s the 32% marginal tax bracket. That’s $800 more in tax per $10,000 that crosses the threshold. That may or may not concern you, but I think with some planning now, you won’t have to pay that added tax.

 

==== Could you fall into the 32% bracket? ====

 

My friend John turns 65 this year. His wife, Sue, is also turns 65 this year. John has been self-employed for a number of years. He contributed to his SEP-IRA as well as a Traditional IRA. Sue has worked and has also contributed to her employer’s plan; she received the maximum match from her employer. She also contributed to a Traditional IRA. They invested well. The sum of both their IRAs is $2.75 million now.

 

They both must take their first Required Minimum Distribution (RMD) five years from now in 2024. That will be 3.65% of the value of their IRAs on the 12-31-2023. They look at the $2.75 million today and judge that that looks roughly like $100,000 RMD then (3.65% * $2.75 M). That RMD would be added to other Normal Income. Their biggest source is Social Security, which is $50,000 Normal Taxable Income, and they estimate another $10,000 in Interest, the portion of total dividends not taxed at capital gains rates, and other income. The sum – $160,000 – really makes them happy and clearly does not budge their anxiety meter about the 32% tax bracket.

 

But let’s see what happens if returns are expected – match the long run average real returns for stocks and bonds. I’ll use 6.3% for the expected real annual return on their IRAs for their chosen mix of stocks and bonds (Stocks real = 7.1%; Bonds real = 2.3%.) Here’s the .pdf of the spreadsheet I use for this post.

 

 

John and Sue could have more than $3.7 million on 12-31-23 in today’s spending power. That means their first RMD would be $136,000. With their added $60,000 of other Normal Income, they just cross into the 24% tax bracket in 2024, and they are very far away from and the 32% bracket. They have more than $3.7 million in their IRA after their withdrawal at the end of 2024: they withdrew 3.65% based on the 12-31-23 value but their portfolio grew 6.3% in 2024.

 

 

Their RMD increases each year for two reasons. The RMD percent they withdraw each year for many years is less than the 6.3% expected growth. The RMD percent increases each year. The combination of the two effects means their RMD starts at $136,000 when they are 70 and grows to almost $300,000 – more than double – when they are 83. That’s the first year they cross into the 32% marginal rate for some portion of income. That’s 18 years from now.

 

 

 

RMD continues to grow thereafter. More and more is taxed at 32%. Eventually, in their late 80s, their income increases such that more than 20% of the total is taxed in the 32% bracket. Assuming they both live to age 90, they take more than $5.4 million in RMD and about $450,000 is subject to 32% or greater. That’s about 8% of their total RMD. This issue may still look small to John and Sue, and it affects them many years in the future. They continue to put this out of mind.

 

(Note: the value of their IRA peaks at $4.8 million at age 83. That’s stated in constant dollar spending power and is about 75% more than they have now. At age 90, they still have far more than they have today.)

 

==== Oops. John dies before Sue ====

 

Let’s assume that John dies, unfortunately, at age 78. Sue now inherits his IRA. Let’s assume she folds it into hers. She is a single filer, and the 32% bracket starts at $174,000.

 

 

Uh oh. A MUCH greater portion of income will now be taxed at 32% starting at her age 79. In just a few years, nearly half her total income is taxed at 32%. Assuming she lives to age 90, nearly 40% of all RMD over her lifetime is taxed at 32% or greater.

 

==== What could John and Sue do? ====

 

John and Sue can take actions now to lessen the chance that they’ll pay 8 percentage points more of tax in the future. These actions reduce their total IRA subject to RMD.

 

1. Convert Traditional to Roth: prepay taxes and get a 25% discount. You pay 24% tax, for example, now but you then distribute from Roth to avoid paying 32% in the future. You can also use Roth to distribute cash for spending and avoid MAGI that kicks in greater Medicare premiums as discussed last week.

 

2. Prepay future donations. John and Sue think they want to make greater donations to charities in the future. They can take a large distribution from their IRA now and contribute it to a Donor Advised Fund like the ones associated with Fidelity,Vanguard, or Schwab and others. In effect John and Sue are prepaying donations. They get a big tax deduction in the year (or years) they donate to their Donor Advised Fund, and each year they direct their fund to grant to the charities they want to support. They also always come out ahead by using QCD for donations when they are eligible at age 70½.

 

3. Sue can disclaim a portion of John’s IRA at his death. The amount she disclaims becomes inherited IRAs for John’s contingent beneficiaries – generally their children. (I like this article on options for an inherited IRA.)

 

 

Conclusion: The amount you have now in your IRAs, your age, and the sequence of future returns will affect your RMD and future Normal Income. You and your spouse as joint, married filers may be a long way from the 32% marginal tax bracket. But you or your surviving spouse as a single filer could fall into the 32% marginal bracket and pay tax than you otherwise could avoid. You can take three actions: 1) prepay, in effect, taxes now and get a 25% discount by converting Traditional IRA to Roth; 2) prepay donations; you donate a large amount to a donor advised fund and then direct annual grants from the fund; 3) plan for the surviving spouse to disclaim a portion of the IRA that would be inherited.

Last week’s post discussed MAGI (Modified Adjusted Gross Income). We retirees want to understand MAGI and estimate our MAGI for our current tax year. What I failed to appreciate in prior years is the fairly BIG BITE that can hit retirees when MAGI crosses specific thresholds: our Medicare premiums increase in large chunks as we cross these thresholds. A small amount of incremental income can trigger $1,500 to $2,400 or more in added Medicare premiums. A retiree could pay incredibly high incremental taxes on the income that just crosses a threshold.

 

The purpose this post is to describe the greater Medicare Premiums (an added tax, in effect) that you might pay and how you might be able to avoid recording income – MAGI – that cross important Medicare thresholds.

 

We see in this table derived from here that greater Medicare premiums generally hit folks with high MAGI. In my mind, that translates to folks with healthy retirement accounts subject to Required Minimum Distributios (RMD). But if we experience an average or above average sequence of returns in the future, many of us will have significant retirement accounts even if we are taking RMD. (This sheet shows this data for single filers.)

 

 

 

==== The mechanics of Medicare premiums ====

 

In December Patti and I received the letter from Social Security that told us our gross payments for 2019 and the deductions Medicare will take monthly for our share of Medicare Part B (medical insurance) premiums – everyone pays at least $135.50 per month in 2019 – and any surcharge for Medicare prescription drug plan (Part D). Added costs for higher income retirees are determined by MAGI on their tax return Social Security had in their hands at the end of 2018, and for Patti and me that was our 2017 tax return filed in early 2018.

 

What does this mean? If you cross a threshold that trips premium increases, you may be unhappy with incremental added income tax + Medicare premiums you will pay. Here’s and example for Herb and Wendy of how the last $6,000 of income can cost $3,860 in added tax. That’s 64% of that last $6,000 of income. (If I had used the example of just $1 over the threshold, the added cost for that $1 of incremental income would be $2,419!)

 

 

You can see that this example applies to folks with high MAGI. Here’s my hypothetical example of the $200,000 of Normal Income for Herb and Wendy in the table above. They have a healthy retirement portfolio (subject to RMD) of about $2.5 million. (They would have crossed that first threshold at $170,000 with a retirement portfolio subject to RMD of a bit over $1 million.)

 

 

==== My preliminary 2019 tax planning ====

 

What does this mean for our 2019 tax planning? We don’t exactly know the thresholds that Medicare will use in the future. Unlike tax brackets, the thresholds are not adjusted for inflation every year. But I’m going to assume that the current thresholds will apply. That means, if possible, I want to plan my MAGI for 2019 to avoid crossing a current threshold. We’ll file that return in early 2020, and Medicare will use MAGI on that return to determine added premiums in 2021.

 

What might I do to avoid a threshold? Here are four tactics in my head right now. You can see my general priorities in last week’s post. Patti and I both are subject to RMD, so we have less flexiblity than folks not subject to RMD.

 

1. ALWAYS donate using QCD from our retirement accounts. QCD donations are not included in MAGI, but QCD counts as part of RMD. This lowers RMD that is recorded as MAGI and the source of cash we want for spending.

 

2. Increase sales of taxable securities for the cash we want to spend. We get to keep roughly 94% of the sales proceeds and 6% is MAGI. This obviously depends on the cost basis of securities we sell.

 

3. Distribute from Roth accounts for cash we need for spending. Roth is obviously a wise choice if it helps avoid 64% marginal tax. We previously paid tax when we put money into the Roth, so we pay no tax – incur no MAGI – when we withdraw from Roth.

 

4. Distribute more from traditional retirement accounts; I’d surpass our RMDs. Let’s assume I cross a threshold by $10,000 and can’t figure out how to cut that $10,000  this year. I might as well blow by that threshold but stay below the next threshold. Thresholds jump by about $50,000. Let’s assume I take an added  $40,000.  That could mean I can figure out how to take $15,000 less in each of the next two years and dodge the threshold for those two years.

 

 

Conclusion. Added Medicare premiums affect higher income retirees, generally those with healthy retirement accounts subject to RMD. If you cross a MAGI threshold by a little bit, you (assumes married, joint filer) can be hit with $1,500 or more added cost – a really high tax hit on the small amount of money that crossed the threshold. Estimate your MAGI for 2019 now and see where you fall relative to the thresholds. You may be able to figure out how to  avoid crossing a threshold. You may be able to save $1,500 or more.

It’s simpler and clearer to understand how we make the most of our money – pay the least in taxes – when we understand and plan our Modified Adjusted Gross Income or MAGI. When we understand MAGI, we know how to pay the least taxes from withdrawals from our nest egg for our spending. We correctly decide where to get cash from the two components of MAGI, each of which is taxed differently. Let me explain.

 

First: what’s MAGI? Modified Adjusted Gross Income (MAGI) for  every retiree is the same as Adjusted Gross Income shown as a line item on your 1040 tax return. (I’m sure some retiree is an exception, but that has to be rare.) The IRS refers to MAGI and not AGI for certain Federal benefits and tax calculations. One of these is important for retirees, so that why I stick MAGI in my head.

 

Patti and I withdraw from our nest egg each December for spending in the upcoming year. Our calculated Safe Spending Amount (SSA) is always greater than our Required Minimum Distribution (RMD). Therefore, I need to complete the puzzle of where we get the added cash for our spending. The question I ask: “How do I manage MAGI to pay the lowest taxes on our total cash withdrawals from our nest egg?”

 

==== Forget itemized deductions ====

 

I can focus on MAGI because I no longer have to spend time thinking about the effect of itemized deductions. Why? Patti and I won’t have itemized deductions in the future. The Standard Deduction in the new tax law is much greater than in the past – $27,000 for Patti and me in 2019. I just need to manage the income before that $27,000 deduction. That income is MAGI.

 

 

==== Two components of MAGI ====

 

MAGI has two components of income that I have to think through. Each is taxed differently. One I’ll label Capital Gains that’s taxed at 15% (That rate is for dividends and on the gains on sales of taxable securities.) I’ll label the other Normal Income that’s taxed – on average – at roughly 15% (Range is 11% to 18%. Details to follow.) (I think accountants use the term “ordinary” for this income.) Note: folks with really high MAGI will pay more than these percentages. 

 

 

I highlight on the table the two concerns that could result in greater taxes than we need to pay if we don’t think about managing our MAGI: 1) Medicare premiums increase as MAGI crosses certain thresholds. (Medicare premiums are deducted monthly from gross Social Security payments for both Patti and me.) 2) Retirees who saved early and invested wisely in their regular retirement accounts could incur a much greater marginal tax rate that they don’t like. I’ll discuss the details of these two in the next two posts.

 

==== Setting priorities ====

 

I have these general priorities in mind when I am considering where to get the cash we want for spending. I want to take cash where the average and marginal tax rates are lowest.

 

 

 

This chart says for Patti and me: we’ll always have a relatively large amount of income we don’t control because of RMD. All retirees must take RMD are going to be in this boat. After that source of cash for spending, the two least cost – lowest taxed – options we control are distributions from Roth retirement accounts and sales of taxable securities.

 

 

I keep this added detail in mind: I need to be wise in distributing from Roth accounts. I really should use Roth to avoid a higher marginal tax rate than I paid when I contributed to the Roth account. To possibly overstate the case, I don’t want to withdraw from Roth if I’m in a 12% marginal tax bracket when I previously paid a marginal 24% tax to get the money for the Roth. I’m losing, in essence, 12 percentage points of the amount I withdraw.

 

==== Taxes on Normal Income ====

 

I used to obsess over marginal tax rates, but when I display federal taxes in terms of the average rates that we pay on Normal Income, I think about this differently. For my general planning, I’m using that we pay an average of 15% on Normal Income. Yes, it’s 15% plus or minus a couple of percentage points (range is 11% to 18%), but 15% is good enough for my planning. That 15% means we get to keep 85%. See here  for a detailed table. A table for single filers is here.

 

 

I highlighted a range of MAGI from $125,000 to $325,000 on the table. The percent we get to keep in that wide range is fairly constant, especially after MAGI of about $175,000. That’s because the marginal tax rates change little over that wide range – the marginal tax rate is either 22% or 24% for MAGI from $106,000 to $348,000.

 

 

Conclusion. We retirees need to think through where we take the money we want for spending. If you pay yourself your Safe Spending Amount (SSA), you’ll always take more than your RMD. You want to focus your planning on the details of the two components of MAGI with the objective of lowest taxes on your total withdrawals for spending. This post shows typical tax bites on each source of cash.

The answer: it looks very bad for funds and fund families that pride themselves on being better than average. That’s what I conclude as I look over the results of Fidelity funds and the flagship fund from American Funds. This post highlights the poor performance of a number of popular actively managed mutual funds in 2018 and over the last decade. My conclusion is that you just can’t afford the poor performance of actively managed funds. If you haven’t done so, immediately switch to index funds in your retirement accounts. You have no tax consequences to do so.

 

==== Active must underperform ====

 

The simple math says that in aggregate actively managed funds have to underperform by their higher costs (expense ratio). I subscribe to a newsletter that shows results of Fidelity funds. (I’ve had my money at Fidelity for decades; I own only two Fidelity index funds now, FSKAX and FTIHX.) The January newsletter showed the 2018 performance of 44 actively managed US stock funds and summarizes the fact that these funds averaged -7.5% in 2018 as “sobering”.

 

Compare this to FSKAX (US total stock market index) at -5.5%. Those 44 averaged two percentage points worse; that’s more than the average expense ratio of those funds – less than one percentage point. That means the active managers were very poor stock pickers. I’d call the performance of those actively managed funds “disastrous.”

 

I counted the funds that failed to outperform their peer benchmark index. Each fund can be categorized to fall into one of these cells in the nine-box. Each cell has an index (Several companies construct indices like these.) and index fund. We can then used the peer index fund as the benchmark for performance.

 

 

I found that 34 of 44 or 77% of actively managed funds failed to beat their peer index. I also added up investors’ assets in these funds, and that also translated to 77% performing worse than their peer index. Wow. Basically three of four investors in Fidelity actively managed funds underperformed by two full percentage points for 2018. That’s biggly ugly.

 

==== Two popular funds underperform ====

 

How did the two most popular, actively managed mutual funds in the US fare? These two, both in the Large Cap Growth category, are in the top ten of all mutual funds ranked by assets and are the flagship fund of their fund family. The other eight in the top ten are index funds. I really like that.

 

 

I get the following information from Morningstar* that compares performance of these funds to their peer Large Cap Growth index. I show the percentage point difference in performance to an ETF that mirrors the peer index that Morningstar uses. The ETF (IWF) performs at .2% below the index, basically its expense ratio.

 

 

With the exception of AGTHX over three years, both funds consistently lag the peer index fund. Over ten years, AGTHX lagged by about 1.4 percentage points per year and FCNTX by about .8 percentage point.

 

These percentage point differences seem small. This was THE segment of the market to be in for the past decade. On an absolute scale over a decade, an investor would have seen more than a three-fold increase in spending power of an initial investment from both these funds. You can bet that Fidelity and American Funds point that out.

 

But I think its best to look at the relative performance to the peer index fund over a decade. On that basis AGTHX’s annual shortfall of 1.4 percentage points meant its accumulated value fell short of its peer index fund by 11%. That cost the investor more that $41,000 in spending power relative to a $100,000 initial investment. (This ignores the 5.75% front-end load or commission to purchase AGTHX; had I included that, AGTHX would have fallen short by 16% and would have costed the investor a whopping $61,000). FCNTX fell short by 6% and that cost the investor more than $24,000. You can bet that Fidelity and American Funds don’t point out these facts.

 

 

In fairness, both AGTHX and FCNTX had good performance, above their peer index, in the years 2003-2008. But that’s a long time in the past for me to think that kind of performance will be repeated.

 

 

Conclusion. More than 3/4s of actively managed funds at Fidelity failed to match their peer index fund in 2018. The average performance was two percentage points worse than the market as a whole.

 

The two most popular actively managed funds in the US failed to match their peer index fund in 2018. These two have trailed their index fairly consistently over a decade. Relative to holding an ETF that mirrors the peer index, an investor who put $100,000 into these two funds a decade ago “lost” as much as $60,000 in real spending power.

 

This post reinforces the message in Nest Egg Care. Stick with index funds. Switch now in your retirement accounts. You have no tax consequences to do so.

 

* The mobile site on my phone shows the comparison of a fund to its peer index. The site on my computer does not compare each fund to its peer index. I think Morningstar is in transition to correctly compare a fund to its peer index on the desktop site.