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How a Family Turned a Job Loss into a Retirement Advantage
- By Travis Echols
- •
- 29 Jul, 2017
Originally written on 6/10/2017.
A family I’ll call Richard and Karen Johnson (for confidentiality’s sake) were experiencing a potential crisis that many families have faced: the unexpected and untimely job loss of the primary breadwinner, Richard. This was a curve ball they were not expecting.
The emotional and financial turmoil of a job loss can be devastating. I read an article in the Wall Street Journal last year entitled, Six Ways the Recession Inflicted Scars on Millions of Unemployed Americans. It cited the National Bureau of Economic Research’s data that one in six U.S. workers lost a job between 2007 and 2009!
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I don’t have to tell some of you how disrupting and unsettling it is to hear the boss say, “Can I see you in my office?” This study showed that job layoffs can negatively affect workers for decades, resulting in lower pay, psychological problems, and even shorter lifespans.
Face the hard facts of your situation
When Richard got the bad news, he had been thinking about starting a business; but he had not planned on starting right away. He wanted to continue to work his job while slowly building the new business. Note: For people starting a new business, unless there is good evidence that the business can really hit the ground running, or unless you have other financial resources to sustain you, it is often best to start the business on a part-time basis and see how it goes before cutting your reliable income sources.
The Johnsons felt like it would be difficult for Richard to find another job close to home paying the same as his old job...and they didn’t want to relocate.
They had to consider launching the business earlier than they had planned. They were willing to take some of their 401(k) and IRA assets to get them through, but they would have to face a 10% penalty for early withdrawals, on top of taxes.
One of their biggest concerns was running out of cash. If they had to do premature distributions from their IRA to live and support the fledgling business, they could create a viscious cycle of having to take more IRA distributions just to pay the taxes and penalties from the previous year. And they wanted to avoid borrowing money if possible.
Fortunately, Richard and Karen were planners and they had saved a significant amount of money…not only for retirement but for emergencies. Their savings outside of retirement accounts could be used to pay the taxes on IRA distributions, but those same savings would need to cover their living and business expenses as the business income ramped up.
Aspire to benchmark what could be, if only possible
What if the Johnsons, who were in their early 40s, could use some of their retirement assets and avoid the 10% penalty? What if they could also take advantage of this situation by improving their future retirement picture? What if they could not only soften the blow of this untimely layoff, but capitalize on it? Instead of allowing the financial curve ball they had been thrown to strike them out, what if they could hit a double or a triple or a homerun?
After evaluating all your options, choose the best one--and work out the details
As we evaluated the options, one idea began to look appealing. What if the Johnsons converted a small portion of Richard’s IRA to a Roth IRA in his first full year of unemployment…when their income would be low and their business deductions would be high?
They could in essence transfer $50,000 of tax-deferred savings into a tax-free retirement account with minimal tax consequences. It would also make the $50,000 available to them in five years, regardless of their age, with no 10% penalty, with certain caveats. See How to Maximize the Roth IRA to Your Tax Advantage.
Since Richard was older and would turn 70½ sooner than Karen, using his IRA instead of Karen’s would also reduce their Required Minimum Distribution (RMD) sooner.
I also felt like the same economic factors which led to Richard’s job lay-off made this a great time to do the conversion. Why? Because the stock market had also greatly declined. With their substantial cash savings, they could invest their $50,000 Roth money in a diversified stock portfolio with much more upside potential than downside potential, especially with a five-year window for the market to recover.
Implement, monitor, and seize every opportunity to continuously improve the plan
That is what the Johnsons did. They did a Roth conversion and paid very little taxes on the $50,000 conversion. They tightened their belt and used their cash savings for business and living expenses. The next year they converted $30,000, then $23,000, then $20,000.
We would do the conversions at the first of each year and decide at the end of the year whether to recharacterize it or let the conversion sail. (Recharacterizing reverses the conversion--the distribution goes back into the traditional IRA and is no longer counted as ordinary income for taxes purposes.)
We did
this to maximize the look-back period to see if the investments had
grown or shrunk over the last year. One of those years, the
market corrected downward significantly, so we recharacterized the
conversion and postponed it until the next year. Why pay taxes on
$30,000 if at the end of the year the market value is only
$25,000? No, let’s share that paper loss with Uncle Sam in our
traditional IRA—not in the Roth IRA. My philosophy is that look-backs
and do-overs are rare in life; take advantage of them any time you
can.January 2018
update: This recharacterization feature was unfortunately
repealed in the TCJA of 2017.
Enjoy the benefits of a well-executed plan
Five years after Richard’s job loss, Richard and Karen had depleted a large portion of their cash savings, but the business revenue had grown and a larger portion of their retirement assets was now in tax-free Roth IRA accounts.
Here is the beautiful thing about this story. Five years later, they used their original conversion Roth IRA to replenish their cash emergency funds and to invest in their growing business. They removed their original $50,000…tax-free and penalty free…while in their mid-40s, and still had over $50,000 in gains in the original Roth IRA conversion account...to continue to grow tax free! Their $50,000 had been invested near the bottom of the market crash and had more than doubled in value in the five years.
And that is not all, fast forwarding to today, the Johnson’s tax allocation is much better than most investors. Of all their retirement assets, which have continued to grow…especially over the last few years…a whopping 46% is in Roth IRAs. The income tax advantage they will have in retirement is tremendous. And if they leave any of the Roth IRAs to younger heirs, their heirs will be able to stretch that tax-free growth over their expected lifetimes.
The Johnsons capitalized on those low-income years. Would they have been better off if Richard had not lost his job and they started the business slowly? Perhaps. But since they didn’t have that option, they made the best out of the situation--and may be better positioned due to having greater tax control throughout their retirement years.
Converting in the low-income years was the key to their success. It gave them quicker access to retirement assets and will provide greater tax control in retirement. However, that strategy would not have been possible had they not planned and had the long-term assets and extra cash savings.
It’s always good to have options. And there’s an often-overlooked benefit of good financial planning: it creates options that allow you to pivot when...not if... the unexpected happens.
The Johnsons planned. That planning gave them breathing room for their business to grow without having to relocate, without having to go in debt, and without having to pay excessive tax penalties...and they are now in an enviable tax situation for retirement income planning.
The moral of the story
The moral of their story is that financial planning cannot always prevent unexpected curve balls from coming your way, but it can prevent you from striking out. And in some circumstances, you might round the corner of third base with hands in the air, thankful for the pitch. Good financial planning is about always keeping your eye on the ball.
If you have been thrown a financial curve ball or want to prepare for such an event, let's sit down together and have a discussion.
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
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Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
Protecting your lifetime retirement savings from excessive taxes is a crucial part of holistic financial planning. This involves protecting your IRA, 401k, lump sum pension rollover, Social Security, and any other type of retirement account or income stream from crushing tax rates.
So let's be sure to differentiate tax preparation
from tax planning
.
Tax preparation , also called tax return preparation, looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning on the other hand looks at taxes in the context of your overall financial picture. A tax planner not only looks in the rear-view mirror but will look forward 20 to 30 years at your projected tax liability and ask what can be done to lower your lifetime tax bill.
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
.
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Originally written on Aug 2, 2018 and updated for tax law changes.
If you are no longer working and have reached the age of 72,
you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution
(RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more,
but this requirement is the minimum
you must take or be severely penalized. Fortunately,
this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)
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If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.
Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo . There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)
However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA) , with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.
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The latest book I am reading is “ The Psychology of Money ” by Morgan Housel. Chapter 3 is entitled “Never Enough”. In this chapter, Housel talks about when rich people do crazy things. He tells stories of wealthy people who never had a sense of enough and wrecked their reputations, families, freedom, and happiness because of it. I have also talked to older couples who tell me they once had a much better retirement in view, but the quest for more led them to make unwise investment decisions that left them financially crippled in retirement. The importance of knowing when you have enough is not only vital to when you retire but also how you retire. It can affect how you invest, how you withdraw, and your overall satisfaction before and during retirement. Be sure to read to the end where I summarize a few key takeaways. Housel makes the four following observations in chapter 3 of his book. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Whether you do mini-Roth conversions over several years or big Roth conversions in a few strategic years, the Roth conversion strategy could save you tens if not hundreds of thousands of dollars over your retirement. This article will get deep into the issues of Roth conversions for retirees and the ten steps to take to be sure it is done properly. Be sure to scan or read to the end where I will give you the simple answer to getting your Roth conversion questions answered. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Making big financial decisions immediately following the death of a close family member can be dangerous. It is often best to allow some time before tackling big financial decisions. On the other hand, some people find getting immersed in the finances is helpful in coping with the loss. Whatever way is best for you, you will need to give it your
careful attention to avoid big financial mistakes. The different types of accounts have different rules. I'll address the most common types. In the case of the death of a parent or anyone other than your spouse in which you are a non-spouse beneficiary, there are many rules that you must know to make the best decision for you and your family. (In this article, I use the common parent-child inheritance, but the planning strategies can apply to other non-spouse situations.) Your decisions can have major tax and investment consequences, both now and in the future. And some of these decisions have time deadlines keyed to your parent’s date of death. Also, some of these decisions are irreversible. You can download my free Estate Planning Survivor Checklist here
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So, you don’t want to rush in and make decisions without knowing the rules, and you don’t want to wait too long and be stuck with fewer options. (In this article, I am not addressing estate taxes. As of 2021, only estates valued at $11.70 million or more are subject to federal estate tax. But there are plenty of other tax pitfalls to navigate around. I am also going to focus on liquid savings like investment and retirement accounts, versus real estate which will be for another time.) Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Delaying Social Security makes a lot of sense for many retirees; but there are common pitfalls that can cost you a bundle. As you know, the longer you delay your Social Security Retirement benefit, the higher your lifetime monthly payments are figured to be. This increase in delaying continues until age 70, after which there are no further increases for delaying. This increase for each month that you delay filing is not small, especially considering the current low interest rates. Even after full Social Security age, your payment goes up by 8% per year until age 70. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . Here are the five big mistakes of delaying your Social Security retirement benefit. |
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Are you wondering about the impact of the
2020 election results on your retirement? If so, you are not alone. The two political parties are greatly polarized. While the Democrat party has moved further toward ethno-centric socialism, the Republican party has moved further toward nationalistic populism. The difference in the two parties’ goals for our country is wider than ever. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . |
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
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