Get With The Plan: August 26, 2012

Miranda wasn’t planning on an early retirement, but the struggling economy put her out of a job a few years earlier than she expected. At age 58, she does some part-time work, but it doesn’t generate much income.

“My major concern is income generation between now and starting Social Security and my pension,” Miranda says. “I would like to hold off until age 65.”

She’s thinking her real retirement will involve moving to a less expensive area, working a part-time job and travel.

Miranda, whose name has been changed, has saved $660,000 in IRAs, $220,000 in annuities, $370,000 in mutual funds, $600 in a brokerage account, $72,000 in Certificates of Deposit, $145,900 in money markets, $23,300 in savings and $10,000 in checking.

She expects, at age 65, to receive a pension of $14,000 in addition the a smaller annual $6,402 per year pension that she’s already receiving from a different employer, and $25,000 a year from Social Security.

The Star-Ledger asked Jeffrey Boyer, a certified financial planner with RegentAtlantic Capital in Morristown, to help Miranda determine how to best handle her money up until and through retirement.

“Miranda has an after-tax spending level of approximately $30,000 a year, not including mortgage payments,” Boyer says. “However, Miranda would like to increase spending during retirement in order to take classes, go on local trips and major vacations.”

For starters, she lacks a well-diversified portfolio. Boyer says the majority of her investment assets are allocated between two asset classes: U.S. large-cap stocks and fixed income.

“She would likely be rewarded, both in terms of return and risk, by being more diversified into additional asset classes such as small-cap stocks, foreign stocks, emerging market stocks, and infrastructure, to name a few,” he says.

Miranda has approximately $260,000 in cash and cash alternatives. Boyer says accumulating cash savings would be appropriate to set aside an emergency fund or to establish a reserve for a known near-term expenditure. But as part of a long-term portfolio, cash has a lower expected return than both equities and bonds.

“Cash is returning negative real yields, meaning that it is failing to keep up with inflation,” he says. Miranda prepares her own tax returns, and a review of her financials and most recent tax return shows she will probably continue having negative taxable income, Boyer says.

She’s currently making contributions to an IRA account for the amount of earned income she generated in 2011 — $1,540. Boyer says there are several planning opportunities Miranda should consider with proper advice from a tax professional — because some of the opportunities are contradictory to one another.

First, Boyer says because Miranda is not paying any tax, she should not be making contributions to a traditional IRA because there is no income tax deduction afforded to her today and withdrawals during retirement will be taxed as ordinary income.

“Rather, if contributions were to be made, they should be directed toward a Roth IRA account because earnings from this type of vehicle will not be subject to tax in the future,” he says.

Next, Miranda holds many after-tax investments that were purchased years ago and are currently being held at large unrealized gains. Current tax law allows for taxpayers in the bottom two brackets to realize capital gains without paying capital gains tax, he says.

“Miranda should take advantage of this current law by realizing gains to soak up the bottom two brackets,” Boyer says. “With uncertainty looming around the future of tax law, it would be wise to seriously consider this recommendation for tax year 2012.”
Also, Miranda holds almost $200,000 in municipal bond mutual fund investments.

Boyer says the benefit of owning municipals bonds is that the income received by the investor is exempt from federal — and sometimes state — income tax.

“These bonds are most appropriate for investors with a high income tax liability,” he says. “As this is not the case with Miranda, she would be better compensated owning taxable bonds with higher yields.”

Additionally, she should consider paying off her the remaining mortgage balance because she’s not benefitting from the interest deduction.

Looking at retirement, Boyer assumed Miranda would pay off the existing mortgage balance and incur $20,000 of home renovations in the next couple years, periodically purchase new cars and incur annual costs of classes and travel that could exceed $20,000 a year in addition to her base annual spending.

“I was delighted to review with Miranda how successful the results of the plan were, and I hope she came away with the same impression,” he says. “Based on the assumptions we made, Miranda has a very high likelihood — 99 percent probability — of having assets through age 93.”

Boyer says Miranda can reduce her exposure to growth assets while still maintaining the 99 percent probability of success. Her current portfolio is invested in 55 percent growth assets and 45 percent fixed income. Boyer says she could reduce her growth exposure to 30 percent while not altering the probability analysis results. Still, he says, it’s important to note that portfolios with a greater exposure to equities will likely result in higher dollar values at the end of the plan.

Overall, Boyer says the key takeaways from this analysis are that Miranda has done a great job accumulating assets during her working career and should feel comfortable retiring today if she so chooses.

“At a minimum, it is important to maintain a portfolio allocation of 30 percent equities and 70 percent fixed income, however, she has the ability to invest more aggressively if she wishes,” he says.

“Further diversification of investments could improve her risk/return profile, and there should be greater attention paid to her tax situation and constructing an investment strategy that is most suitable for Miranda.”