By Samantha Compton
This month, we’ll continue our focus on Financial Principle #4: Don’t Let Your Portfolio Take a H.I.T. (Healthcare, Inflation, Taxes) as well as the Growth Bucket. Next to unexpected health care expenses, inflation and taxes are the next most likely culprits to put a damper on your long-term savings and retirement plan.
If you are betting that taxes and inflation rates will go up, well, you’re right. There is no doubt that they will go up. But when and how much? The unknown answers to those two important questions are some of the biggest challenges to long-term financial planning. As we look at these, I think you’ll see why saving enough to allow for having a Growth Bucket in addition to an Income Bucket during the retirement years is so important.
Will Rogers once said, “The only difference between death and taxes is that death doesn’t get worse every time Congress meets!”. While this may be an exaggeration, it is a sentiment that many relate to. I hear it from clients in various seasons of their financial lives, but especially when on a fixed amount of income in retirement.
One of the ways to plan for taxes in retirement is to try to limit them! Take advantage of tax-free accounts as much as possible for your retirement savings. As I’ve mentioned in prior months, that can be done through utilizing Roth IRAs and Roth 401ks, as well as utilizing properly designed life insurance policies that allow you to access funds tax-free while you are still living.
With that said, no amount of planning can eliminate the possibility of new taxes or higher tax rates.
This is where the Growth Bucket becomes so essential. Regular income taxes can be planned for in the Income Bucket to meet our net (after-tax) needs. But as time progresses, those tax rates will most likely change. That is when we go to the Growth Bucket to access funds that are not already committed to producing income.
Inflation is a hot topic right now, and rightfully so. With Covid-19 related slow-downs and closures, many goods and services are costing more than they have in years. There are varying opinions about whether these inflated costs will come down or stay inflated for the foreseeable future. However, bank on this – if you plan to live in retirement for at least 10-30+ years, you will see things get more expensive. On a fixed amount of income, this can be a problem.
A common practice in retirement planning is to use a Monte Carlo analysis. In simple terms, this is a projection of certain values, for example, what your savings might be worth and how much income you might need with inflation factored in over a set amount of years. When entering data for an analysis like this, the rate of inflation is set at a fixed number, and each year the cost of living and therefore saving requirement goes up by that set amount. In most cases, the output of this kind of analysis will project a needed income that is much higher than what actually might be needed. The reality of how inflation affects people’s finances in retirement may look more like this:
Year 1: No increase
Year 2: .50% increase
Year 3: 1.0% increase
Year 4: No increase
Year 5: 2.5% increase
In a scenario like this, a couple in retirement may, by year 3, begin eating out less or cutting back on some activities they used to enjoy, without even thinking about it. By year 5, they may begin noticing that they have to dip into savings every few months to make ends meet. It may not be until year 5 or 6 that they give themselves a raise in the income bucket. In this scenario, using the three-bucket approach I’ve been teaching you, the Growth Bucket would have received at least four additional years of potential growth before funds may have been moved to the Income Bucket.
The main benefit of having a Growth Bucket at retirement (and not just simply using a Monte Carlo analysis to determine how much your living expenses will go up each year) is that you may get additional growth on those funds before needing to move them to something more conservative to produce income. That could add up over your retirement years and make a difference in how many years your savings will last!
This month, it’s pretty simple. If you haven’t already come up with a way to save even a LITTLE bit more in your long-term savings/retirement accounts, it’s an excellent time to focus on that. If you haven’t yet explored your tax-free/Roth savings options, do that as well!
Samantha Compton is an SWSM contributor and financial advisor. She is also a Senior Financial Advisor & Women’s Investment Specialist with an SEC Registered Investment Advisor Firm in the Kansas City, MO area. She places a high value on financial education and believes it is essential for creating and sticking to a well-written financial plan!
This article is written to provide general information on the subjects covered. It is not, however, intended to provide specific legal or tax advice and cannot be used to avoid tax penalties or to promote, market, or recommend any tax plan or arrangement. Please note that Wise Wealth, LLC and its representatives do not give legal or tax advice. Consult your tax advisor or attorney for advice specific to your circumstances.