Income Allocation

For all the saving and planning you do to prepare for retirement, there remain two questions that are impossible to answer about the strength of your plan:

1. What will the stock market do during my retirement?
2. Will I outlive my savings?

A lot of planning expresses those risks like this: “Under our Monte Carlo analysis, you have a 90% chance that your money will last until age 90.” Or if you’re more sophisticated, they’ll give you a plot point like the following and then ask you to select the best set of outcomes.

There are two problems with these approaches:

You may have read this article in Kiplinger’s online magazine, in which I explain how to earn maximum tax advantages from your investment in income annuities. I republish it here, slightly modified.

Like most taxpayers, I am a fan of legally minimizing your income taxes. But I think — if you are retired or about to retire — you should concentrate less on minimizing taxes and more about increasing after-tax spendable income and your financial legacy to heirs. Sounds like a non-sequitur, but it isn’t.

As an example, you could invest your entire savings in high-quality intermediate-term municipal bonds and pay no taxes on interest earnings. But you would earn something like 2.5% (or $25,000 on $1 million in bonds) in annual income. Wouldn’t it be an improvement if you paid some taxes and generated an income stream equal to, say, 6% after taxes?

Over dinner with friends who live in the Northeast, they expressed concern about how the recent tax changes may increase their federal income taxes. They’re right to worry. New rules limit the amount of property and state income taxes that can be deducted – and they live in a high-tax state.

Like everyone, I am a fan of legally minimizing your taxes. But I think – if you are retired or about to retire – you should concentrate less on minimizing taxes and more about increasing after-tax spendable income and your financial legacy to heirs. Sounds like a non-sequitur, but it isn’t.

As an example, you could invest your entire savings in high-quality municipal bonds and pay no taxes on interest earnings. But you would earn something like 2.5% in annual income. Wouldn’t it be an improvement if you paid some taxes and generated an income stream equal to, say, 6% after taxes.

The financial industry figured out how to improve saving before retirement, and 401(k) investors are taking advantage.

The idea is simple: create an investment choice that allows you to “set it and forget it” until you retire. These options available in a 401(k) plan are called target date funds (TDF). If you elect a TDF when you’re young, the fund automatically recalibrates as you age, becoming more conservative as you near retirement. In that way, the fund captures growth and is less likely to experience severe setbacks from market downturns as you approach retirement.

An article in the San Francisco Chronicle says Vanguard reported that just over half of participants in the 401(k) plans it administers are invested in a single target date fund. These funds account for one-third of the assets in all 401(k) and other defined contribution plans run by Vanguard.