A reader writes in, asking

“I’m a big fan of Morningstar and the stuff they’ve released recently on ‘safe withdrawal rates.’ My question is how I should be thinking about future Social Security payments, when I calculate my ‘safe withdrawal rate.’

To me, it makes sense to add the NPV (calculated conservatively) of the future Social Security payments that I expect my wife and I to receive to our current portfolio, before I do the math on what our starting annual withdrawal number looks like.

Have you published anything on how to think about that question?”

That’s a great question, and it gets directly to the limitations of safe spending rate research. That is, such research is very helpful for determining approximately how much a person should have saved before retiring, but when trying to use it as an actual spending plan, it comes up somewhat short.

The biggest issue isn’t that the strategy of spending a fixed (inflation-adjusted) amount from the portfolio every year is necessarily a bad strategy (though it does have some drawbacks). Rather, the issue is that such an idea is simply not applicable for most real-life households.

That is, in most households, it’s rare that (inflation-adjusted) spending from the portfolio will be kept constant from one year to the next, because the amount of non-portfolio income changes meaningfully over time — for example as the person semi-retires, then fully retires, then Social Security begins. And for a couple, there are even more distinct phases, because there are twice as many retirement dates and twice as many Social Security start dates.

As far as considering the expected present value of your lifetime Social Security benefit to be a part of the portfolio, and then calculating an initial spending amount accordingly, the issue I see with that is that it depends significantly on what real interest rates are at the time of the calculation. And the higher that real interest rates are (i.e., the higher the discount rate used in the PV calculation), the lower the PV will be, which would indicate spending a lower dollar amount. And that’s rather backwards (i.e., higher real interest rates should indicate that you can spend at a higher rate).

My preferred way to incorporate Social Security into the analysis is to consider it a reduction in spending, for the years in question.

You can do this manually. Calculate what your non-portfolio income will be, year-by-year (including Social Security, earned income, and anything else). Then you can carve out a piece of the portfolio to “replace” that income in the years in which it won’t exist. And then you can spend at a fixed (inflation-adjusted) rate from the rest of the portfolio. (In the context of Social Security, this is often referred to as creating a “Social Security bridge.”)

Very basic example: Bob is single. He’s 65, just retired. He plans to file for Social Security at age 70, at which point he’ll get $36,000 per year. He could allocate 5 x $36,000 = $180,000 to something safe (e.g., a short-term bond fund or a 5-year CD ladder). And he could spend from that chunk of money at a rate of $36,000 per year. And he would spend from the rest of his portfolio at a fixed (inflation-adjusted) rate, which would lead to a fixed (inflation-adjusted) total spending rate also.

As mentioned above though, a real implementation of this idea is likely to be more complicated than this simple example, because there may be a phased retirement — or perhaps a pension or annuity that starts on some particular future date. And there may be two people involved, which would mean even more dates at which the level of non-portfolio income will shift.

Also, ideally, the above calculation would be done on an after-tax basis.

And, admittedly, all of that can get rather cumbersome when taking a DIY approach.

If you want, you can use financial planning software for this, because it can do all of this math (including the taxes) very quickly. The software I use for retirement spending analysis is RightCapital. It’s great, but it’s priced for advisors. The only reason I mention it is that, because I’m happy with the software that I’m using, I’m not also spending time test-driving a whole bunch of other software packages. So I can’t confidently recommend one software package or another for individual users. I have heard good things about the following, but I have not tested them myself.

A reader writes in, asking:

“The age old question: Lump Sum or Monthly Payment? A few years ago it was considered lunacy in the office for anyone who took the Monthly vs Lump option. With increasing interest rates the Lump option today is significantly smaller than last year – and stability of guaranteed income the Monthly is looking more attractive in today’s climate. How does someone figure out – optimal choice, not just Lump vs Monthly, but, if you go Monthly understanding the financial tradeoff on choices of survivor percentage, to “X year Certain and Life Annuity” and “Cash Refund Unpaid Balance” payment options. How do you figure out what is the better option – or at least what you are trading off on one vs the other?”

For pension decisions, when looking at the decision for a client, I typically take two approaches.

First is the quick/easy approach, which is to compare via an online annuity quote provider, such as immediateannuities.com. I’ll put in a given premium (e.g., $100,000), and see what is the annual percentage payout available, for a person who is the age in question (or for a couple of the applicable ages).

And then that percentage payout can be compared to the percentage that is available as the pension annuity option (i.e., annual income, divided by alternative lump sum). Sometimes what you’ll see is that, relative to what’s available in the private marketplace, the pension annuity option is a very good deal or a very bad deal, which then makes the decision relatively easy. Often though, the answer is that it’s a roughly “fair” deal.

And I’ll repeat that process for each pension option for which there is a comparable annuity option. Sometimes you’ll find that one of them is clearly the best deal, actuarially. One limitation of the above method though is that there are often a broader range of pension payout options (especially survivor options) than comparable options on annuity websites.

The second approach is to do an expected present value comparison. For a single person, that’s essentially asking what is the person’s life expectancy, and then “discounting” those expected payments (from the lifetime annuity option) to determine the present value, and see whether that is meaningfully higher or lower than the amount available from the lump sum. (This article has steps for doing a present value calculation in Excel.)

For a married couple, it’s the same general concept but a bit more involved. In that case, I use this spreadsheet (credit to #Cruncher on the Bogleheads forum) to calculate how likely each of the mortality scenarios is for each year going forward (i.e., probability both people are alive, probability only personA alive, probability only personB is alive, probability neither person is alive). And then for each year I multiply those probabilities by the benefit payment in question (i.e., payment if both people are alive, payment if only personA is alive, and payment if only personB is alive). And then I discount all of those probability-weighted cash flows back to their present value, and see how that compares to the lump sum option.

When doing an analysis similar to the above, it’s important to use varying mortality assumptions to see how sensitive the results are to such changes. And the results should be treated as a rough conclusion, because we don’t know how long you (and/or your spouse, if applicable) will live. So, for example, if two options are only a few percentage points apart in terms of expected present value, rather than concluding, “ah, this option is better,” I think a more appropriate conclusion is, “these two options are very similar.”

In addition, all of the above is purely dealing with the actuarial expected payout. And there are two other factors to consider as well: taxes and longevity risk.

With the Social Security filing decision, tax planning is usually a point in favor of waiting (because Social Security benefits are themselves tax-advantaged). But with the pension decision, it could point in either direction, or neither.

From a longevity risk point of view, the annuity option (if married, the annuity option with the highest survivor benefit) is generally the better option, though as per the above discussion it could make sense to take the lump sum and buy an annuity elsewhere. In addition, for people whose desired retirement spending is very modest relative to available resources, longevity risk is already very low. So a further reduction in that risk isn’t particularly valuable.

Most research on retirement spending strategies accounts for longevity risk and market risk. They account for longevity risk by simply assuming that you live to an advanced age. And, after making that assumption, various modeling is done with regard to investment returns, with the conclusion generally being that it’s prudent to spend from your portfolio at a pretty low rate early in retirement, because you might get bad market returns (especially in the critical early years of retirement).

That’s all well and good. It’s an important takeaway — because of market risk and longevity risk, a low initial spending rate is a good idea. (What “low” means depends on circumstances, especially your age, current interest rates, and stock market valuations.)

But most such research still leaves out a major source of risk that exists in real life. Specifically, most such research assumes that your amount of annual spending is something over which you have complete control. But anybody who spends even a few moments thinking about it realizes that that’s just not the reality.

Maybe your car needs to be replaced unexpectedly. Maybe you have a major home repair that isn’t covered by insurance. Or maybe you end up needing 10+ years of expensive chemo treatment. Or you need several years of nursing home care or in-home care. Or maybe there’s a pandemic which ends up causing a large amount of unexpected inflation soon after you retire.

Spending shocks happen in real life. And, critically, they can occur in years in which your spending plan actually calls for reducing your spending.

For example: imagine you’re using a spending plan that calls for you to spend a given percentage of the portfolio each year based on your age. At your current age, you’re supposed to spend 4.5%, and your portfolio has declined over the last year, which means the dollar amount of spending is supposed to be reduced. But you also just learned that you’re going to need a particular medical treatment which you sure as heck aren’t going to skip. And that means that you’re going to be spending 7% of the portfolio balance this year — and likely next year as well — regardless of what the spending plan says.

That’s a big point in favor of a low initial spending rate — to build in “wiggle room” for such spending shocks. In a recent piece of research, Wenliang Hou for the Center for Retirement Research at Boston College found that, for retirees, the risk from health costs was actually greater than the risk from market uncertainty. And that’s just looking at one source of spending shocks (albeit probably the largest source, with inflation being the other largest potential source).

It’s also a point in favor of doing regular updates to your financial plan throughout retirement to see if you’re still on track and to see what adjustments should be made (to the extent that they can be made). As the late Dirk Cotten once remarked, “retirement finance has no cruise control.”

A reader writes in, asking:

“We have decided against long term care insurance and have allocated a portion of our portfolio for long term care expenses.

First question, what are your thoughts on the best asset location for these funds – Roth or Traditional IRA? Currently, we have allocated half in Roth and half in Traditional.

Second question, thoughts on where to invest this money, do you put in all into Vanguard Total Stock Market and let it ride, or do you do a more conservative approach?”

I don’t think there’s a clear-cut answer to either of those questions. The primary issue here is that, in order to implement a typical asset-dedication strategy, you have to know (at least roughly) when the dollars are going to be spent. With long-term care, we don’t know that information. We don’t even know if that cost will arise.

With regard to asset location, the theoretical goal would be to try to incorporate it into the broader retirement distribution plan (i.e., which dollars to spend each year), with the idea always being to spend tax-deferred dollars when your marginal tax rate is lowest. That is, we would create a year-by-year plan. For each year, we first ask how many dollars need to be spent in the year in question. Then we determine which dollars to spend to get to that level. First we spend from current income and taxable-account dollars where cost basis is at least equal to the current value. Then we spend from tax-deferred dollars, to use up relatively-low-tax-rate space (if any). Then Roth or possibly taxable.

But the practical reality is that meaningfully incorporating long-term care costs into such a plan is pretty much impossible, because, again, we don’t know when these dollars will be spent.

Similarly, for investment selection/asset allocation, in theory it would depend on your risk tolerance for these specific dollars. How much can you afford for them to decline — and by how much? The younger you are (i.e., the further away a long-term care need is likely to be), the greater the risk you can afford to take with these dollars — and the more return you might need in order to try to keep up with rising LTC costs.

At least in this case, depending on your age, you might be able to make some useful decisions. For example, if you’re age 50, you could say, “it will probably be at least 15 years, likely even longer.” And that’s enough to tell us something about the appropriate asset allocation. But if you’re in your 60s or beyond, it could be a few years from now, 20 years from now, or never.

Given those practical challenges resulting from the high level of uncertainty, I’m not sure how much is to be gained from making asset allocation or asset location decisions specifically for these dollars. If it were me, I think my personal approach would be:

1. Consider them part of the overall portfolio and continue making overall-portfolio level decisions for asset allocation and asset location.
2. If the desire is still to have dollars set aside specifically, do that via the “how much to spend” each year decision. For example if, in a given year, the plan calls for you to spend X% of the portfolio balance, instead spend X% * (portfolio minus LTC-dedicated amount).
3. If/when the LTC need does arise, make the decision at that time as far as which specific dollars to spend (i.e., stocks/bonds and Roth/tax-deferred/taxable).

With regard to that last step though, there is admittedly a potential problem in that, depending on the reason why you need care, you may not be in a position to actually make such decisions. If you’re married, making sure your spouse understands the household finances and the plans is important. Giving a trusted loved one (or trusted professional fiduciary) authority to act for you via a durable power of attorney can help. And keeping the portfolio as simple as possible is helpful to make it easier for another person to implement your plans.

A reader writes in, asking:

“Would it be possible for you to write an article on how to best account for state income taxes when planning as a retiree or near-retiree?”

It’s obviously challenging to write any sort of catch-all article about state taxation, because the rules vary from one state to another. But the following are the primary questions that I start with when doing a retirement/tax plan. (Of course, the answers to these questions sometimes bring up other questions.)

• What are the state’s rules regarding taxation of Social Security benefits?
• What are the state’s rules regarding distributions from traditional IRAs?
• What are the state’s rules regarding distributions from tax-deferred employer plan accounts such as a 401(k)?
• Does the state have an estate (or inheritance) tax? If so, what is the threshold, how is the taxable estate calculated, and what are the tax rates?

A relevant point is that these rules do change from time to time. So be skeptical about the websites that purport to tell you about all 50 states, as there’s a meaningful chance that that information is out of date, given how hard it is to keep something updated for so many states. (Plus there’s the chance that any general-audience media publication will simply get something wrong or leave out important facts.)

If at all possible, it’s best to find the applicable information on the website of your state’s department of revenue.

Tax Treatment of Social Security and Retirement Accounts

There are many states in which Social Security benefits are not taxed, yet distributions from tax-deferred accounts are taxed. When this is the case, it’s a point in favor of spending down tax-deferred accounts in order to delay Social Security. Reason being, when you spend down tax-deferred accounts earlier, you’re giving up future gains in those accounts. And those additional tax-deferred dollars that you’re giving up would have been fully taxable, whereas the additional Social Security dollars that you’re getting in exchange will not be taxable.

And then there are cases where particular states have very specific rules that create planning opportunities.

For example, Connecticut gives better tax treatment to distributions from 401(k) or similar plans than it does to distributions from traditional IRAs (at least for now), which is a point in favor of rolling IRA assets into a 401(k) just to take advantage of that better tax treatment.

Colorado has an annual “pension or annuity deduction” for people age 55 and up, which allows you to deduct annuity income, pension income, Social Security income, or tax-deferred distributions that were taxable at the federal level. However, there is an annual limit based on your age ($20,000/person if age 55-64, or $24,000/person if age 65+). One exception to the limit is that if your Social Security benefits exceed the limit, all of your Social Security benefits will be excluded from your Colorado taxable income. How this affects planning is that a) it’s another point in favor of delaying Social Security and b) you don’t want to go under the limit in some years and then way beyond it in other years. (You can use Roth conversions to take up any space in a given year that would otherwise be unused.)

These are just the sorts of things where you have to take the time to learn the rules in your state and think through what the ramifications might be.

State Estate Taxes

The federal estate tax only affects a very small percentage of households these days, with its $12,060,000 exemption as of 2022 (and double that for a married couple).

But there are some states that have their own estate tax, and in some cases the exemption amount is much lower. For example, Oregon’s estate tax applies to the amount by which an estate exceeds $1,000,000. In Massachusetts, any estate over $1,000,000 has to pay estate tax, and it has to pay the tax on nearly the whole amount, not just the amount by which the estate exceeds the threshold. Washington state has an estate tax for estates over $2,193,000.

Again, it’s best to just take the time to look up the rules specific to your state.

If your state has such a tax, depending on the threshold amount, the accompanying rules, and your projected assets, there could be lots of planning implications. It might be a big point in favor of gifting/donating during your lifetime. It might be a point in favor of creating certain types of trusts. It’s often a point in favor of Roth conversions, because when you do a conversion, the size of the taxable estate is reduced. (For example, after a given year’s conversion you may be left with $80,000 in a Roth IRA rather than $100,000 in a traditional IRA, which is a good thing as far as estate tax goes.)

In general, once you become eligible for Medicare (either by reaching age 65 or by being on Social Security disability for two years), your Medicare premiums for a given year are based on your modified adjusted gross income (MAGI*) from two years prior. For example, a person’s 2022 premiums are based on their 2020 income level.

The law is written this way for a simple pragmatic reason: “two years ago” is generally the most recent data Medicare has at the time they must determine your premium for a given year. For example, a person’s 2022 Medicare premiums must be determined in 2021 — at which point Medicare doesn’t have the person’s 2021 information yet, so they use 2020.

However, the law also provides that, if your income declines significantly from one year to the next due to a “life changing event” you may request that your premiums be based on that more recent year’s level of income, rather than your income from two years ago. This request may be referred to as a “request for reconsideration”, “Medicare Part B premium appeal”, or “Medicare IRMAA appeal.” Life changing events include:

• Marriage,
• Divorce/annulment,
• Death of a spouse,
• You or your spouse stopped working or reduced the hours that you work,
• You or your spouse experienced a loss of income-producing property that was not at your direction (i.e., you did not intentionally sell the property), or
• You or your spouse experienced a cessation, termination, or reorganization of an employer’s pension plan.

Filing Form SSA-44 is how you make such a request for reconsideration.

Why Is This Important?

In short, this is most likely to be important for:

• High earners who retire in a year they (or their spouse) turn 63 or older or
• High earners who retire when their spouse is receiving Social Security disability benefits.

Consider this example: Amanda and Neil collectively earn about $250,000 per year. They both retire in June of 2022, at age 64, after having earned roughly $120,000 for the year. When they begin Medicare at age 65 in 2023, their premiums will initially be based on their 2021 level of income ($250,000), which puts them in the third Medicare IRMAA tier.

They can, however, file an IRMAA appeal and request that their premiums instead be based on their 2022 income level. The net result is that they save $180.30, per month, per person in Medicare Part B and D premiums by filing Form SSA-44.

*For Medicare IRMAA purposes, MAGI is calculated as your adjusted gross income, plus tax-exempt interest, plus any foreign earned income or income from US territories that was excluded from your gross income.