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Pension Choices: Lump Sum or Monthly Payment?

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.

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  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

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The Third Reason to Use a Conservative Spending Rate in Retirement

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.”

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Asset Allocation and Asset Location for LTC-Dedicated Dollars

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.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

How Do State Taxes Affect Retirement Planning?

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.)

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Medicare IRMAA Appeal (a.k.a. Request for Reconsideration)

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.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Roth Conversion Analysis: Not Breakeven Analysis

A reader writes in, asking:

“I am planning to do a smallish conversion each year before I turn 72. I am 66.

Now though, I recall hearing a CFP say that it is important also to do a ‘breakeven analysis’ before converting money from a traditional to a Roth IRA. He has found that, for most of his clients, the breakeven point is too distant for a conversion to provide a meaningful benefit. Clients would have to be in their 90s.

If you have room in your blog, please touch on what a “breakeven analysis” is in the context of a Roth conversion and how to do it.”

This is a common misconception — one that is common even among financial professionals, unfortunately.

In most cases, breakeven analysis simply is not applicable to a Roth conversion decision. (There is one specific exception, discussed below.) For a Roth conversion decision, the length of time in question usually does not matter at all.

The reason has to do with the commutative property of multiplication. That’s the rule from grade school math that tells us that A x B x C is the same as C x B x A. The order in which we multiply figures is irrelevant — we get the same answer every time.

When you pay taxes on a distribution from a tax-deferred account, it’s a multiplication function. For example, if you take a distribution and you have a 20% total marginal tax rate, you’d be multiplying the amount by 0.8 in order to see how much is left after taxes. And the same is true for a Roth conversion, if you pay the tax from the IRA.

Imagine that you are considering doing a $50,000 conversion. And imagine that you have a 20% tax rate right now. If you convert it, you’re left with $40,000 in a Roth IRA. And the Roth IRA can now grow tax-free, which means your after-tax value can be represented as:

  • $50,000 x 0.8 x Year-1 return x Year-2 return x [any additional years of returns]

(Note that in the above, a 7% return would mean multiplying by 1.07. A negative 5% return would mean multiplying by 0.95.)

Or, you can keep the money in a traditional IRA, let it grow, and pay tax later. If we assume that you would also have a 20% tax rate later, then your after-tax value can be represented as:

  • $50,000 x Year-1 return x Year-2 return x [any additional years of returns] x 0.8

And the key point here is that those are the same thing. It doesn’t matter whether the returns are good or bad. Nor does it matter how many years of returns there are in between. It’s a textbook case of the commutative property of multiplication.

Breakeven analysis is predicated on the concept that you’re paying some cost up front, which is bad, and that you have to wait for some period of time before paying that cost is “worth it.” But with Roth conversion analysis, if you don’t pay the cost now, you have to pay it later (i.e., the cost cannot be completely avoided). And because the figures in question are all multiplication, it’s no worse to pay it sooner rather than later. (And in fact paying it sooner is often advantageous, because waiting until later to pay the tax often means the distributions themselves are larger — because the account has grown — which can itself increase the rate of tax. And again, the rate of tax is what we care about.)

Some smarty-pants might say, “but you’re forgetting time value of money! Time value of money tells us that it’s better to pay the cost later.” Nope. Not in this case. If the cost were a fixed dollar amount, that would be true. (Because then what we’re doing is subtraction. And once you mix subtraction in with a bunch of multiplication, the order becomes important.) Paying $10,000 today is worse than paying $10,000 several years from now.

But the tax on a distribution from a retirement account is not a fixed dollar amount. It’s a percentage. Paying 20% now vs. 20% later really does not matter. (Again, see our two bullet point options above. They’re the same.)

The Roth conversion question is generally just about whether you can pay a lower percentage now than you would pay later. If so, a Roth conversion is advantageous. And that would be true even if you planned to take the money out of the account next year (assuming, that is, that you’re at least age 59.5, so we don’t have to worry about the Roth conversion 5-year rule).

Again, we can just try the math for ourselves to demonstrate. Imagine it’s again a $50,000 amount you’re considering converting. And imagine that you have a 15% marginal tax rate this year, and a 25% tax rate next year.

If you do a Roth conversion, the after-tax amount is: $50,000 x 0.85 x the return over the next year.

And if you don’t do a Roth conversion (and instead take the money out of the account next year) the after-tax amount is: $50,000 x return over the next year x 0.75.

No matter what you plug in for the return, the first option is better. No need for the money to be in the account for a given length of time. (Again this is assuming that you’re at least age 59.5. Otherwise we have the Roth conversion 5-year rule to consider.)

When Breakeven Analysis Does Apply to Roth Conversions

As noted above, if the tax rate you would pay on a conversion is lower than the tax rate you would pay when the money comes out of the account later, a Roth conversion is advantageous. But there’s one case in which it can make sense to do a Roth conversion even when your current marginal tax rate is slightly higher than the marginal tax rate you expect to face later. Specifically, that can occur if you aren’t paying the tax out of the IRA but rather paying the tax out of assets you have in a taxable account.

And that’s when a breakeven analysis could apply. Because in that case, we’re no longer multiplying the IRA assets by a given figure, to represent the tax paid on the conversion. Instead, the entire amount taken out of the traditional IRA is going into the Roth IRA. And you’re paying the tax from somewhere else. (Effectively, you’re using taxable assets to “buy more” Roth IRA space.) And whether it makes sense to do that depends on a whole bunch of things, one of which is the length of time that the money will stay in the Roth (i.e., how long do you get to benefit from the tax-free growth that the assets will now experience, because they’re no longer in a taxable account). Other factors that are relevant in such a situation include:

  • What rate of return you anticipate earning on the assets,
  • What rate of tax you would have to pay on that return (and when you would have to pay it), if the assets stayed in a taxable account,
  • What (if any) tax cost is incurred as a result of selling the taxable assets in question now in order to use that money to pay the tax on the conversion.

But if I’m being honest, I would be reluctant to recommend a conversion to anybody if they’re paying a higher rate of tax on the conversion than they expect to face in the future, even if a breakeven sort of analysis showed that it might ultimately be advantageous. In most cases, I think it’s best to simply compare the tax rates, and if the current marginal tax rate is lower than the anticipated future marginal tax rate, a conversion is advantageous. And if you’re paying the tax out of taxable assets, then, great, it’s a little bit more advantageous.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
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