Managing Money During Retirement
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Defined Withdrawals
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How Much Do You Need in a Roth IRA to Achieve All of Its Benefits?

By Roger & Kevin Katzenmaier

October 16, 1997

Note: When this article was written the Income Strategy Generator was called the Investment Scenario Generator .

For those individuals who are using Individual Retirement Accounts (IRAs) for financial retirement planning, the new Roth IRA poses an important question. What portion of retirement capital should be in a Roth vs. an Ordinary IRA?

The value of an Ordinary IRA can be prematurely reduced due to the minimum distribution rules post age 70&1/2. This occurs when mandatory withdrawals become greater than the retiree’s income needs which accelerates taxation and reduces investment capital. Further, in the event of death, the beneficiary of an Ordinary IRA must pay income taxes on all amounts received from the IRA. The new Roth IRA does not have these drawbacks. However, a Roth IRA must be funded with after-tax income.

The Roth IRA also offers tax-free earnings which is bound to attract many takers. However, it is important to consider not only the benefits of a Roth IRA but also the costs associated with getting capital into a Roth IRA.

Choosing between a Roth vs. an Ordinary IRA is a complex issue and depends on many variables including: the availability of funds not held in an IRA, eligibility for tax deductible contributions to an Ordinary IRA, present vs. future tax rates, age and individual planning goals. This article is not intended to explore all of the advantages and disadvantages of a Roth vs. an Ordinary IRA. Instead, this article will explain how to avoid mandatory withdrawals in excess of income needs due to the minimum distribution rules associated with an Ordinary IRA with only a relatively small amount of capital initially in a Roth IRA. For many, it is possible to achieve all of the benefits of a Roth IRA with only a portion of capital initially in a Roth IRA while also maximizing tax-deferment of an existing Ordinary IRA.

To achieve the balance of capital in a Roth vs. an Ordinary IRA, we will use the Investment Scenario Generator or ISG. The ISG is a powerful software tool which can be used to simulate a wide range of investment scenarios. (For information about the unique ISG methodology, visit www.DefinedWithdrawals.com) Using this tool, we will develop a two-part plan where during the first phase of retirement, income will be provided exclusively from an Ordinary IRA in compliance with the minimum distribution rules. The goal will be to completely consume capital in the Ordinary IRA before the person dies. The second phase of the plan will use a Roth IRA to fund retirement income after the Ordinary IRA has been depleted. This will free the retiree from the escalating minimum distribution requirements and allow the retiree to leave remaining capital to heirs income tax free.

Assume an individual is retiring at age 60 and expects to live to at least age 80. Also, assume the individual would like to maintain an after-tax retirement income from investments of $42,000 annually, increasing each year by an assumed inflation rate of 3% and with payments received on a quarterly basis. In addition to providing the desired retirement income, let's also assume that this individual's goal is to leave roughly $1,000,000 in today’s dollars to heirs income tax free. How much should the retiree have in an Ordinary vs. a Roth IRA?

We will plan to fund retirement income with an Ordinary IRA up to age 80. Withdrawals will be subject to income tax. Therefore, to achieve the desired after-tax income of $42,000, we must plan to withdraw this amount in addition to the amount required for income taxes. This individual plans for an initial withdrawal of about $55,000 to cover both the desired income and income taxes. Next, the ISG will be used to determine how much Beginning Capital is required to provide this income up to age 80 while also depleting capital in the Ordinary IRA by age 80.

Assume that Interest-Bearing Obligations (fixed-rate investments) will provide an average yield to maturity of 6%, Blue Chip stocks will provide a total return of 10% (with dividends reinvested to take advantage of dollar-cost averaging) and the maximum required Holding Period for Blue Chip stocks will be 10 years. 

For those unfamiliar with the ISG, it employs a unique methodology whereby income is provided from both the interest and principal of a ladder of Interest-Bearing Obligations (IBOs) for as long as the assumed stock Holding Periods. This approach gives a realistic means of providing essentially guaranteed income that has a unique synergy with market realities and guarantees that stocks can be held for the long term.

After running a few scenarios with the ISG, we find that $720,000 will provide the desired inflation-adjusted income given the above investment parameters if initially 66% is allocated to IBOs and 34% is allocated to Blue Chip stocks. Using the Multiple Allocations feature of the ISG, a fixed allocation of 100% IBOs was defined for the end of the tenth year so that capital could be depleted by age 80 (after 20 years) without violating the assumption that Blue Chip stocks may need to be held for up to ten years prior to being sold to achieve the assumed total rate of return.

If market conditions are favorable, it might be wise to sell Blue Chip stocks earlier than the assumed Holding Periods and therefore, it is a good idea to analyze the effect of doing this. Again, using the ISG, we find that if Blue Chip stocks are sold to replenish IBOs after only 5 years, then about $740,000 is required to meet the desired income up to age 80. To build in this measure of safety, we will assume $740,000 total capital in the Ordinary IRA.

Having determined the amount of capital that is required in the Ordinary IRA to meet income needs up to age 80, it is easy to confirm from the ISG annual projections that this plan is in compliance with the minimum distribution rules for an Ordinary IRA.

Next, we will determine the desired amount of capital in the Roth IRA to meet income needs after age 80. Capital in a Roth IRA at age 60 will have 20 years to grow before it needs to be used to maintain income. We will assume that for the first 15 years this capital will be allocated 100% to Blue Chip stocks within the Roth IRA. But after 15 years, the allocation will be split between Blue Chip stocks and IBOs in preparation for providing income after age 80. With the Roth IRA, income withdrawals will be tax free. Therefore, for the second phase it is only necessary to plan for the $42,000 desired income--of course adjusted for inflation. Using the ISG’s Custom Income Schedule, we specify an income of $42,000 in Adjusted-Value Dollars beginning in the 21st year or after age 80.

We will run an overall 30 year scenario this time. For the first 20 years, capital in the Roth IRA is allowed to grow while income is provided exclusively from the Ordinary IRA. During the last 10 years, income is provided exclusively from the Roth IRA. After a few tries we find that $250,000 initially invested in the Roth IRA will provide the desired income and an inflation-adjusted Ending Capital value of about $1,000,000 if allocated 30% to IBOs and 70% to Blue Chip stocks in the 15th year and again assuming maximum Holding Periods of 10 years.

It should be pointed out that the exact amount left to the heirs depends upon when the individual dies. The ISG can easily predict these values. Of course, one could adjust the Beginning Capital amount in the Roth IRA to plan for alternate outcomes.

In this example, the individual achieved the desired income, avoided all minimum distribution rules in excess of income needs and also planned to have somewhere between $900,000 and $1,000,000 in today's dollars for heirs at the time of death exclusively in a Roth IRA not subject to income taxes. It doesn’t get much better! The Roth IRA provides an excellent means to avoid mandatory withdrawals in excess of income needs and for passing on wealth income tax free. However, the key point is that for many, not all capital needs to be in a Roth IRA to achieve all of its benefits. In this example, $740,000 was initially in an Ordinary IRA and $250,000 was in a Roth IRA--a 75/25 percent split. However, those who are not planning to maintain income from an IRA and/or those those who have significant capital not held in an IRA which could be used to pay the taxes incurred from converting an Ordinary IRA to a Roth IRA may benefit from having a greater percentage of capital in a Roth IRA.

It should also be pointed out that it is possible to avoid mandatory withdrawals in excess of income needs using a tax-deferred annuity in a similar manner. However, the tax-deferred annuity does not allow for income-tax-free inheritance and includes insurance mortality and administrative charges that reduce the return from investments.

Remember there may be costs associated with getting capital into a Roth IRA. But, if you can afford to invest about 25% of IRA funds in a Roth, you can likely accomplish both your income and estate planning goals based upon your desired plans not federal tax rules. Using the ISG and the new Roth IRA, you can make terrific financial retirement plans!

 

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