Which Account Should I Use for Cash Flow in Retirement?

If you think that saving for retirement is hard, wait until it comes time to spend it. When you are working and making contributions to a retirement plan, it’s pretty easy. You open a retirement account, contribute to it regularly, and off you go. If you are lucky enough to have a company-sponsored plan, you make your deposits into the account via payroll deduction.

Oh sure, you will have to actually sign up for the retirement plan. And you will have to make decisions about a few things, but it’s pretty easy. When you open the account, you will name a beneficiary who will inherit the assets if something happens to you. Next, you’ll have to decide how much to contribute to the account. I would suggest that you shoot for at least 10% of your gross pay, but anything is better than nothing. If you are really lucky, your company will match your contribution—that’s free money! Make sure you are contributing at least enough to get the full company match. Finally, you’ll need to make decisions about how your account is invested. Often, when just starting out, a target retirement date fund is a good choice.

That’s it! Pretty simple. During your working years, you’ll hardly notice the retirement account. But boy, do you start paying attention to it when it comes to start spending it. Going from living on a regular paycheck to living off of your retirement funds is often more difficult than saving is! In last week’s post, Are You Living Too Frugally, I discussed how we are seeing a trend of older clients holding on to a big pile of money and underspending in their retirement years. I believe the perfect retirement plan ends with a bounced check to the funeral service. Just kidding. Sort of.

When you look to replace your paycheck, you must consider your resources and start to develop a plan of action. Usually there will be Social Security income and maybe a pension. The rest of the cash flow that you need to fund your lifestyle will have to come from your savings. Hopefully, you’ll have some after-tax savings—maybe cash you received when you downsized and sold your longtime home. You might have an IRA or a 401(k) or 403(b) from your working years. Maybe you have a Roth IRA. More and more people do.

The question then becomes “What’s the best way to take money out of my accounts?” The answer, like most answers in the financial planning world, is “It depends.” In the above scenario, our fictitious retired couple has three buckets of money to choose from. They have their after-tax money from the sale of the house. This money has already been taxed at some point, and any cash flow that comes from this bucket is not taxable again, except for the interest, dividends, and capital gains the investments generate. Our couple also has a bucket of tax-deferred money, which comes from their IRA, 401(k), or other retirement accounts. Any cash flow coming out of these accounts will be taxed as ordinary income. Finally, they have a couple of Roth IRA accounts that they funded in the years leading up to retirement. This gives them a bucket of tax-free money.

By managing which bucket you take money out of to fund your cash flow needs, you can, to some degree, control the tax consequences of your retirement income. For example, you might want to take distributions from your post-tax bucket first. Any cash taken from this account is not taxable, except for tax that may be due on the interest, dividends, and capital gains. But that’s generally OK because capital gains tax rates are lower than ordinary income tax rates. And, depending upon your tax bracket, they may be tax-free.

If you are taking distributions from your retirement account, those funds are considered ordinary income. Monitor how much you are taking, and if you are getting close to moving into a higher tax bracket and still need cash flow, you can take some distributions from the tax-free pile, your Roth accounts.

Please remember, the example above is just that—an example. It is not a recommendation. We do, however, recommend that everyone review their individual situation by doing some tax planning. Having a distribution plan in place can help you get the cash flow that you need while lessening the tax bite on those treasured retirement dollars.

A Teaching Moment for Teachers

Our teachers are a very special group. They work long hours for low pay, helping to shape the minds of our young. They are a very important part of our society. So why do the local governments that they serve allow them to be taken advantage of when it comes to their retirement planning?

I am lucky enough to have several clients who are either retired teachers or are planning to be one. In my work with them, I get to know their financial situation pretty well. While teachers don’t make a lot of money, they are one of the few groups who still receive a pension. If they qualify, and most do, the pension provides a monthly income for the rest of their life. But since the benefit amount is based on their income, they won’t be getting rich from the pension. When you add in any Social Security benefits, most teachers will be able to maintain a “modest” lifestyle.

But what if the teacher wants a little more? What if they can save a little from each paycheck to improve that future retirement lifestyle? In the private sector, many of us have access to a company retirement plan; most often, it’s a 401(k). We can have money withheld from our paycheck and have it invested automatically for our future. Our contributions are deducted pre-tax, and grow tax-deferred over the years. Teachers have access to a similar plan, but for them it is known as a 403(b).

In the private sector, the employer selects an investment firm to handle the administration and investing of the plan’s assets. For our teachers, the School Board selects a handful of “approved” providers from which the teachers can place their retirement funds. The problem comes from this list of “approved” providers.

It has been shown, and it just makes sense, that the costs of an investment portfolio are a huge factor in its long-term performance. At Rall Capital Management, we know that we can’t control the financial markets, so we don’t try. Instead, we work to control what we can control, one of the most important being the costs involved in managing the account.

Most of the plan providers that teachers have to choose from are insurance companies. That usually means that the retirement contributions are being invested in an annuity contract, often with layers of different types of expenses. Most of the other providers on the “approved” list are investment firms that put together a menu of funds for teachers to choose from. All too often, the funds on the menu have very high expense ratios, creating an unnecessary headwind for account performance.

The expenses in the plans that are available to our teachers are among the highest. In fact, the New York Times did a 5-part report highlighting the abuses across the country. The first part of the series is entitled, “Think Your Retirement Plan is Bad? Talk To a Teacher.” I think the title says a lot. The article says a lot more. And it showed me that the problem is not just local to Brevard County’s teachers. It’s like this across the country. Why?

I’m not trying to be conspiratorial (or maybe I am) but I would dare to say that there’s some combination of politics and money at the core of the “approval” process. This system has been in place for years and any change is now subject to inertia. There’s not enough of a rank and file movement to improve the choices because most teachers don’t know. It’s been widely reported that most people don’t know how much they are paying to have their accounts managed. Teachers are no different.

It’s so much of a problem that I will typically advise my teacher clients to stop participating. What?? Advise a client to stop contributing to their retirement plan? No; we just advise them to redirect those contributions. Instead of investing in high cost annuities or other funds, I often recommend that they fund a Roth IRA instead. Roth IRA contributions are made with after-tax money and you lose the ability to have it taken directly from their paycheck, but that’s a small price to pay for the money you’ll save.

Inside the Roth, you can invest in low-cost funds that are often 1/10th the cost of many of the 403b accounts I’ve seen from my teacher clients. A 1-2% difference in costs over a number of years will make a huge difference in the value of your retirement account years from now.

One big difference between the 403(b) plan and the Roth IRA plan is the amount you can contribute. Like the private sector 401(k), participants in a 403(b) can contribute up to $18,000/year; $24,000 if you are over 50. You can only contribute $5,500 a year into a Roth IRA, or $6,500 if you are over 50. If you do have the ability to contribute more than the Roth maximum, one option would be to direct the excess to the 403(b) plan.

To become successful financially, you must do a lot of little things right. Not paying exorbitant investment expenses is one of those things.

So, if you are a teacher, here’s your homework: evaluate whether it makes more sense to fund your 403(b) account, or whether it would be better to fund a Roth IRA. If you are not a teacher, but you know one, please forward this article to him/her. They should know this!