Author: Ryan Serrecchia
This article was originally published in The Street.
Many conscientious savers will dutifully prepare for retirement over several decades, setting aside money from every paycheck, evaluating and selecting appropriate investment options, practicing patience through market fluctuations and maintaining a long-term perspective. But as retirement draws nearer, a new mindset must be adopted — focusing more on distribution than accumulation.
To successfully navigate this transition, there are several important aspects to consider. Investors often have different sources of money they need to evaluate as retirement nears, and taxes are typically one of the greatest expenses for retirees. So a significant question becomes, “How do you manage the potential tax impact of these different buckets and devise a cohesive distribution strategy that minimizes taxes?”
Developing a systematic plan around these assets you’ve accumulated over the years is paramount. From stock options and restricted stock to Social Security benefits and Roth IRA conversions, I delve into some of the relevant considerations below.
Executives or corporate professionals may have buckets of money tied to the performance of company stock. These can include stock options and restricted stock, among other holdings. If you already have extensive company stock concentrations, it’s vital that they be unwound to reduce their liability and exposure while you move into retirement.
Stock options can be taxed in different ways, including as ordinary income or potentially at capital gains rates. So it’s important to evaluate and understand the different types of stock options you have, along with their potential tax impact. If you have a significant concentration in company stock, recognize how that will need to be factored into your liquidation strategy.
Restricted stock is essentially offered to employees as a bonus or performance metric. For instance, you may be granted a certain amount of shares that will not vest for a given time period. Once the vesting occurs, you receive these shares and are taxed at ordinary income rates.
The relative value is tied to the performance of the company. If you are granted 100 shares at $25, the initial value of that stock would be $2,500. But once it vests, perhaps five years later, it might be worth $5,000. Thus, there’s an incentive to continue working for the company and doing well by it.
In this scenario, you would be taxed at $5,000 in ordinary income when the stock vests. You might choose to sell those shares immediately and treat the money like a bonus. Alternatively, you might keep most of the stock, selling a portion to cover the taxes that you incurred and letting the remainder accumulate more value.
As we assess the respective situations of clients approaching retirement, we might develop a distribution strategy around deferred compensation or the liquidation of company stock. This decision depends on the age at which they plan to retire and the assets they’ve accumulated. While devising such a strategy, it’s important to address whether to accept Social Security benefits upon becoming eligible or potentially defer them.
The current age to receive full benefits ranges from 66 to 67, depending on the year you were born, while 62 is the minimum age to start receiving partial benefits. From a planning standpoint, deferring your benefit means it will increase by about 8% each year until you reach full retirement age. Conversely, you would be subject to an 8% reduction in benefits for every year you elect to receive them early. The difference between waiting until full retirement age versus starting to take partial benefits at 62 can thus add up to more than 30%.
If you’re eligible to take Social Security now, one factor potentially impacting the decision is whether you will be taxed on it, since up to 85% of this benefit can be subject to tax. For executives who have accumulated various buckets of money, we may need to reduce their exposure to company stock or help them start exiting deferred compensation they have received as a benefit. If these actions will generate enough income to sustain their lifestyle, it might be better to defer Social Security.
During this evaluation process, we seek to determine the “break-even age,” which is the difference between having that money today so it can be utilized to accumulate more, or deferring and hoping the higher benefit amount later will exceed what you would have accumulated by taking it earlier. There are times when it can make sense to take early benefits, but typically only if you have fewer income sources, need more predictable cash flow and won’t be taxed on the money.
It’s no secret that the Social Security system has made headlines in recent years, with various articles warning its current structure is unsustainable and the program will run out of money by the early 2030s. As a result, you might feel your most prudent course of action is to start receiving benefits as soon as possible. Although I do believe Social Security could eventually be means tested, with possible benefit reductions based on a person’s relative income, I don’t envision the system ever disappearing entirely.
The fundamental issue is that when Social Security was enacted in 1935, full benefits were made available to men and women at age 65, after the average life expectancy at the time. Life expectancy among Americans in 1935 was just 59.9 years for men and 63.9 for women, with a combined expectancy of 61.7. And yet we can claim Social Security at about the same age, more than ten years before our average life expectancy (In 2018, life expectancy had reached 78.7 years for the total U.S. population).
The system has clearly not evolved to reflect this reality. As a result, by most financial estimates, Social Security will not be able to provide the full benefits that have been promised over the long term. But the math required to provide solvency is simple — raise the full retirement age to at least 70, and the system will probably function effectively for another 30 or 40 years.
For younger people, that may mean planning for a higher Social Security age when calculating their retirement plans.
Another avenue worth potential exploration for retirees and near-retirees adopting distribution mentalities is a Roth IRA conversion. If you’re evaluating whether to pursue this option, the key is to identify opportunities where you will have lower income and thus a decreased tax rate.
For some people, that could happen early in retirement. For an executive or corporate professional, it may depend on the distribution or liquidation strategy related to their assets or retirement plans. But if your income decreases for any period of time, it can make sense to conduct a Roth conversion with IRA funds that are subject to required minimum distributions.
The moment that conversion is executed and taxed, you would have less money to your name. Accordingly, as with our Social Security evaluation, we try to assess the break-even age when your assets post-conversion would catch up to their level without a conversion. How likely you are to reach that age influences whether the decision would make sense or not.
With all of these strategies, I recommend being cognizant of your income and its potential impact on taxes. A higher income bracket means not only increased capital gains tax but potentially elevated Medicare premiums. The question essentially becomes, “How much income should you elect to receive in a given year based on your personal tax situation?”
Determining the correct answer often requires significant analysis and expertise, which is why consulting a knowledgeable financial advisor might prove beneficial. But whatever course you pursue, remember that transitioning from the accumulation to distribution phase of your financial plan goes far beyond simply changing your mindset and can entail extensive tactical modifications as well.
Ryan Serrecchia, CFP®, is Executive Vice President and Partner at EP Wealth Advisors in the firm’s Orange County, California, office. His client base includes small business owners, lawyers, doctors, executives and employees of publicly traded companies, real estate investors, divorcees, widows, and retirees. In his work with clients, Ryan addresses their finances, investments and taxes in relation to their goals. He has over 20 years of experience in financial services.