The 80% Myth

The 80% myth is what I call the belief that many people have about how much they are going to spend in retirement, and thus how much in assets is enough to retire. The belief is that retirees should be prepared to live on 80% of pre-retirement income. As a planner, I believe this approach is far too simplistic and can leave a lot to be overlooked. Hind-sight is always 20/20, however when it comes to retirement, my preference is to be as prepared as possible, I’m sure you feel the same way.

Preparing for retirement simply by assuming you can, or will have to live on 80% of what you are earning right now is inherently flawed. If you don’t believe me, ask yourself the following questions:

• Have I ever tried to live on 80% of what I make? How did it feel?
• What am I living on right now?
• Am I sure this is what I am living on right now? Does my work provide any perks that won’t be provided in retirement (vehicle allowance, health insurance, etc.)?
• Am I effectively saving and budgeting, or am I spending every dollar I make?What expenses do
• I have right now that I won’t have in retirement?
• What expenses will I have in retirement that I don’t have right now?

How did you respond to the questions posed above? Did any of your answers surprise you? Do you feel you have an accurate picture of your living costs?

The first step in truly preparing for retirement is figuring out what it costs you to live currently, and, as one of the questions above encourages you to do, make sure it’s a true picture. Put a pencil and paper (or Excel worksheet) to the task and begin to investigate your monthly/annual expenses. Be sure to be as specific as possible and to include as much discretionary spending as possible. Don’t just write down the basic survival costs. Don’t forget about any and all of the perks that your practice may provide to you (vehicle allowance, health insurance, travel, etc.) these costs may still exist in retirement, however they are often overlooked when preparing the pre-retirement budget.

Aside from overlooking “practice perks” another common mistake that clients approaching retirement make is assuming they will automatically spend less in retirement than they spent in working years. This is not necessarily true, in fact one expert, and I happen to agree, has found that Doctors tend to spend more money in their first years of retirement then they had anticipated. This could be for a variety of reasons, not the least of which being that in the first years of retirement, retirees are still enjoying good health and active lifestyles.

Step two in this process is to begin to design a budget for your retirement years. Start thinking about what expenses will still exist, and which ones may not. For example, if you have hobbies like boating or travelling, you will probably continue to enjoy these in retirement, and the costs must be planned for. However, you may also have paid your mortgage off, so that is one expense that may not exist in your retirement budget. It will also be important to factor inflation into the calculation.

As you can see by know, and probably knew already, planning for retirement is more complicated that just assuming that you will have to drop your standard of living down to a point where you can support it on 80% of your current income. Hopefully, I’ve given you enough information to begin to think about what it will truly cost you to live in retirement. Fortunately, with appropriate planning and saving, you will have a long and enjoyable retirement ahead.

Taking the Back Road to Roth

File your taxes, pay your taxes, let’s face it, you have a lot to do by April 15, 2009.

There is one other thing you might want to consider doing on or by April 15, 2009 and that is fund your IRA for 2008. That’s right, the IRS says that you have until April 15, 2009 to make a 2008 contribution to your IRA. This rule applies to both Roth and Traditional IRAs. The contribution limit for a 2008 IRA contribution is $5,000 if you are under 50, and $6,000 if you are age 50 or over. You can make a contribution up to these amounts as long as you have at least that much earned income. However there is a catch, if your adjusted gross income is above certain thresholds (limits depend on filing status), you probably already know that you can’t contribute to a Roth (after tax) IRA, and can’t deduct a contribution to a traditional (tax deductible) IRA

So what are you to do if you can’t contribute to a Roth and can’t deduct contributions to a Traditional IRA? The answer: Contribute to a non-deductible IRA.


Types of IRAs, a Quick Breakdown:
When an investor funds a traditional IRA they can sometimes deduct contributions made to that account. The investments then grow tax-free until retirement (age 59 ½) and are taxed at the regular income tax rates of that time upon withdrawal.

When an investor funds a Roth IRA however, there is not an immediate tax deduction. However, investments grow tax free until retirement (age 59 ½), and are then withdrawn tax-free. A great tool if you think you will be in the same tax bracket, or a higher tax bracket when you are planning on withdrawing assets.

If an investor opens a non-deductible IRA, they are essentially using a traditional IRA but foregoing the tax deduction. Then, upon retirement, (age 59 1/2 ) money is withdrawn using a ratio of contribution to investment earnings. For example, if an investor contributes $40,000 to a non deductible IRA that grows to $100,000 by retirement, 60% of all the withdrawals from that account are taxed as ordinary income. The remaining 40% of withdrawals are considered a return of basis to the investor and not taxed.


Until recently, contributing to a non-deductible IRA was barely worth investigating because you couldn’t deduct contributions, you can’t fund at a very high level, and withdrawals were partially taxable upon retirement, so why even bother?


Here’s why to bother:
In May of 2006 President Bush signed a bill that lifted the income limitation on Roth IRAs in 2010. This means that in 2010 there will be no income limitation on people who would like to convert their traditional IRAs to Roth. So in preparation for this magical year in financial planning, it could be appropriate for some clients to fund traditional (non-deductible) IRAs each year until the 2010 income limits are lifted. This will allow contributions to be built up for a few years then converted to a Roth IRA.


Getting in through the back door:
As I mentioned above, it may be appropriate for some clients to examine opening non-deductible IRAs to fund for the next few years until 2010. This way, in 2010 when the income limit on Roth IRA conversions is lifted, investors will be able to convert their non-deductible IRAs to Roth IRAs, paying only the tax on what investment gains the non-deductible IRAs will have experienced in those few years. Best of all, you don’t have to pay all the tax in 2011. The IRS has decided to let you split the tax on the a 2010 Roth conversion, paying half if 2011 and half in 2012! This is true as long as the funds aren’t immediately withdrawn from the Roth IRA following conversion.

Once the conversion to Roth is made, the investments can be withdrawn upon retirement tax free. In essence, using the non-deductible/Roth conversion strategy, allows investors who ordinarily wouldn’t be able to take advantage of the benefits of a Roth to get some of their retirement funds in position to take advantage of Roth tax treatment.

What if I already have a traditional IRA where some contributions have been deducted and some have not:

If you are like many investors, you probably have made some deductible contributions and some non-deductible IRA contributions. Unfortunately, for purposes of converting a traditional IRA to a Roth, the IRS does not separate deductible and non-deductible IRAs and all IRA earnings will be prorated to calculate tax in a conversion situation. This puts the burden of calculating basis in the IRA and historic deductibility on the shoulders of the investor. Furthermore, if contributions were deducted, they will be treated as earnings for purposes of a conversion. This means that you will have to pay tax at conversion on contributions you previously deducted as well as the earnings.


However, this is but only a minor setback. If you have a traditional IRA and want also to fund a non-deductible IRAs for the coming years, it may be possible (depending on plan provisions) to roll your traditional IRA into a 401(k). Once done, new IRAs could be opened and funded as non-deductible. This way, in 2010 your old IRAs are out of the picture (and into your 401(k)) for conversion purposes, and you only convert what you know to be non deductible.

Funding a non-deductible IRA until 2010 can be a very beneficial technique. If taken advantage of, using this strategy could allow you to establish a small, after-tax nest egg that can grow in the coming years tax free and be withdrawn at retirement with no tax. I encourage you to examine this option if you think it will work for you.

Introduction

Dear Readers,

Welcome to Your Financial Treatment Plan. Your Financial Treatment Plan is a blog I have established and will maintain to help address financial questions and issues as they relate to dentists. I will be adding new posts on a monthly basis, and more often if someone poses a question or something happens in the economy that I think it would be beneficial to address.

Right now, I would like to take this opportunity to introduce myself, and my firm. My name is Ted Schumann, II. I am a client service adviser with the DBS Companies. The professionals of the DBS Companies are in the business of helping dentists achieve their goals and improve the quality of their lives.


The DBS Companies are a one-stop financial services firm for dentists. The services we offer include:

• Dental Practice Brokerage and Appraisal
• Dental Practice Buyer Representation
• Monthly Accounting
• Tax Preparation and Planning
• Financial and Retirement Planning
• Fee-only Investment Advice
• Practice Management Consulting

In addition to these services we are also very proud to host our monthly study club, the TBTI Study Club. TBTI Study Club is held on a monthly basis and alternates in location between the Holiday Inn Gateway Centre in Flint, MI and Laurel Manor in Livonia, MI. We cover a variety of topics at the study club including associateships, retirement planning, effective scheduling, marketing and more.

I hope you find this blog interesting and insightful. I encourage you to consider myself, and this blog a resource for any questions you have that I may be able to address. If there is a topic that you would like me to address, please let me know.

Best,

-Ted Schumann II