People save for retirement all their lives. They do it through 401(k)s, IRAs, SEP, SIMPLE, pensions, annuities, real estate, and life insurance. But at retirement, it’s time to stop putting in and start taking out. The two questions I want to address are: How much money can you safely withdraw from your savings each year and expect them to last the rest of your life? AND Is one savings vehicle any better than another for providing retirement income?
Living off the interest:
The problem with living off the interest is that this doesn’t account for inflation. If your principle never grows and the cost-of-living goes up each year, then each year you’re purchasing power is slowly eroded. If the inflation rate were 3% for example, prices of goods would double every roughly every 25 years. If your income had been such that you could live off of it at the time you retired, it wouldn’t provide half of what you need if you survived until age 90.
The 4% Rule:
Typical financial advisors use what’s called the 4% Rule to plan for lifetime income for their clients. The idea is that if you withdraw 4% of your assets each year it supposedly allows you to keep up with inflation and ride the ups and downs of the stock market—assuming some of your assets are still exposed to market risk when you retire.
The problem with the 4% Rule, of course, is that it’s only 4%. If you had managed to save $1 million, for example, that would mean only $40,000 of income per year. It’s even worse if your money is in a Traditional IRA or 401(k). Remember those tax deductions you claimed when you put the money into the IRA? When you retire and start taking income out of your IRA/401(k), the IRS will tax every dollar as if it is income. So your $40,000 of income will look more like about $27,000. It’s very distressing to think that every million dollars of savings will only mean $27,000 of after-tax income.
What’s the best solution?
Choosing the best retirement planning vehicle is important. 401(k) plans and Traditional IRAs are attractive options because of the immediate tax deductions, but not only is the original contribution taxed when you withdraw it, but every dollar of interest and growth is also taxed. A Roth IRA on the other hand, offers much greater potential for tax-free income at retirement age.
As you approach retirement age, your investment strategy should be geared towards investments that protect your principal. Clients at retirement age should have minimal exposure to Wall Street type investments. Remember, anyone who retired with their money exposed to Wall Street in 2000 or 2007 lost 35-40% of their portfolio’s value when the markets crashed. Annuities purchased inside of a Roth account can provide over well over 4% annual returns and include cost-of-living adjustments.
Permanent life insurance is where the real magic happens. I think most people understand that you can cash out a permanent life insurance policy or borrow from it. I think the biggest misunderstanding about life insurance is that you are not borrowing from the policy’s cash value; you are borrowing against the policy’s cash value.
Why is this significant? Because it means that every dollar of your principle is still growing year after year. You are never truly withdrawing your money. And you are getting your income tax-free because it is a loan, not a withdrawal. Permanent life insurance allows for significantly more than 4% income each year. With proper planning, the death benefit can even replace the income you used so that you can leave your wealth to the next generation.