Planning retirement distributions from IRAs and similar accounts to adjust for cost of living. (Individual retirement accounts)(Personal Financial Planning)by Crommett, Alfred F.
It also seems odd that while cost-of-living adjustments (COLAs) are readily available in IRAs and 401(K)s, few people are informed about their availability and concepts.
Consider These Facts
1. A House of Representatives subcommittee on retirement income and employment heard testimony that only 4% of American retirees have protection from inflation in their pensions!
2. The current IRS life expectancy tables indicate that two people, ages 65 and 63, can expect that one of them could live for 26 more years to age 91 or 89! (IRS Publication 575, page 63.)
3. One hundred thousand dollars invested at 8% could provide $705 fixed monthly retirement income to age 95 and beyond. Under the mild 4% inflation rate, however, the purchasing power of this plan would drop by 64% down to $254 per month after 25 years!
4. Conversely, by using the IRS Minimum Distribution Formula, the same $100,000 invested at 8% in an IRA could provide payments beginning at $321 per month, but these payments could rise to $1,419 per month in 25 years or $511 per month when adjusted for 4% inflation! (See Figure 1.)
Any mention of COLAs in retirement has usually been restricted to increases in social security benefits. Thus, the concept of a COLA in a qualified plan distribution has not been recognized.
COLA Effect of Minimum
Creation of COLAs in an IRA is dependent on an understanding of the various minimum distribution methods permitted by the IRS.
To calculate a minimum distribution at age 70 1/2; the IRS requires that life expectancy be divided into the December 31 balance in a tax- deferred fund. The desired COLA effect will not appear, however, until the next year's calculation. In the second and succeeding years, life expectancy values decline while in the early years the fund's year end balance increases because of earnings in excess of withdrawals, thus producing larger distributions each year.
Mr. Robert Preston, a CPA and actuary, pointed out in his retirement newsletter, The Preston Report for Mar/Apr 1990: "Each year, from age 70 onward, your distributions from any IRA will get larger and larger. The intent of Congress (in making distributions larger) was to assure all (or most) IRA monies are used up by death, i.e., IRAs are not to be used as a vehicle to transfer wealth between generations."
While mandatory at age 70, minimum formula withdrawals can be started at age 59 1/2, or even earlier, if permanent disability exists; or if a plan of "substantially equal periodic payments" and other IRS requirements are carefully evaluated.
The IRS minimum distribution method can be used with after-tax funds as a means of creating and managing any income plan. For example, a bank trust department charged with managing money for a retarded child or adult could use the formula to create a payment plan that would meet inflationary needs over a long term.
The IRS minimum formula may not be wise for all retirees. There is a trade-off. The fixed plan payment starts at a higher amount; while a minimum distribution payment begins at a lower amount.
After about 10 years of COLA increases, however, the minimum plan payments are about equal to the fixed plan payments and the COLA increases continue for about another 15 years.
This trade-off decision is typical of the human conflict between the demand for early gratification on the one hand and deferral of gratification in return for the prospects of a better life later on the other hand.
Those with limited retirement resources might want to start retirement with the higher, fixed plan. However, many of those with more discretionary retirement resources would probably opt for the COLA plan, because of the potential of higher pay-outs later. The full impact of now versus later is presented more clearly in Figure 2 and 3.
Financial planners frequently advise retirees to save some of their retirement income to offset inflation in the future. These savings, however, must come from
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deferment of taxable income. By retaining some income that might otherwise be paid out, the IRS minimum distribution formula allows for overall greater tax-deferred growth in the account.
Two Methods of Calculating
The IRS recognizes two different methods of factoring life expectancy into the calculation of annual distributions. Each method produces different distribution amounts and remaining terms for pay-out of the balance in the account. The non-recalculation method acts to exhaust retirement funds sooner than the second method, called the recalculation method.
Both methods determine a minimum annual distribution amount by dividing the account balance at the beginning of the year by the remaining life expectancy. The non-recalculation method requires only one "loopk-up" in the IRS Life Expectancy Table to find a value for the first year of retirement. Life expectancy values for each succeeding year after retirement are determined by reducing each prior year by exactly one. The fund is exhausted when life expectancy calculated in the first year of retirement is reached.
The recalculation method requires a "look-up" to find the life expectancy value for each year after retirement. The life expectancy values in the table do not decline by one each year. For example life expectancy at age 65 is 26 years, whereas life expectancy at age 66 is 25.1, a decline of nine tenths of a year. The higher life expectancy in the recalculation method results in lower annual distribution after the first year of retirement and thus permits pay-outs to continud for many years longer (age 95 and beyond).
A variation of the IRS minimum plan starts with the IRS minimum recalculated formula, but adds an additional distribution based on interest earnings, on declining life expectancy values, and on a selected extra income factor. The calculations for this are complex, and the use of an electronic spreadsheet template or other software assistance is of great help.
Another variation provides COLAs at half of the average interest rate. With average earnings at 8%, COLAs are calculated at 4%. A "what-if' routine is necessary to find the correct initial monthly payment that will not result in a 50% under-withdrawal penalty at any later time.
CPA planners can help to rectify the fixed income versus inflation dilemma. They are uniquely qualified and positioned to inform their clients about the availability of COLAs in retirement; that fixed income--a good option for some people--is not the only option; and that COLAs don't have to come to a halt when employment stops.
Most benefit-based retirement plan have historically offered only fixed payment options. In the days of shorter life expectancies after retirement, this was not a widespread problem. This is not so today, when life expectancies are longer and inflation has more time to reduce the purchasing power of retirees.
Helpful Suggestions for Clients
* Clients should be urged to ask their benefits administrators if distribution options that result in COLA-type protection are available. If unavailable, the pension committees should be asked to look into the possibility of offering such an option. If still not available, it might be suggested that a client ask for a lump sum distribution that could be transferred or rolled over to a custodian who would administer a COLA type distribution schedule. Your client should not wait; not all plans would permit a lump-sum distribution.
* If a client has an annuity of any kind, or a mutual fund intended for retirement, the carrier should be asked to present the COLA options as well as the standard payout options.
* Consider using graphs or hand-drawn sketches similar to Figures 2 and 3 to show clients both sides of the fixed versus COLA concpets, so that a more informed decision can be made.
The accountant can help the client see more clearly where different income options could lead over a span of 10 to 20 years of retirement.
Sources of Information
Accountants who are interested in the income side of retirement planning can obtain retirement cash flow software by writing to Alfred F. Crommett, The IRA Annuity Generator, 32 Bruce Avenue, Shrewsbury, Mass. 01545, or by calling (508) 842-8154. The cost is $69.
The Retirement Benefits Institute offers accountants a software package on pre-59 1/2 and/or grandfather distributions. The institute can be reached at P.O. Box 14310, Cleveland, Ohio 44114-9523, or at (216) 566-0207. The cost of an annual subscription is $195.
Readers needing consultation on retirement strategy or actuarial computations can reach Mr. Robert Preston at 57 North St., Suite 322, Danbury, CT 06810; or (203) 790-4556.
IRS Pub. 575 and 590 are official guides to qualified plan distributors. Prop. Regs. 1.401(a)(9).1 and .2 give IRS questions and answers to distribution rules for qualified plans.
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