Retirement Withdrawal Strategies WITHDRAWAL STRATEGIES DURING RETIREMENT MEET MARY ELLEN DUGGAN. I. Taking inventory of available resources

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1 Retirement Withdrawal Strategies Not FDIC-insured. Not bank-guaranteed. May lose value. Dreyfus Service Corporation, Distributor CONVERGENT RETIREMENT PLAN SOLUTIONS, LLC WITHDRAWAL STRATEGIES DURING RETIREMENT I. Taking inventory of available resources II. Selecting a sustainable withdrawal strategy III. Reducing taxes and avoiding penalties MEET MARY ELLEN DUGGAN Status: Single, Age 50 Retirement Goal: Age 55 Reality: She s ready now. Financial situation: With real estate assets totaling over $2.5 million. Mary Ellen feels that she has enough to retire comfortably. Mary Ellen needs to ensure that she has enough liquidity in her portfolio to give her ready access to cash, and a steady source of income. She knows she needs the help of a financial advisor but has not spoken to hers in almost a year and doubts that he has the knowledge and experience to be of help to her. 1

2 TAKING INVENTORY Consider all Resources Not just discretionary resources 360º View of Available Resources Necessary to determine most strategic liquidation/withdrawal strategy Opens door to asset consolidation discussions Adapt a Formalized Process for Taking Inventory Builds credibility Ensures consistency TAKING INVENTORY Annuity-Type Income Social Security Pensions Discretionary Income Sources Taxable Savings Tax-Sheltered Savings Tax-Qualified Assets (IRA, 401(k), etc.) Nonqualified Tax-Sheltered Annuities Nonqualified Deferred Compensation Tax-Free Savings (Roth IRA, Roth 401(k)) Other Available Assets Real Estate Life Insurance, etc. CREATING A BUDGET What the experts tell us: 70% to 80% Good starting point at best For most, retirement income needs change over time 2

3 PROJECTING CURRENT AND FUTURE INCOME NEEDS Consider dividing projected expenses into two basic categories: 1. Baseline income needs 2. Lifestyle income objectives Compare projected baseline income needs against projected income from annuity-type sources Identify potential baseline income gap BASELINE INCOME NEEDS There are the Basics... Food/Shelter Auto Insurance Utilities, etc. But Don t Forget... Health Insurance LTC Insurance Financial Planning Prescription Drugs, etc. BASELINE INCOME: SAMPLE GAP ANALYSIS Projected Baseline Income Need (after-tax): $100,000/yr. - Less Projected Social Security Income: - $ 28,000/yr. - Less Projected Pension Income (after tax): - $ 40,000/yr. Projected Baseline Income Gap: - $ 32,000/yr. Are any of the projected Social Security benefits likely to be taxable prior to Social Security full retirement age? Will the pension payments be increased in the future for cost-of-living adjustments? How much of the client s discretionary assets will need to be earmarked for generating the income necessary to close the baseline income gap? 3

4 GENERATING RETIREMENT INCOME FROM DISCRETIONARY ASSETS Systematic Withdrawal Programs Variable Annuities Immediate Income Annuities Fixed versus Variable Living Benefit Riders Hybrid Arrangements SUSTAINABLE WITHDRAWAL RATES Experts continue to disagree on what constitutes a safe or sustainable withdrawal rate Methods for calculating systematic withdrawals vary Static versus market-sensitive % initial balance versus % current balance Indexing for inflation Longevity risk is a key factor Ongoing research continues to place downward pressure on what actually constitutes a truly safe withdrawal rate SUSTAINABLE WITHDRAWAL RATE: TIME HORIZON CONSIDERATIONS Chances of Living Beyond Age 65 To Age: Single Female Single Male At Least One Member of a Married Couple 85 53% 41% 72% 90 32% 20% 45% 95 13% 6% 18% Source: Derived from statistics published by the Society of Actuaries. 4

5 SELECTING A SUSTAINABLE WITHDRAWAL STRATEGY Payout Period Inflation Adjusted Portfolio Success Rates: 1926 to 1995 (75% Stocks/25% Bonds) 3% Withdrawal Rate as a % of Initial Portfolio Value: 4% 5% 6% 7% 8% 15 Years 95% 82% 68% 20 Years 90% 75% 61% 51% 25 Years 85% 65% 50% 37% 30 Years 98% 83% 68% 49% 34% Source: Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable, AAII Journal, February 1998, Volume XX, No. 2. SUSTAINABLE WITHDRAWAL RATE Quandary: The more conservative the withdrawal rate used, the less likely the client is to outlive his or her financial resources. However, extremely conservative withdrawal rates are arguably quite inefficient from a consumption perspective (i.e., the more conservative the withdrawal rate, the greater the likelihood of significant residual assets remaining at death). THE IMPLICATIONS OF DOLLAR COST RAVAGING Beginning Balance: $100,000 Annual Distribution: $5,000 R e t u r n 25% 20% 15% 10% 5% 0% -5% % -15% -20% Years Average Annual Return: 7% Time Horizon: 30 Years Portfolio Value YR. 20: $167,639 YR 25: $204,357 YR. 30: $256,205 Portfolio Value YR. 20: $22,481 YR 25: $5,014 YR. 30: $0 5

6 STRATEGIES FOR CREATING A SUSTAINABLE WITHDRAWAL PLAN Begin transitioning investment strategy for withdrawals prior to retirement Consider adjusting annual withdrawal rate to coincide with market downturns Factor in potential future reductions in purchasing power for annuity-type income sources that are not inflation adjusted Consider modifying retirement date or income expectations when circumstances warrant Explore potential use of longevity risk mitigation alternatives such as annuities and longevity insurance CONVENTIONAL WITHDRAWAL HIERARCHY 1. Taxable 2. Capital Taxable I Capital II Tax-Deferred III 3. Tax-Deferred 4. Roth Roth IV WITHDRAWAL HIERARCHY: SPECIAL CONSIDERATIONS Liquidation timing considerations Market conditions Surrender charges Anticipated change in personal tax liability Avoiding taxation of Social Security benefits Potential option for full/partial Roth IRA conversion Pending changes/sunset provisions in current tax law 6

7 EXAMPLE: POSSIBLE EXCEPTIONS TO TRADITIONAL WITHDRAWAL HIERARCHY Taxable $40,000 $40,000 Capital $500,000 $15,000 Tax-Deferred $450,000 Income Need for Current Year: $50,000 Roth $200,000 MAKE MINE A ROTH The Potential Wealth Transfer Implications of Roth IRA Conversions $6,000,000 1st Generation 2nd Generation $5,000,000 $4.98M $100,000 Roth IRA conversion in 2005, IRA holder and spouse beneficiary born 1/1/1940, 1 st $4,000,000 generation income tax rate = 35%, $3,000,000 $2.88M $4,182,406 2 nd generation beneficiary born 1/1/1975, 2 nd generation beneficiary income tax rate = 28%, conversion taxes paid out of pocket, zero $2,000,000 $2,239,804 consumption by 1 st and 2 nd generation beneficiaries throughout $1,000,000 projection. $0 637,000 $799,000 Traditional IRA Roth Conversion THE 10% EARLY DISTRIBUTION PENALTY Typically applies to taxable withdrawals of retirement plan assets taken prior to age 59½ Two key penalty exceptions* Separation from service after age 55 Separation from service after age 50 (governmental DB plans only) Substantially equal periodic payments *Additional penalty exceptions exist under IRC Sec. 72(t). 7

8 Minimizing Taxes and Penalties AVOIDING THE IRS EARLY DISTRIBUTION PENALTY Three safe harbor methods for calculating substantially equal periodic payments: RMD method Amortization method Annuitization method Must continue payments until the later of Five years, or Age 59½ Election is made on an individual IRA basis SUBSTANTIALLY EQUAL PERIODIC PAYMENTS Comparing the Three Safe Harbor Methods RMD Method Amortization Method Annuity Method Assumptions Monthly Distribution $3,000 $2,500 $2,000 $1,500 $1,000 $500 $ Age IRA Holder DOB: 1/1/1955 Spouse Bene. DOB: 1/1/1958 Start Date: June 2006 Withdrawal Frequency: Monthly Earning assumption for RMD Method: 8% Interest Rate Assumption for Amortization and Annuity Method: 5.2% (120% Applicable Federal Mid-Term Rate for May 2006) Life expectancy: Uniform Life Expectancy Table SUBSTANTIALLY EQUAL PERIODIC PAYMENTS: STRATEGIES FOR DIALING IN DESIRED INCOME AMOUNT Safe harbor calculation method Life expectancy options Single life expectancy Joint life expectancy Uniform life expectancy Interest rate assumption (amortization and annuity methods only) Adjusting IRA balance via rollovers/transfers prior to start date 8

9 SUBSTANTIALLY EQUAL PERIODIC PAYMENTS Individual s Age: 51 Applicable Federal Rate: 4.73% Target Dtbn. Amount: $1,500/mo. Safe Harbor: Annuity Method Option #1: Single IRA Option #2:Split IRA $500,000 A $290,000 B $210,000 Rate Assumption: 2.5% Life Expectancy: Joint (51/48) Disadvantages: All IRA Assets Tied Up Any Unscheduled IRA Distributions Will Trigger Retroactive 10% Early Withdrawal Penalty Rate Assumption: 5.2% Life Expectancy: Single (51) Advantages: IRA-B Available for Penalty-Free Distributions at Age 59½ Discretionary Distributions from IRA-B Will Not Affect Series of Substantially Equal Periodic Payments from IRA-A SUBSTANTIALLY EQUAL PERIODIC PAYMENTS Impact of Life Expectancy Election Safe Harbor Method RMD Method Uniform Life Expectancy Table $915 Life Expectancy Option Joint Life Expectancy Table $1,026 Single Life Expectancy Table $1,251 Amortization Method $2,350 $2,419 $2,596 Annuity Method $2,700 $2,700 $2,700 Assumptions: IRA Holder DOB 1/1/1955, Interest rate assumption 5.2%, Spouse bene. DOB 1/1/1958, Beginning IRA Balance $500,000 SUBSTANTIALLY EQUAL PERIODIC PAYMENTS Impact of Interest Rate Assumption Safe Harbor Method Interest Rate Assumption (Based on Monthly Mid-Term AFR for May 2006: 4.73%) 80% AFR 120% AFR RMD Method Amortization Method Annuity Method $1,016 $1,982 $2,264 $1,016 $2,419 $2,700 Assumptions: IRA Holder DOB 1/1/1955, Monthly Distributions, Joint Life Expectancy, Spouse bene. DOB 1/1/1958, Beginning IRA Balance $500,000 9

10 EMPLOYER SECURITIES: NET UNREALIZED APPRECIATION Employer securities in retirement plans often qualify for special tax treatment Opportunity for tax on net unrealized appreciation (NUA) to be deferred until securities are sold If rolled to IRA, NUA is taxed as ordinary income upon distribution from IRA If not rolled to IRA, NUA is taxed at capital gains rates when securities sold Best course of action depends on facts and circumstances EMPLOYER SECURITIES: NET UNREALIZED APPRECIATION Option #1: Complete Rollover 401(k) Plan ($500,000) $500,000 Rollover Rollover IRA Facts Value of Employer Securities: $200,000 Cost Basis in Employer Securities: $40,000 Entire Balance Rolled Over on 11/15/05 Joe Begins Systematic IRA Withdrawals of $1,500/mo. on 1/1/06 $1,500/mo. IRA Withdrawals Results No Tax Liability on 401(k) Distribution in 2005 IRA Withdrawals (Including NUA) Taxed at Ordinary Income Tax Rates EMPLOYER SECURITIES: NET UNREALIZED APPRECIATION Option #2: Partial Rollover 401(k) Plan ($500,000) $300,000 Rollover Rollover IRA Facts $200,000 Employer Securities Value of Employer Securities: $200,000 Cost Basis in Employer Securities: $40,000 Joe Begins Systematic IRA Withdrawals of $1,500/mo. on 1/1/06 $1,500/mo. IRA Withdrawals Results $40,000 Cost Basis Taxable in 2005 (as Ordinary Income) IRA Withdrawals Taxed at Ordinary Income Tax Rates NUA Taxed at Capital Gains Rates when Securities Sold Opportunity for Stepped-Up Basis for Heirs 10

11 EMPLOYER SECURITIES: NET UNREALIZED APPRECIATION Circumstances that Tend to Favor Rollover Intend to liquidate employer securities in near future The ratio of NUA to cost basis is relatively low Concerned about future increases in capital gains rate Circumstances that Tend to Favor Distribution Intend to hold employer securities for a relatively long time The ratio of NUA to cost basis is relatively high Higher income tax bracket (greater disparity between ordinary tax rate and capital gain rate) WITHDRAWAL STRATEGIES DURING RETIREMENT Taking inventory of available resources Selecting a sustainable withdrawal strategy Minimizing taxes and penalties You re Important to the Process Planning Understanding Trust Building Expertise During pre-retirement planning, a substantial number of investors consolidate advisors!* * McKinsey Retirement Affluent Consumer Survey,

12 ROLE OF THE ADVISOR Adequate preparation can help lessen negative feelings associated with uncertainty of retirement Positive Uninformed Optimism (Honeymoon Period) Completion Mood Informed Optimism Time Informed Pessimism Negative Source: Adapted from Used with author s permission. Path to Partnership Dreyfus Commitment -10 Modules - Regional Retirement Specialists - Dedicated Investment Analyst & Internal Specialist to Build Appropriate Portfolios Your Commitment - Dreyfus as Top 3 Fund Partner Next Step: Give Me Your Card Questions? 12

13 Investors should consider the investment objectives, risks, charges, and expenses of any fund carefully before investing. Investors should receive a prospectus that contains this and other information about the fund, and should be advised to read it carefully before investing. This information is general in nature and not intended to constitute tax advice. Clients should always check with their tax or legal advisor before engaging in any transaction regarding IRAs or any other tax qualified investment. Thank you! Not FDIC-insured. Not bank-guaranteed. May lose value. Dreyfus Service Corporation, Distributor CONVERGENT RETIREMENT PLAN SOLUTIONS, LLC BKR-PWSPRS