Katie Nealis:
So the first question we have is, we are 65 years old, and we are getting ready to retire. And our first question is, can we retire?
Tom Vaughan:
Alright, let me share my screen. This is a great question to ask, right? I mean, they’re not quite retired, but the right at that retirement age, they’d like to retire. But before they decide to retire, it would be a really good idea to really stress test that and see if it’s going to work, you know, before you quit, it’s always nice to see if that’s a good idea. And so what I call is the retirement path, you need to find your retirement path. And one of the things that I think is super important is that there are you know, you kind of have your own path, everybody has a different path, but there’s a lot of commonalities. And unfortunately, there’s a lot of wrong paths for people. So we’re going to kind of talk about, you know, what to watch out for, here. And then you know, what to, you know, really look for and what parts of the path, you need to look at as far as that goes. So, I’ll start off just showing you a sample client here. And literally, I named these people Joe and Jane sample. And so this is one of the data pages, just so you know, what we’re looking at here, you know, and they’re both both born on the same day, I just wanted to keep things simple. Interestingly enough, I have one client who couple who were both born born on the same day, same year, that’s kind of cool. Anyway, and they both have the same income, they live here in California, etc. So just some basic information about their background. And then here’s another area that’s kind of interesting is just, you got to pick an age to plan to. And that’s obviously very difficult, none of us know how long we’re going to live, as far as that goes.
And so in this particular station, I’ve just chose to age 95, as a, you know, a point of time to plan to as far as that goes. And so that’s, that’s, I think, an important you know, piece of it, you can go shorter, you can go longer. And one of the biggest advantages of this financial planning process is you can try out all kinds of different things very easy when we do plans they’re live. And we can go back and say, Hey, somebody thinks they’re gonna live shorter or longer, or what have you, we can change it and see what type of an impact that has as far as that goes. All right. So the next piece here is around their goals. And this is just some of the basic information that we want to do here, we want to figure out what it is that they’re trying to accomplish in their retirement. So we’ve gone through this process with Joe and Jane, and they’ve said, Hey, we need 7000 a month for our basic living expenses. For us basic living expenses are everything that’s not already on this list, and not including tax. And so they said 7000 a month, which comes out to 84,000. They do have a mortgage $22,008 a year is being spent on their mortgage, it’ll be paid off in 2042. So that’s another area should we pay it off early, should we not and what have you there, once they retire, they’re going to sign up for Medicare. This is the average in our area right now about 50 $716.
We also put hearing aids and dentistry in there, we randomly chose years base age 80. And as 85. Oftentimes, we get calls for these, that’s why we put this in the plan, people aren’t covered for hearing aids, or if they are, they’re not getting the ones they want. They’re not covered enough for the dentistry, some of that’s kind of expensive. So we have something in there, maybe they don’t use it, but maybe something gets used someplace else. But that’s what that’s for. And then obviously keep up your home, they own a home. So I got 3000 a year going, they want to travel in retirement. So 20,000 for retirement, I mean for travel per year, they buy a car every 10 years. So we got 40,000 for that. And then they have grandkids, and they would like to put $2,000 a year towards their grandkids, you know, college education. So that’s all of their wants, and needs and wishes the things that they’re really trying to, you know, accomplish throughout their life.
Easan Arulanantham:
So there’s the outflow, how do we achieve that outflow and make sure it’s going to work? And how do we test to see what would happen in the future? So whatever, they’re kind of like big, do we always put every kind of expense we can think of? Or do we only put like the big ones, like the big capital expenditures?
Tom Vaughan:
Yeah, we break out, we could put it all in one number. And, you know, add up all of these and put them in one number. But there’s two reasons we break it out. Number one is, you know, just there’s some interest areas, college savings or travel and some of those types of things. But the other reason we break things as because some of them just grow a lot faster than inflation. So for example, Medicare is always broken out because the cost of medical in general grows faster than average inflation. So yeah, it’s it’s, it’s a little bit more of an art and a science in some regards, and what what the key here is that We go back every six months and have a strategy session with the client. So as they retire, six months, 12 months, 18 months, 24 months, etc, we’re constantly going back and looking at this plan. And then we can really see, you know, for sure, okay, this works, or this doesn’t work or this expenses inaccurate or what have you. And there’s just a constant evolution of kind of, you know how you work on that. But yeah, it’s a, it’s an interesting area, it’s, it’s important to get it pretty close. But getting an exact I mean, life is not a straight line, you know, so it’s always a little bit of a challenge. So here’s some of the incomes coming in. So let’s just say they’re going to take Social Security. Now, if they retire at 65, might not be the best option, but we’ll use that as a base case, Joe is going to get 32,000 and change, and Jane is going to get 24,000 and change. So even though they’re making the same amount of money, Jane was home for a while taking care of the kids before she re entered the workforce. So she’s getting a little bit more. And so that’s in there, we also have their assets. So they both have $750,000 in their 401k, $100,000. And joint checking and savings accounts, you know, bank tight money, and $900,000 and kind of like brokerage accounts, taxable if they, you know, move it type of thing. And, you know, everything in here is invested except for the cash savings and checking, everything’s invested at 60% stock and 40% bond, just generic simple concept as far as that goes.
And so this is the asset base that’s going to be drawn on, over and above social security in order to accomplish their lifestyle. All right, they have a home. So here in this area, a million and a half dollar homes are all over the place. So that’s what they have. Now, notice one thing here, we’re putting it down, not funding goals. So at the very moment, we’re just going to ignore the home even though it’s a big asset, we’re going to not count it for anything. And, you know, there’s options, we can say we’re going to sell it and see what happens and all kinds of things. But for the moment, just keep in mind that we’re not counting. Alright, so then we get to what’s called Monte Carlo simulation. So just and this is this is going to answer their question, should I retire now or not? Yes or no. And in the old days, we used to way back, you know, I used a yellow legal pad and an HB 12. c, and I would sit there and calculate year by year by year, and then we got spreadsheets. That was cool. And so we could make these spreadsheets and everything was done on a straight line basis. Well, the problem is straight line basis is life is not a straight line, you know, we had to estimate for those, how much the market would make? Well, you know, it’s all over the place all the time. So, Game Theory came out with this Monte Carlo simulation concept. And the idea here is that we’re gonna run when I push this button, we’re going to run through Joe and Jane’s plan 1000 times. And it’s allowing the computer to randomly move between different variables. And some years, they have really high inflation and low inflation and other years and higher expenses and lower expenses in the stock market, spectacular Spark, it’s awful, all of those things that can happen. And you know, so it’s basically, you know, replicating their life 1000 times. And so when I push the button here, oops, sorry, push the button, you can see what happens. We’ve got this kind of green spaghetti that comes out of here. So key here is that they had 990 successes out of 1000 times, ran down their life 1000 times. And they had money till age 95 990 times with all of these different wild variables. What I would like to see before I would say that they should retire is at least 85% probability success. So they’re at 99%. So simple answer, long, long, long way to get there. But is that yes, they can retire with their existing goals and assets and structure of their portfolio as far as that goes. So, you know, there’s there’s the first question as far as that goes. So what what would be something else that somebody would ask? commonly, Katie?
Katie Nealis:
What happens if we have a big stock market downturn or inflation is really high? How would I retirement look then?
Tom Vaughan:
Okay, so now I’m going to share my screen again, I’m going to show you kind of some stress testing. We can do a lot of different stress testing in these programs. And it’s really, really interesting. So the first stress test I’m going to do, I would push this button, it says Great Recession loss. So what the program’s now doing, it’s saying, okay, we’re going to run run a Carlo simulation, again, we’re going to run it 1000 times, or we’re going to do it off of a known situation that soon as Joe and Jane retire, the stock market’s going to fall again, just like it did back in the Great Recession back into 2008 downturn. And so what that means is that, you know, basically, the s&p 500 fell about 52%. The total stock market index fell almost 60%. Right. And what it’s saying here, first of all, is that their portfolio as it is currently structured would actually lose about 23%, right? Because they don’t have the whole thing in the market. And it knocked down their probability of success to 90%. That was that 99. And now it’s at 90%. Still very good. So I would say they’re okay, at least the way it’s set up. Now, for a big downturn like that to happen, they still have a 90% probability success, so that that’s okay. And then I would push this button here for inflation. And it would run it 1000 times again. And I’m saying, Okay, let’s say inflation for the rest of their life on all their goods is 5%. So again, now we’re running at 1000 times with a known variable, that inflation is much higher than average. And that just basically, you know, adds to that. And you can see that drop back to 84%. That’s a little bit lower than my 85% kind of threshold, but not bad. Okay. So, you know, just something we’d have to watch for, and inflation is a hot subject right now. And so it’s something you know, to think about as far as how that would go, or, you know, what we need to do there? So, you know, there the answer to that question would be, I think they’re okay, in either of those situations, with their current structure and their current needs.
Katie Nealis:
So what are some other common like scenarios that we run just this kind of stress test to make sure that this plan is solid for them?
Tom Vaughan:
Yeah, let me share that, again. It’s, so one of the most common is down here long term care, I get asked all the time. Oh, you know, what, if Joe or Jane ends up in long term care, you know, which is really expensive, here, it’s 10 to $15,000 a month for some of the different types of care here, you know, if it’s, if it’s a dementia, or what they call memory care, it can be really, really expensive. And so we can push this button down here at the bottom, and essentially stress tests that say, okay, at age 80, Joe goes into long term care costs 150,000, a year for four years, it runs it 1000 times, and it says, Okay, here’s your probability of success in that situation. And, you know, if it’s really bad, then maybe we want to look at some long term care insurance, you know, so that’s, that’s a really big one actually, as long term care. But we can we can, if somebody has a big concentrated position, let’s say they have, you know, they worked at a company for a long time, they have 30% of their assets in that position, we can see what what happened, what happens if that drops in half, that great company I worked at just has trouble and a stress test that what’s the probability of success after that? So I would say concentrated stock positions and long term care are probably the two most common that I see that come up there that are things that we look at as far as that goes. Alright, so what would be another issue to look at Katie?
Katie Nealis:
Another issue? Another question we have is we are thinking about taking social security at retirement at age 65. But is that the best choice?
Tom Vaughan:
Alright, so one of the things, so you choose to security, and you have some time that you could change it, but basically eventually becomes irrevocable. And I don’t think enough people spend enough time really looking at when ideally they should take so security. And it’s basically a math problem. And it can be solved to figure out the optimum time to take so security. And you could be leaving a lot of money on the table and actually really damaging your retirement by not optimizing your Social Security, you’d be amazed. So let me show you kind of what we would do here. I know this is kind of small letters here, you might not be able to see this as well as you want, I’ll just describe it. This is a social security Maximizer program, it’s really cool. We put in their data, their ages, birthdates, how much money they would get at full retirement age. And it runs through this particular calculation for Joe and Jane, and ran through 3029 different scenarios, and is presenting kind of the top four in this particular case. And so you can see here, you know, that they’ve their life expectancy, we picked average for this, which is 84 for Joe and 87. For J. Okay, so it realized that we plan to age 95, and their plan that we’ve just worked on. And so we’re looking at a longer life expectancy there just in case that’s part of the stress testing of that. But in terms of social security, we’re going to use the averages here. And so they you know, give you options, what would happen if you claimed early like now at 65? What if you waited until full retirement age, which for them is 66 years and four months? What if Jane claims now and Joe claims that 70 but the maximum lifetime benefit for them all this calculations, all this data, everything together was both of them taken at age 70. And so that’s the max now, if you go back one step and look at kind of Jain claims early and the total is not that far. So if somebody is really desperate to try to claim early which so many people are Maybe Jane claims early and then Joe waits. And one key there is that Joe has the bigger so security. And so if something happens to one of them, the bigger one stays. So the idea is you want to make the bigger one grow as much as you possibly can. So that there’s a higher level of income for that one person that does survive the other. The other advantage of waiting and the reason that this thing is working out this way, is that once you get the full retirement age, which is 66 years and four months for Joe and Jane, you get an 8% increase guaranteed on your income. And so every year that you wait, you get another 8% Plus, you get any cost of living increase that was given to those people that are already getting there. So even though you’re not getting it, you still get, even though you’re not receiving Social Security, you still get the increase. So last this year, for 2021, the cost of living increase was 1.3%. So you would have gotten the eight plus the 1.3, you will get 9.3% growth, which guaranteed by the government. Now that’s hard to get I mean, the market is a lot more volatile to try to get those types of rates of return. But here’s a really big deal, that inflation is a little bit higher this year. And they’re gonna announce in October, how much people get next year for 2022. And we’re hearing five 6% will be the cost of living increase for 2022, which is just a huge deal. That means you’d get 13 to 14%. Guaranteed. So if at least Joe can wait for a year or two years, all the way to age 70. He’s going to make maybe, you know, 13 14% next year growth on that I am using an average of 2.6% in this program, because that’s what social security should says we should use. But if they actually achieve a higher cost of living increase during that time, you get even more so anyway, this this is something I think is really important. A lot of people don’t take a look enough at their social security maximization. All right, so what, what would be the next thing that we would look at?
Katie Nealis:
We see that waiting until 70 might be the best choice, but we are worried about not living long enough to make up for the missed years. Shouldn’t we take it now? If that’s a concern?
Tom Vaughan:
Yeah, it’s one of the main there’s two main things that I hear about social security and why people want to take it early. I guess their street. Number one is people just don’t have anything else. Right? I mean, the average American retiree just doesn’t have enough money. And so they take Social Security, because there’s no other alternative. Joe and Jane have two and a half million dollars, and a million and a half dollar house. So they have some options as far as that goes. And so for those people that have options, I hear two issues, number one, afraid so security is going to go out of business. That’s not going to happen. You know, and I’ve done lots of studies, I go to classes every year on Social Security, they’ve been talking about social security going out of business since the 1940s. It’s still here, I would suppose that you know, younger people, like myself are younger than myself, like my kids, they won’t get the same deal. I mean, for retirement age for me is 67, full retirement age for my father was 65. For example, it might be 69 for my kids, right? So there’ll be some lowered benefits. But right now, Joe and Jane are 65. And it’s not going to go out of business, they don’t need to take it now. Because it’s going to go out of business before they turn 70, then that’s not going to happen. It’s too easy to fix. And I do an entire seminar. And so security and I won’t get into all the details, but just just you know, we’ll go with that parameter. The next thing is just I might not live long enough. So I’m missing five years worth of income and I got to get a higher payback. But you know, how long would it take me to get that back? And so let me show you the scenario for Joe and Jane here. So what I’ve done here is I basically just said, Okay, we’re going to shorten their life expenses, I use below average life, my 80 years old for Joe, and 83 for Jane, okay. And if we go down to the maximum benefit, it does change, it still says Joe should wait till 70 and Jane should wait until 68. Okay, so instead of both them at 70. So and again, the second choice that’s still very close, says the same thing as the last one, which is Jane takes 65. And Joe takes it at 70. So, again, we can play with this. I guess my main point of this is that in order to really maximize you just need to figure out all the parameters that are important to you. And if you think you’re not going to live to age 80 you know, we can do that too. We can figure out like what is that maximum way to get the money? I would say the biggest risk in financial planning by far is not dying early because that’s easy in terms of financial planning. You know, your money doesn’t have to support you as long as it’s actually living too long. That’s the biggest risk and so making sure that that risk is somewhat taken off the table, especially if it doesn’t mean Radek ating your fund during your early part of retirement. If you can Both, that’s a really good way to go as far as that goes. So now the next thing I would look at with them would really be looking at this social security inside of a financial plan, and how that plays out. So this is the table that comes out of the financial plan that we started with. And if you look at runs through all these scenarios, taking at 65, taken at 66, taking it at 874, both taking an 874, Joe and 66. For Jane, it does all the calculations. And the most important part about this, is that inside your financial plan, if you’re gonna wait till age 70, you’re actually taking the money from someplace else, they’re gonna be taking it from their taxable assets are gonna be taking it from there, you know, from their 401 K’s, it still says 870 for both of them is the maximum payoff, right. And then we can go in and stress test that. So if you remember, we took a look at their situation under the Great Recession. And now we put in age 70, instead of 65, for both our CIO securities, and if you remember, originally, without the Great Recession, it was at 99. But when we applied the possibility of the Great Recession happening, immediately it went to 90, this just went to 93, we just added 3%, to their overall probably success, just by maximizing Social Security. And then again, if we go to inflation here, it went from 84 to 87%. Again, 3% increase just by maximizing Social Security. So anyway, it’s pretty cool.
Easan Arualanantham:
As far as that goes, is it always better just to plan that you live longer than rather than shorter. And so you should always try and, you know, maybe give yourself a couple years out more likely.
Tom Vaughan:
Yeah, with with one exception, somebody really doesn’t have enough money to make it work. And if you if you say, a stretch out the number of years, and then somebody is just living on a bare minimum to kind of get out those number of years, and they’re having a fairly miserable life below what they really want. And in the hopes that they live longer, that one exception, you might shorten up the life expectancy and kind of go for it. And we have other people that are dead, certain they’re not going to live that long, which is kind of scary. But anyway, that does happen. And so in those scenarios, we would you know, shorten it up, you know, 85, or something along those lines. But yeah, in general, especially like for Joe and Jane here, if you’re looking at it closely, we plan to 95. And it still works that that’s good. I mean, that’s just like more buffer built into the plan. They’re still accomplishing the standard of living that they really want, which I think is really cool. All right, what would be the next question that might come up?
Katie Nealis:
We’re thinking about moving to Arizona? How would that impact our retirement?
Tom Vaughan:
Okay, so, our practice, we have clients in 26 states outside of California, and all over California for that matter. And one of the reasons is because the house prices here have appreciated so much. And people are, you know, taking those gains and moving other places. And so it’s a really big portion of the planning processes for those people that are interested in that to kind of stress test that and see how that might work out. And so I’ll show you what, what we do here. So first of all, one of the really cool things here is that we can change the state that they’re going to retire in into Arizona. So because the program is calculating tax, and so we are going to look at Arizona’s tax rates instead of California. And then you can pick different states and test them out, I want to go to Georgia or Nebraska, or you know, Nevada or whatever it might be. And you can see how that changes your probability of success. So I’ve changed them to Arizona, which I think is interesting. And then we’re going to go to, you know, add their assets. So a million and a half dollar house. So we would take a look at you know, okay, if you sold it for that much, you’re gonna pay a realtor X dollars, you might have to pay a certain amount of tax, and then you know, you’re going to go buy another place. And so let’s just say for example, in this case, we ended up with $500,000, left over after all moving expenses, new furniture, you know, all these things. And so we put that in there, and we also invested 6040. And let’s see what happens. So now we’ve got Arizona taxes and say California, and we’ve added 500,000 to the overall case, they’ve moved, you know, and let’s see what happens there. And so then we go and we run the Monte Carlo simulation, obviously, it’s still at 99%, you know, that more money, so that should work. But let’s look at the stress test and see what happened. So now we run the Great Recession loss again, and we’re all the way up to 99%. So remember, this was at 90%. And we moved it to 93 by maximizing Social Security. And now that they’re moving to Arizona, possibly as a test anyway, it would go all the way to 99%. Even if we had a giant stock market return right at the beginning of their retirement. And if we look at the inflation scenario here, that’s all it to 97% again, it was at 84. It went to 87 was so security and now it’s at 97 with the extra five 100,000. So, really cool, it’s a great way we can try all kinds of different things. They can buy a less expensive house, a more expensive house, they can move to different states, we can stress tested and see how that would work. And these things are all helpful in decision making process, in my opinion.
Easan Arulanantham:
So what are some of the other like, kind of properties scenarios, we can test? Like, can I keep my property and set and bias like at home and like rent out this other house? Yeah. Really test all those kind of different possibilities and see which one actually works best for us?
Tom Vaughan:
Yeah, that’s right. So it gets some clients that just they want to keep their house, they’ve seen the appreciation, and they really just want to turn it into an income stream, and see if it’ll continue to appreciate. And maybe they’d sell it later, you know, whatever. But they just look at it as one of their assets. So that million and a half dollar house could someday would be worth 3 million, right? And so they would keep it here in California rented out. And you know, you got to figure out all the tax ramifications and you know, all these different things. And then they’re going to move, you know, to another place, we got to figure out how they’re going to buy that where that capital is going to come from see how that works. But basically, what you’re what you’re looking at is the rent that you can get net after all expenses and taxes versus, you know, pulling money out of your existing accounts to buy that place in Arizona. So, but yes, and you can tell pretty rapidly using kind of the stress testing whether or not that works out better or not. All right, what would be another question they might ask.
Katie Nealis:
Another question we have is, we have $7,000 a month estimated for our expenses. What if we end up needing more than that?
Tom Vaughan:
Yeah, this is part of my stress tests that I always look at inside of a plan is I will look at if they said 7000, I want to go find out what income would still be be spent and still be able to hit 85%. You know, if it’s 70 $500, that tells me they’re right on the edge, really. But if there’s a bigger margin for error, I just want I want to know, because honestly, what I’ve seen throughout time is that sometimes it’s difficult to really nail down, you know, what your expenses are, especially, you know, just before retirement. And so what we do here, there’s a there’s a section of the financial plan called the plays zone. And this is really cool. It’s just these little sliders, we can change the retirement age. And so what happens is this left hand right hand column over here will stay at the recommended which is at 99%. But every time I change one of these sliders, it’ll redo this chart and run it 1000 times. And so what I’ve done here is I’ve already solved for, you know, their situation where, how much could they spend and still be at an 85% probability success. Again, I consider that kind of the floor. And it would be 11,000 a month. So that’s a lot of room for error. They could spend seven, right? Or if they, you know, had to they could spend up to 11, in my opinion, still kind of make it work. So that’s how I would answer that question, you know, so in other words, they’d have some capability of getting, you know, farther down the road as far as that goes.
Easan Arulanantham:
So how much of a warning with this plan? Give me like, would I get like five years of a warning system a year? Like, how much can I expect to like, be able to make adjustments?
Tom Vaughan:
Yeah, in my opinion, it’s five to 15 years. So basically, what these is talking about is when we do our strategy sessions, every six months with the clients, the financial plan is, you know, either live or updated a little bit as we’re going through the session. And then we push the Monte Carlo simulation. And so let’s say they’re at 99%. But we’ve just had some other unexpected expenses and kids needed money, or, you know, there was a big medical situation that wasn’t expected and the money has shrunk, or the market has fallen. So we could kind of push that button every six months. And when you start to see a lot of red, you know, which just basically means there’s a lot of failures in that MonteCarlo simulation, that gives you a chance to make an adjustment. So Oh, you know, maybe I need to spend 6000 instead of seven for a while or something along those lines to make sure I don’t run out of money, because that is the ultimate goal of retirement don’t random money. So that’s I think that’s one of the strongest ways to do it. It’s a good point. All right, Katie, what would be another question that somebody might have? Between the two of us we have $1.5 million in our 401k is, how can we maximize these?
Yeah, so 401 K’s are really fascinating, especially here in the valley, you know, pensions have disappeared. But there’s a high amount of pay.
So people can put away a certain percentage of their pay, which turns out to be a lot, because people get paid a lot. And then their companies will match and actually the matching is become competitive. So you know, we’ve got companies like Google that are matching 100% of your pay is whatever I mean, 100% of your contribution, all the way up to the max, which is amazing. So we’re starting to see a million to $5 million 401k is all the time. I mean, that’s a common thing here in the back. And, and that’s fantastic. I mean, it’s a huge amount of money. But there are some challenges to that. And so let me share, you know, my ideas on what I would do in that scenario. First of all, I would consider rolling that 401k out into an IRA. And again, this is just from my Outlook, a 401k usually has like 20 to 40 different investment options that you can use. And so that’s kind of a limited list. As far as that goes, if I roll that into an IRA, and again, there’s lots of parameters here, you got to look at, I’m giving you some of the simple ones. But if I roll that into an IRA, I have kind of an unlimited options. So I like exchange traded funds, I think they’re one of the best investments, I use them all the time. There’s 20 443, exchange traded funds right now in the list that I’m constantly searching through. This is my current 60% portfolio, which I could never can construct inside of a normal 401k. And so I got I got Vanguard total stock market index, the vanguard, s&p 500, etc, you know, 40%, in bonds, I got a lot of Treasury inflation protected securities right now, which is a good thing to have in a higher inflationary environment, etc. So that that I think is important. And then, of course, in either 401k, and Ira, you can move from one area to another with no taxes, because it’s tax deferred. So if you decided, Hey, I wanted to be more aggressive, you know, here’s our 80% portfolio, or I want to be more conservative, you know, here’s our 40% portfolio. And then the last one I’ll show you is really, really unique. And this is a what’s called an ESG. portfolio. ESG stands for environmental, social, and governance. And just to give an example, here, this Vanguard ESG, US stock portfolio, ESG V is a ticker symbol, they take the total stock market index, which basically has all of the stocks on the US market, and they apply an ESG screen. So there are companies that rate the companies like Apple and what have you for how well they do on the environment, how well they do and social, how well they do in their communities, and etc, and they give it a number. And so what Vanguard will do then is just cut it off and say, we won’t buy the stocks that are below this number. And so all of these are ESG screened. And this is actually done really well. And these aren’t really available inside of a traditional 401k situation, too. So again, just some more flexibility, some different things that you can do, you know, that you can’t do inside 401k. So that would be one of my first things if you’re trying to maximize 401k, maybe make it into an IRA and get a good structured portfolio in place. But the other part has to do with tax. And so let me show you a piece here. And I know this is a lot of numbers. Let me show you the overall concept. So first of all, this is kind of a behind the scenes thing, looking at this financial plan that we’ve been working on to show how much taxable income Joe and Jane might have, right? So first of all, you know, it’s basically the first several years here, it’s around $50,000 worth of taxable income. And they’re in the 12 to 15% tax bracket during that period of time. But you see what happens here at age 72, it jumps up to higher to 34,000. And what what happens, then, of course, their taxes jump up and they jump up into the 25% tax bracket. And the reason is, because at age 72, the government makes you start taking money out of your retirement plans, 401 K’s 403, B’s IRAs, those are they’re all the same. As far as that goes. It’s called the required minimum distribution, we call them rmds. And you can see this just gets worse, I mean, these people are pulling out more and more. And so if you have a large 401k, or a large IRA that used to be a 401k, or what have you, you’re basically sitting on a tax time bomb, because the government’s going to force more and more money. And if you look, I mean, here they are at age 80. They’re pulling out $200,000, whether they need it or not, and taxable income. And if we go down even farther, you can see they jump in tax bracket, again, this is all all projection, you know, the amount you have to take out continues to grow. And the account theoretically should grow also, right? Because it’s invested. And so by the age of 90, you know, we’re at 325,000, whether you need it or not, and you’re in your 28% tax bracket, even though you’re in a 15% tax bracket before all this started. And so that that’s critical, is trying to deal with that tax. So if I’m trying to maximize a 401k I want to look at the flexibility of an IRA from an investment standpoint, but I really want to start planning and thinking about the tax ramifications of those 401 K’s This is a big piece of retirement planning in my opinion.
Easan Arulanantham:
You know, and especially because you’re also not just your or your tax goes up your Medicare premiums go up when you’re playing more for medical.
Tom Vaughan:
Yeah, that’s right. Yeah, the higher taxes are, you know, you’ll pay taxes on Social Security versus somebody who had lower taxes might be able to save that. And then you’re right medic. Medicare is a means tested, which just means the more you make, the more you’re going to pay. And they have different brackets and limits and what have you but I’ve seen a lot of clients because of They’re required minimum distributions now have to pay more tax, but they also have to pay more for Medicare. And so again, you got to look at that you got to look at the whole picture. And so let me step you through just real quickly how we would look at the possibility of reducing some of that taxation by using Roth IRA conversion, early in retirement. And I’ll show you how that might work for you know, this, this particular couple. So first of all, we have this program that does an amazing analysis around, you know, Social Security, sorry, around Roth IRA conversions. And I’ll try to explain this, this green blob here is basically just the numbers we looked at. It’s, it’s how much income they would have on their tax return, year by year. Again, you can see this big jump that happened here because of the requirement of distributions.
And this income is all assumed under a withdrawal sequence that’s called pro rata. So it would, at some point, when they retire, they’re going to have social security, but they still need more money, or maybe they wait for Social Security, and then they need more money out of their assets. So where do you get it, which place first, which account first, it’s incredibly important. So what we’re showing here is a base case is just what’s called pro rata. So he would say, hey, if I have 10%, in this account, I’m going to take 10% of my income out of that if I have 20%. Out of this account, I take 20%, that’s pro rata. And so essentially, it’s a base case, it’s not the best way to do it, but I’ll show you what happens. So look at a second way to withdraw the money. All right. Again, this is part of maximizing your big 401 K’s. So the second way, you can see by this arrow that I’ve just changed from pro rata to what we call standard, which is taking the money out from your taxable account first, and then your tax deferred. So this would be your 401k account, and then tax free. Now they don’t have any tax free account, that would be a Roth at this point. Well, that adds up to 877,000, higher net worth than taking it out of pro rata methodology. So that’s a big deal. But what’s more important is that fact that a lot of people are taking it out the wrong way. So if I go to the next slide here, you can see what I put in here is where you’re taking it out from the 401k. First, so the most common comment I’ve heard is I save for retirement and my 401k, I’m now retired, I’m taking money out of my 401k to support me, which makes sense, except it’s actually $745,000, less of net worth over their lifetimes, you know, versus pro rata. So they could have had 877 more by taking it out in the right distribution methodology. And because they did the wrong one, and it was centered $45,000 less, that’s a $1.5 million differential in their net worth just by understanding withdrawal sequence. And this is part of tax planning. And so again, this is part of us Investor Education, this is important.
And so now, okay, we’ve got this settled, we’re going to do standard, we’re at 877,000 increase over pro rata, that’s great. What happens if we start to move money out of the 401k or IRA into a Roth IRA, when we do that we pay the tax as that money moves out, but we then get tax free growth on that Roth IRA. Thereafter, this program is going to calculate that and what we want to try to figure out here is what tax bracket will work best. Okay, so, first thing we’re going to do, you see down here in this box, I move this little slider over to the 12%. bracket 12% eventually becomes 15%, you know, because the current brackets are sunsetting and 2025. And so you can see this little blue area here, that’s the year we’re filling in the 12% bracket. So even though they had less income than what was allowed under the 12% bracket, we took more by converting a piece of the Roth IRA, a piece of their 401k to a Roth IRA now that increase the net worth from 877 to almost 1.1 million, so that’s good. That bracket works. Let’s look at the next bracket. Next bracket is 22%. So what happens if we filled in the 22%? bracket, right? A 1.2 million, that’s better. Okay, that’s good. So we can do 22, we can do 12, we can do 22. What about 24? Oops, 24 weeks ago, backwards. So 22 is the max. Right, that’s, that’s what I’m trying to get from this program. I’m dealing with Jane and Joe, every single year, we’re going to try to fill in a 22% bracket, we’re going to take a look at what incomes they have, and then figure out you know how much you know, we can still convert and get to the 22% bracket and we pay the taxes, you know, out of their taxable account for that. And so there’s lots of details here. But here’s the key. This is really cool. If you look at this, I just took away the green and I’m just looking at what happens if you go look back here, see, take away the green right. And just looking at now this new scenario, where they’re going to convert every year as much as they can and stand and eat this 22% bracket And but look what happens to their taxable income by age 82. They’re done converting, they now have zero tax for the rest of their life. So they’re no longer paying taxes on Social Security, it’s a tax free benefit in this situation, they are paying the least amount of money that they can pay for Medicare, because of this conversion situation. And that’s unbelievable, because they’re living off of this tax free growth, that they’re an income that they’re pulling out of their Roth accounts that they’ve converted over. So bit of a painful process here to pay the tax.
But we still end up even after paying those taxes and everything considered with $1,254,000 more on a projected basis by doing these conversions. So if you want to maximize your, you know, retirement plans, I would look at an IRA or 401k. And then I would look at the Roth conversion possibility doesn’t work for everybody. But you want to run through this program and see how that’s going to work. And then lastly, and the very last piece of this is that Joe and Jane have a daughter. And so what happens to the daughter, well, she’s going to get more money as an inheritance because they converted everything over. So what would happen here, at least from a tax standpoint, you get more money, there’s all kinds of other reasons that you might not, but under their current scenario, they have zero money in tax free, right. And so a big chunk of it is the tax taxable account that they would get. And then this other chunk is the tax deferred. So they would inherit those 401 K’s or if they converted into IRAs, they would inherit those IRAs. The current law says that their daughter has to take all of that money out over 10 year period. And so they have pretty big 401 K’s and by the time they die, they could be even bigger. And so the daughters now saddled with this taxes, because she has to pull it out over a 10 year period. And that’s pretty onerous. Now, it’s still a great inheritance. Nothing wrong with that. But if they were able to convert, you know, the money over to the Roth side, they can get that nice tax free growth from 82 and beyond for themselves and have a nice situation. But if they passed away, now the daughter’s inheriting those Ross, and they have a tax free inheritance from an income standpoint, you can still have a state tax, that’s another issue altogether. But what would that would mean Is she still has to take it out in 10 years, but she could leave it growing for 10 years tax free, and then just take it all out and have no taxes to pay beyond that. This is why I converted all of my accounts over to Ross. And so because I want to make sure that my kids have that at least 10 year tax free growth. I think that’s a really important piece as far as I’m concerned.