By Timothy Barrett, JD, Senior Vice President, Trust Counsel, Argent Trust Company
I’m not a fan of financial plans that use straight-line projections or Monte Carlo analysis. These plans rely on assumptions relative to your future wage earnings, your asset allocation and investment performance, anticipated taxes and costs, and your future spending needs to provide a range of probable and possible outcomes. However, once you project beyond about ten years, probability mostly gives way to fantasy. There are just too many variables–human, technological, economic, natural and political–to build a reliable plan. But you should still obtain one.
Most people don’t really consider experiencing the range of bad outcomes depicted in those projections because that kind of failure is incomprehensible. Especially if you have been generally successful so far. But for many people, unanticipated financial loss, unemployment, health issues and accidents will derail even the most modest of those projections. To overcome those obstacles, we must first accept that they can occur.
Effect of tax laws on planning
It doesn’t help planning that the current income and estate tax laws are unreliable. Much of the Tax Cuts and Jobs Act of 2017 (TCJA) is subject to a “sunset,” or expire, on January 1, 2026. It is likely some form of the current tax code will be extended, with yet another sunset on the horizon, but can we rely on that? Especially when the TCJA failed to benefit wage earners equally and disproportionately benefitted very wealthy households over everyone else.
The TCJA did reduce taxes for working households earning under $100,000 a year by a greater margin than households with annual earnings over $100,000 but under $250,000, absent special circumstances; like high itemized deductions, closely held business income, deferred compensation, etc.
Take a family of four with working parents and an annual income of $75,000 in 2019, who take the standard deduction and two full child tax credits. They will pay only about $1,684 in federal taxes. After the tax laws sunset in 2026, with those same facts, their federal tax would be $6412, a 381 percent increase.
But, apply those same facts except increase the annual income to $180,000 in 2019, and the federal taxes are about $23,949. Then, after the tax laws sunset in 2026, the comparable federal tax for this family increases to $27,252. This is only a 14 percent increase, which is significant, but not comparatively.
It seems the $100,000 to $250,000 range households mostly didn’t gain that much in income tax savings from the TCJA, but also aren’t situated to lose as much when the TCJA sunsets. Because most households have annual income under $100,000, most people may see their taxes go up significantly in a few short years. They may see their costs increase dramatically, too.
Consider the effect healthcare costs will have on your retirement. The Affordable Care Act (ACA) currently provides post-retirement insurance coverage for millions who do not have employer coverage. You will join that group one day even if you wait to retire until age 65, when you qualify for Medicare coverage. The ACA currently requires insurance providers to offer affordable and comprehensive healthcare coverage without regard for any preexisting conditions.
But can you rely on the ACA provisions lasting until you need them? If the present administration succeeds in repealing the ACA, finding suitable and affordable coverage, including Medicare supplemental plans, will be more difficult if you meet certain health profiles and impossible if you have certain preexisting medical conditions. Insurers will also be allowed to offer only minimal coverages for retirees at affordable rates while pricing comprehensive plans much higher and even out of reach of many with high risk health factors.
Formulating a plan
The probability of higher income tax rates and skyrocketing healthcare costs makes financial planning even more necessary, and more problematic. So, what should you do about it? You must formulate an actionable financial plan.
First, plan to eliminate debt, especially revolving credit lines, without sacrificing annual contributions to your qualified retirement plan. Most retirement plan contributions are tax deferred and may even include employer matching. When you fail to take employer matching, usually up to 5 percent of your gross wages, you are essentially agreeing to work about 2¼ weeks that year without pay.
Second, you should reduce your lifestyle costs below your monthly net wages, including your retirement plan contributions. Third, plan on working until you have paid off your mortgage. If that pay-off date is well past full retirement, you should strongly consider downsizing your home now while mortgage rates are relatively low.
Finally, you should get the most from your Social Security retirement by planning to work longer. Even if you find later that you can afford to retire early, planning and saving for a later retirement date increases your chances for a successful outcome.
Retirement and Social Security
Wage earners born after 1960 may retire at age 62 but must work until age 67 to get an unreduced benefit. Those who retire at age 62 will receive only 70 percent of the full rate. If you work until Medicare is available at age 65, your benefit rate is 86.7 percent of the full rate. But the unseen cost of early retirement is the loss of up to five years of your highest earnings from the calculation of your monthly retirement benefit.
Your monthly retirement benefit is based on your highest 35 years of covered earnings, indexed for inflation. Anyone filing with less than 35 employment years will have some years of zero earnings in the calculation. Each year of additional work at your highest wage that is used in your 35-year average will increase your monthly benefit while every year of lower or no wages used will decrease it. Those who delay retirement past age 67 will also earn credits to further increase the retirement benefit.
Should you plan work after retirement? Be aware that younger retirees face a harsh penalty against their Social Security benefits for working part-time. For every $2 earned over the annual limit you will lose $1 in Social Security benefits. But once you reach full retirement age, your retirement benefits are not affected by any earnings.
Retirees can also have unlimited unearned income from sources like retirement plans, pensions, annuities, interest, dividends and capital gains without losing any Social Security benefits, although you may have to pay income taxes on 50 percent to 80 percent of your Social Security retirement benefits if your income exceeds the annual threshold.
Financial planning is important, but don’t be lulled into complacency by unrealistic projections. Have your advisor run projections with scenarios like:
- You stop working ten years early
- You must purchase expensive private health coverage
- You must weather an economic depression
- One of you dies very early, one of you becomes disabled, etc.
If the results of these projections show that sometimes your plan will fail to meet expectations, you must consider what is an acceptable chance of failure.