In our previous articles, we introduced the Buckets and Tools Approach to Retirement Planning. In essence, we categorize each dollar available for retirement among the four necessary priorities of liquidity, income, protection from premature death and long-term care, and growth.

After providing enough money for emergency reserve and short-term goals (the liquidity bucket), the next most important priority is covering the income gap that exists between predictable income and expenses.

Calculating how much of the retirement dollars need to be dedicated to the income gap bucket can be tricky. This is due to the following complexity: If the money withdrawn for covering the income gap is in retirement accounts (IRAs, 401ks, etc), the tax liability must be calculated and accounted for.

I’ll provide an example from a recent meeting.

Roger and Ingrid have an income gap during the next six years in retirement. After this, because their mortgage will be paid off, this is their only income gap. They need to determine how much money to put in the income gap bucket in order to fund both the income gap during the six years *and the tax liability of withdrawing funds from their IRA accounts.*

Here’s a screenshot of the amount of the annual income gap before income taxes were considered:

Unfortunately, they couldn’t just take the annual amount indicated in order to cover their income gap. They need to “gross it up” for federal and state income taxes that will be due when they deduct these funds from their IRA accounts.

How do we determine the annual amount to actually take for these years?

The first step is to determine their marginal tax bracket. There marginal tax bracket is the tax rate that the next dollar will be taxed at. By viewing our financial planning program (or last year’s income tax return) we can determine their current level of taxable income and the marginal tax rate on the next dollar withdrawn.

In their case it is 22% at the federal level in approximately 8% at the state level. So we will assume a 30% marginal tax rate.

The second step is to divide the annual income gap by the converse of their marginal tax rate. The converse of 0.30% tax rate is 0.70%. The converse is basically 100% minus the 30% tax rate, equaling 70% or 0.70% as a fraction.

Here is the math for the first year’s income gap of $19,536.

$19,536 divided by 0.70 = $27,908

So they will actually need to take $27,908 from the IRA account to net and income of $19,536.

They have many options about how to invest the money needed to produce the income gap.

They could choose an extremely conservative approach of setting aside enough money during the six years so that none of the funds are at risk and they simply take needed distributions out of the money market.

They could also choose an approach of investing a larger sum of money that creates the right amount of annual interest to cover the total income gap. This is actually what they chose. By setting aside $400,000, they were able to create enough annual interest to both pay taxes and cover their income gap. At the end of the six year time horizon, the original $400,000 would be intact and available for other purposes.

*The critical element to the strategy was to understand that the actual total cost of each year’s annual income gap needs to include the taxes due at the federal and state level in order to make sure that the right number of dollars was in the income gap bucket.*

If you have any questions about your retirement circumstances, contact me.