If you’re like many retirees, you may like to leave a financial legacy at the end of your life. Many retirees that we’ve talked to have this as one of their priorities and goals with the savings that they’ve accumulated for retirement. Many retirees are in a position to actually pull this off; they have a sufficient amount of savings for their retirement income and lifestyle, and they have extra assets that they can leave behind for financial legacy purposes. That legacy can be steered towards family, kids, grandkids, etc, or to charities, and we see all types of financial legacy happening from today’s retirees.
Tax-Free Financial Legacy
Another important element to that financial gifting and that legacy goal for retirees is that this would be a tax-free gift to the beneficiary. Many retirees want to leave a legacy as big as they can without income taxes getting into the mix and reducing what that overall gift would be to the beneficiaries, and this is a reasonable motive for many retirees. Now, there’s a conventional way that many retirees are trying to create tax-free legacy assets, but when we look at things through the 4Buckets lens, we’re actually going to show a different way to create tax-free assets and will pose that this might actually be a better route to create tax-free assets in retirement. Let me explain.
Determining your “True” Retirement Lifestyle
One of the first things that we do with the 4Buckets process is to have a retiree really evaluate their retirement lifestyle. Many times we are coaching and encouraging our retirees to elevate their lifestyle to increase the amount of income that they are receiving in retirement. Why would we do that? Well, we understand that there are many forces and factors that are depressing retirees’ lifestyles today. It happens naturally from aging and mental decline that we tend to expect less and want less as we get older. But, there are also forces outside of us in the realm of marketing and advice that say, “You really don’t need so much, just go ahead and live on less in retirement,” and we see many retirees settling into this modest lifestyle that in some ways, may be more modest than necessary.
So, one of the first things that we do with retirees is ask them questions that they may never have been asked before. “What do you actually want to do in retirement? What are some of those unspoken dreams and goals that you have?” And we begin to open up the heart and the mind and activate the retiree to talk about some of those dreams and desires that we actually have. These are questions that may or may not have been approached before and it’s fun to see how this conversation unfolds. There are three reasons why we do this, and it’s the front end of our 4Buckets process and in a lot of ways it dictates where we go and the type of strategy that we put in place.
The first reason that we do it is simply for enjoyment. These are your hard-earned savings. This is what you have worked two, three, four, even five decades for to reach retirement, to use these savings for your enjoyment. So, there’s a personal motivation there – that we want to see retirees use the money that they’ve worked hard to save.
The second reason we do it is actually for investment purposes and for efficiencies around investments. When we work through the 4Buckets process and we’ve established that lifestyle number that a retiree wants, we are now going to build towards that number. The retiree has anchored to that figure in a good way, we want them to really envision themselves getting that amount of income, that lifestyle number on a monthly basis for the rest of retirement. So, once we latch on to what that number is, we then start building towards that using Bucket Two and Bucket Three.
As we do that, and as we’re building towards this lifestyle number, we’re going to look at the available assets that a retiree has and we’re gonna say, “Okay, in order to meet this monthly lifestyle, here are the breadth of retirement income tools we can use to make this monthly income happen.” We look at the whole range of tools from investments to insurance to see how we want to create this lifestyle income. As we do that, we are going to try on different tools, we’re going to understand how much of the retiree’s nest egg is going to be used to meet this monthly lifestyle.
Non-Income Assets
Once we solidify that, we then have much better clarity on what extra assets exist. When we have clarity and confidence about the lifestyle and the income being derived to meet that lifestyle, we actually can have much clearer conversations about one: how much extra assets exist, and two: how to invest those assets so that there’s no murkiness on “Are these my income assets? Are these my growth assets?” The 4Buckets process segments that out in a very clear-cut way that many retirees aren’t accustomed to, but it’s extremely helpful for them to understand how their monthly lifestyle is being met and how they’re investing the extra dollars that they have. So that’s the second purpose, that we try to elevate the retirement lifestyle.
Creating Tax-Efficiency Unconventionally
The final reason is taxes, and that’s the main point of today’s video. There’s actually some tax savviness involved in what we’re doing here, but it’s unconventional – it’s not how retirees typically think about creating tax-free assets. So, let me explain to you how it works: once a retiree has solidified what they want their lifestyle number to be, they may receive an income that is significantly higher, perhaps double the amount of retirement income that they were originally expecting to receive. Working through their goals, their dreams, helping them to think and dream bigger, we reached a point where we were able to say, “It would be much better if we had one, two, three, five thousand dollars more a month for our retirement lifestyle,” and that’s a good thing.
Before I go any further, what we talked about so far is how we elevate a retiree’s lifestyle and the three reasons why we do it: enjoyment, investments, and taxes. I need to first talk to you about how a typical retiree approaches creating tax-free assets – the conventional route. Well, in many circumstances, a retiree has never been asked the sort of questions that we’re asking. They’ve never been allowed to consider what their retirement lifestyle could look like beyond what their lower expectations are, beyond what required minimum distributions might dictate to them.
The Conventional Tax-Free Path
So naturally, many retirees who haven’t gone through a process like this are often settling on a lower monthly number for their lifestyle. What does that mean? Well, it actually means that they have more extra assets available to them. And that’s what we typically see with retirees who haven’t undergone the 4Buckets process – they’re underutilizing assets for their ongoing lifestyle and they actually have more assets than necessary that are available for legacy at the end of their life.
So as retirees go through retirement, they’re naturally going to spend less on their retirement and do less. There’s going to be a natural decline already in their lifestyle because of aging, and a retiree who has started out with a lower lifestyle may see that overall nest egg, those extra assets, continue to get bigger and bigger. The retiree, seeing that bigger nest egg and seeing the end of life continuing to approach them, is going to think, “How do I create more tax-free assets?” The way that it is traditionally done is through Roth conversions.
What’s a Roth Conversion?
A Roth conversion sounds technical, but it’s fairly simple: it’s moving money that is in pre-tax accounts, like an IRA or a 401K, and shifting that to a Roth IRA. When a retiree shifts money from these pre-tax accounts to a tax-free account in a Roth IRA, something has to happen. They have to declare income to the IRS. Even though money is being shifted from one account to the other and it’s not being experienced as income to the retiree, it’s still a taxable event. So in that process, the retiree will declare income in that given year, and a portion of their retirement assets are converted to Roth assets.
The Benefit of a Roth Conversion
Well, what’s the benefit of a Roth? Why even do that in the first place? Well, a Roth IRA is after-tax dollars that are allowed to accrue tax-free by investment earnings through dividends, interest, and capital gains, and they can be passed on tax-free to beneficiaries tax-free at the end of life.. That’s pretty good. That’s a good deal. So, a typical retiree will move extra assets that are not being used for their lifestyle, they’ll periodically move some of these assets into tax-free assets. When they do that, they have to signal to the IRS that this has been taken as income. Again, while it’s seen as income on a tax return, the retiree doesn’t really get to utilize those dollars – they’re simply moving it from one account to the other, and in doing so they have to declare taxes in order to pay the appropriate amount.
The 4Buckets Lifestyle
What’s different about a 4Buckets retiree who has gone through our process is their lifestyle. Like I said, a traditional retiree typically has lower expectations and has settled on a lower lifestyle number. They have never been asked to think bigger or dream bigger. A 4Buckets may have a retirement income and retirement lifestyle that is significantly higher than their peers.
As we are building that retirement lifestyle, we are using assets to create that retirement income that they’re looking for. Now, as that is being done, a retiree is naturally going to withdraw more from their assets to use for lifestyle than a traditional retiree – someone who has not adopted the 4Buckets. You might be thinking, “Well, why would I want to withdraw more from my account?” Well, if you think about it, that’s the whole point of retirement income so that as you withdraw money from accounts, you have more options that can be available for your lifestyle, for enjoyment. You can even give the money away if you’d like, you can let it continue to build up, you can reinvest it – it gives you many more options. It opens up a range of options to you, rather than settling on a lower lifestyle and just seeing accounts continue to get bigger and bigger over the rest of your life.
Tax-Efficiency Done Differently
I’m not saying you have to spend it, and that’s what many retirees get concerned about when we talk about elevating this lifestyle. They’re like, “Well, I don’t really need it. What if I don’t want it?” That’s okay, because we are creating efficiencies by what we’re trying to accomplish. What are those efficiencies? Well, I talked about the fact that this money first and foremost is landing in your pockets – it’s landing in your accounts. If you think about the way a Roth conversion works, you’re simply moving money from one account to another. You don’t really get to see it, you don’t get to use it; you’re just doing some shifting across your balance sheet. A retiree that is withdrawing more money, and is using more for their lifestyle, have more options available to them.
Now, what will happen for a retiree is that their spending, their lifestyle, may naturally decline anyway. The aging process, as we’ve discussed, creates what is called a “Retirement Spending Smile.” This is a research-backed visual showing that as we progress through retirement we are actually spending less with a final increase in spending due to healthcare expenses. That’s okay. That’s a good thing because what is happening is that the retiree who has gone through the 4Buckets, has created a retirement income system that is paying income tax on dollars that they can choose to use or not use, but what they’re doing is building up a basis and that basis is very important.
The Cost-Basis Step-Up
The retiree is paying income taxes on the money that they’re withdrawing from their accounts; they’re building up a cost-basis. Typically, retirees will reinvest this money, so we’re already getting back into some of those habits that were effective when you were in your younger years and you were saving for retirement. That’s a really cool thing. It’s a great investment principle: dollar cost averaging money back into investments. But what’s different, is that these investments are accruing a cost basis and they are ultimately accomplishing the same tax-free treatment except this route provides more options.
What? How does that work? Yes, it’s called the cost-basis step-up. It’s written into the tax code and it allows investments like real estate, individual stocks, ETFs, and mutual funds to be stepped up to the market value at the date of death of the retiree. The basis that existed when the retiree paid income tax on – that is stepped up to the higher market value on the date of death of that retiree. Meaning, a beneficiary such as a child or grandchild that wanted to liquidate that investment the same day would not owe any income tax.
That basis gets stepped up to the value that it is on the date of death. It’s called the cost- basis step-up. It achieves the same thing that a Roth IRA does. They’re both tax-free assets but what we’ve shown you is that for a 4Buckets adoptee that has worked through this process, they have done the same thing but instead of simply shifting money across accounts, they have spent an entire life chapter – their retirement – receiving income and having options to do with whatever they wanted to do with it and still creating tax-free assets at the end of life. It’s really cool. It’s one of the main reasons we emphasize retirees adopting a higher lifestyle. It’s cool to think about it and retirees don’t always quite get it right away. Sometimes it’s one of those things that you have to see unfold and enjoy this new process and this new way of thinking for it to start clicking. That’s what’s really neat is that we can talk about this on the front end, that we still have some tax-smart, tax-savvy approaches to creating tax-free assets in a way that you perhaps have never thought about before.
