"When can I retire?"
When clients ask this, they are usually expecting to hear a specific date. But the most useful answers look at multiple possible dates and show clients how the choice will affect retirement income.
Clients are often surprised to learn that delaying retirement can increase retirement income by a lot. There are multiple forces at work. Retiring later provides more time for existing retirement savings to accumulate and allows workers to make additional contributions. And Social Security benefits increase substantially for each year of delay up to age 70. Delaying retirement shortens the expected retirement period, so the combined result is more money spread over fewer years. Although each case will be different, I'll present an example to provide some general insights.
An example
Developing a full retirement plan for each of a client’s possible retirement dates requires a lot of input and number crunching. I'll do a shortcut version for this example.
This example will be based on a 62-year old individual assumed to live to age 90. This is a longer lifespan than we might think of for the general population, but it reflects typical advisory clients, who are more upscale and have better longevity prospects than average. This analysis will use a fixed lifespan — incorporating variable longevity will be a future project.
This person has a number of choices:
Retiring immediately and receiving Social Security
Retiring immediately and delaying Social Security
Continuing to work to age 66 and making retirement plan contributions
Continuing to work to age 66 and no longer making contributions
Continuing to work to age 70 and making retirement plan contributions
Continuing to work to age 70 and no longer making contributions
I assume this individual is currently earning $75,000 and has accumulated $500,000 in a tax-deferred retirement plan that he or she will use to generate retirement income. (Funds set aside for emergencies are separate.) Monies in the plan are split 50/50 stocks/bonds and will be rebalanced to maintain this allocation. The annual average nominal return assumed for this portfolio is 6.15% after expenses, with a standard deviation of 10.35%. These returns assume an underlying inflation rate of 2.5%. Withdrawals from retirement savings will be taxed at a 25% marginal federal rate and a state income tax rate of 5.2% (based on Massachusetts).
This individual's primary goal is to generate income for retirement, with a secondary goal of leaving a legacy. This person also has the flexibility to adjust retirement consumption depending on investment experience. Given these considerations, the planning will aim for retirement withdrawals that will give a two-thirds probability of not having to reduce consumption over the course of retirement. This is a lower probability of success than is often used in retirement research (where 95% probabilities of success are common), but such plans push spending toward the end of life or into legacies, which is not consistent with my assumptions in this case. This client might be considered a good candidate for an annuity to mitigate longevity risk, but for this analysis, I'll just use regular investments and leave the annuity analysis for future research.
Continuing to work and save
The chart below provides a comparison of projected retirement income for retirements at age 62 versus delaying to 66 or 70. Retirements after 62 assume continued contributions of $7,500 each year increasing with inflation until retirement. This level of contribution is 10% of assumed salary and roughly equal to the U.S. average employer and employees’ combined contributions for those who have retirement plans. All projected income and tax items assume annual increases at the 2.5% rate of inflation, but the dollar figures in the chart have been discounted to age 62 at the 2.5% inflation rate to facilitate comparing the real dollar effect of retiring at different dates.
Retirement at different ages with 401(k) contributions until retirement
Retirement age |
62 |
66
|
70 |
Social Security income |
$16,800 |
$22,400 |
$29,568 |
401(k) withdrawals (gross) |
$23,558 |
$30,520 |
$40,788 |
Income tax (incl. tax on SS) |
$7,813 |
$12,017 |
$18,388 |
After-tax retirement income |
$32,545 |
$40,903 |
$51,968 |
Dollar increase over age 62 |
|
$8,358 |
$19,423 |
Probability of success |
66% |
66% |
66% |
Median bequest |
$233,000 |
$257,000 |
$261,000 |
Source: Author's calculations using AllocationMaster software
All dollar figures discounted to age 62 at the 2.5% inflation rate
The Social Security amounts are estimated for an individual age 62 currently earning $75,000. The benefits assume the individual begins receiving Social Security at retirement. The age-62 benefit is 75% of the age-66 benefit, and the age-70 benefit is 132% of the age-66 amount. The 401(k) withdrawals were determined by testing different amounts to come up with the amount that produced a 66% probability of not depleting funds before age 90. These amounts, and the withdrawal amounts in the examples that follow, were tested to insure that they exceeded Required Minimum Distributions (RMDs). The income tax was determined by applying the marginal federal and state rate to 401(k) withdrawals.
I used an approximation of the complicated three-part formula specified by the IRS to determine the portion of Social Security benefits subject to income tax. This formula depends on Social Security and other income, including 401(k) withdrawals. Up to 85% of Social Security benefits are taxable under the formula. Only about 15% of Americans receiving Social Security are subject to this tax, but it hits higher-income taxpayers – more typical of advisor clients. In this example, the taxable percentage of Social Security ranged from 21% for the age-62 retirement, with the lowest income, to 77% for age 70. Note the sharp increase in tax amounts for higher retirement ages.
This tax on Social Security dampens the increases in retirement income that one can achieve by retiring later, although the impact is still substantial. The increases in after-tax income for four-year delays (62 to 66 or 66 to 70) are roughly 25-27%. I've seen other estimates on the order of 33%, but these do not take into account taxation on Social Security benefits.
Advisors should ideally have software that handles the three-part formula for the taxation of Social Security benefits. However, such software requires the input of lots of tax return items, so some software simply leaves it up to the advisor to do calculations offline, which can be inexact and time-consuming. However, it's important to include this element in projections.
Continuing to work but stopping contributions
The chart below is similar to the prior chart except that there are no retirement contributions after age 62.
Retirement at different ages with no 401(k) contributions after age 62
Retirement age |
62 |
66
|
70 |
Social Security income |
$16,800 |
$22,400 |
$29,568 |
401(k) withdrawals (gross) |
$23,558 |
$28,973 |
$36,850 |
Income tax (incl. tax on SS) |
$7,813 |
$11,190 |
$16,282 |
After-tax retirement income |
$32,545 |
$40,183 |
$50,136 |
Dollar increase over age 62 |
|
$7,638 |
$17,591 |
Probability of success |
66% |
66% |
66% |
Median bequest |
$233,000 |
$248,000 |
$251,000 |
Source: Author's calculations using AllocationMaster software
All dollar figures discounted to age 62 at the 2.5% inflation rate
It is perhaps surprising that, for this example, stopping contributions does not have a big impact. If we compare the first and second chart for age 70, we see that the 401(k) withdrawals are about $4,000 higher in the first chart, but taxes eat up more than $2,000 of this difference, so a lot of the income benefit from additional contributions goes to the IRS rather than to the client. This reflects the odd workings of the three-part formula, in which increasing percentages of Social Security income get taxed as income increases. Although the marginal federal and state rate may be below 30%, the effective marginal rate including Social Security taxation may exceed 50%. It helps to have software that can accurately do the number crunching.
Retiring at age 62 but delaying Social Security
This final chart is based on stopping work at age 62 but delaying Social Security. The "missing" Social Security until the commencement of benefits is assumed to be provided by 401(k) withdrawals. The remaining 401(k) savings not needed for these interim payments is spread over the full retirement period.
Retirement at age 62 with Social Security beginning at different ages
Begin Social Security |
62 |
66 |
70 |
Social Security income |
$16,800 |
$22,400 |
$29,568 |
401(k) withdrawals (gross) |
$23,558 |
$18,284 |
$9,353 |
Income tax (incl. tax on SS) |
$7,813 |
$5,932 |
$2,703 |
After-tax retirement income |
$32,545 |
$34,752 |
$36,218 |
Dollar increase over age 62 |
|
$2,207 |
$3,673 |
Probability of success |
66% |
66% |
66% |
Median bequest |
$233,000 |
$155,000 |
$94,000 |
Source: Author's calculations using AllocationMaster software
All dollar figures discounted to age 62 at the 2.5% inflation rate
As one might expect, with work stopping at 62, we no longer see the big increases at age 66 and 70, but we still see increases. The rewards for delaying Social Security beyond age 62 are substantial, so from a pure financial perspective, it pays to delay if one is in reasonably good health (as I discussed in this Advisor Perspectives article earlier this year). The downside to this delay strategy is that the 401(k) is drawn down considerably during the early retirement years, which may be unsettling for clients. For example, using the delay-to-70 strategy, the original $500,000 401(k) balance drops to a projected average of $261,000 by the ninth year. This compares to $557,000 in the ninth year for a client starting Social Security at age 62. The delay strategy actually builds a more secure retirement, but it may not feel that way.
Taxes go down at the higher ages. The 401(k) balances are drawn down faster, so there is less income subject to tax, and the effect of the three-part formula diminishes rather than increases at the higher ages.
General comments
For this particular example, we see significant benefits from delaying retirement, but continuing contributions does not make a big difference. Part of the reason is that the hypothetical client has already built a significant 401(k) balance by age 62. Future contributions will have a bigger impact for those with smaller balances who need to catch up. Also, the assumed income level happens to be in a band in which income increases get hit hard by the Social Security taxation formula. This effect phases out for lower and higher incomes. For advisors, it's important to do the calculations with actual client income numbers.
There are considerable income differences between the second and third charts. The key difference is that in the second chart, the client is assumed to earn enough from continuing to work that the starting 401(k) balance is left to grow, even though contributions have been stopped.
All the income projections in the charts were intended to be equivalent from a risk perspective by setting 401(k) withdrawals at a level that produced a 66% probability of plan success. However, the strategies that generate higher Social Security do have the additional benefit of providing a higher secure base of income and covering a larger share of basic living expenses. Also, this Social Security income provides longevity insurance for those who live longer.
Final word
For clients who are anxious to quit work and head for the beach or the golf course, the bad news is that they may be giving up a lot of potential retirement income. However, for those who are not financially prepared for retirement, the good news is that working four or five years longer will improve things greatly.
Regardless of the client's situation, do the necessary detailed work to provide a fair picture of the options.
Joe Tomlinson, an actuary and financial planner, is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. His practice focuses on retirement planning. He also does research and writing on financial planning and investment topics.
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