Inflation, Taxes, Volatility Affect How Fast You’ll Deplete Retirement Savings
Q: I’m always reading articles about the “safe” withdrawal rate from a retirement fund. One study recently said withdrawal rates higher than 5% dramatically increased the probability of running out of money if the withdrawal period was longer than 15 years. That’s nonsense. If I have $100,000 and withdraw 5% ($5,000) every year, my nest egg will last 20 years, even if I keep it under my mattress. If I put it in a certificate of deposit at 6% annual interest, I could withdraw $5,000 per year until the Fed freezes over and would have more than I started with at the end. Even assuming a very conservative rate of return of 6% from a stock-dominated portfolio, one could withdraw 8% to 9% for a great deal longer than 15 years. The numbers don’t lie, so obviously I’m missing something, or the professors who do these studies can’t add (which seems somewhat less likely). So what’s missing?
A: Three rather crucial factors: inflation, taxes and the volatility of stock market returns.
Yes, you can keep your money in your mattress and pull out 5% a year. But by the end of 20 years, your $5,000 is going to be worth a heck of a lot less than when you started. Mild inflation of just 3% will reduce your buying power by nearly half in that time.
That’s why most retirement calculators assume that you will adjust your withdrawal amount upward for inflation each year. You might start with 5%, but the amount withdrawn will be increased by, say, 3% each year. Doing that means you run out of money during your 16th year of withdrawals.
On to your CD example. In addition to losing ground on inflation, you’re also going to have to pay taxes on the interest you earn. The higher your tax bracket, the more you’ll pay. In the 34% combined state and federal bracket, you’ll pay about $1,700 in taxes, reducing your withdrawal to $3,300. Adjusted for 3% inflation, your withdrawal would be worth about $1,800 in today’s money at the end of 20 years.
You’re right that an 8% to 9% annual return would put you in the clear and allow you to withdraw more than 5% over 15 years. Problem is, the stock market doesn’t guarantee steady returns. You might be up 20% one year and down 30% the next--and down 10% more in the third year. The biggest problem for retirees comes when the stock market dives and stays down shortly after they begin their retirements. They’re withdrawing from a shrinking pot, and if they don’t cut back sharply they risk running out of money much sooner than they expect.
The authors of these studies are trying to warn retirees and other investors not to count on stellar stock market returns throughout their retirements. Conservative withdrawal rates and a diversified portfolio are particularly important for people who can’t make up stock market losses with future earnings--and that includes most retirees.
Cheating Uncle Sam Won’t Fly
Q: Thanks for alerting people to the fact that Uncle Sam gets as much as 55% of what we so frugally accumulate during our lifetimes if we leave an estate in excess of $675,000. People should know that it is foolish to leave the estate-planning responsibility to the lawyers and CPAs. Their responsibility is to the court and to their profession first and the client next.
A: Your letter went on to list several Web sites that encourage tax fraud. Many of those sites discourage people from consulting with attorneys and CPAs with much the same logic you used. Nice try, but it won’t fly.
Every second-rate con artist has a scheme to cheat the U.S. government, and a raft full of reasons their scams will work. People who buy this bunk and who refuse to consult a responsible professional ultimately deserve what they get--audits and huge legal bills, or estate plans that give Uncle Sam an even bigger bite than he might have had otherwise.
Where Your Stock Money Goes
Q: I think this question is so basic that nobody ever asks it, but I also think most investors do not really know the answer. What exactly happens to all this fluctuating money that investors willingly turn over to corporations when buying stock? Are there restrictions as to how much of these precarious funds can actually be spent by the company?
A: Perhaps nobody asks the question because that’s not what really happens in the marketplace most of the time.
When individual investors buy shares of XYZ Corp., they’re not giving money to the corporation unless the company is selling the stock. That happens only occasionally, in “public offerings” through underwriters. After that, investors trade XYZ Corp. stock among themselves. So when share prices zoom and fall, it’s share owners who bear most of the consequences.
*
Liz Pulliam Weston is a personal finance writer for The Times and a graduate of the personal financial planning certificate program at UC Irvine. Questions can be sent to her at liz.pulliam@latimes.com or mailed to her in care of Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053. She regrets that she cannot respond personally to queries. For past Money Talk questions and answers, visit The Times’ Web site at https://www.latimes.com/moneytalk.
