How to Pay for Unexpected Expenses in Retirement without Blowing Up your Financial Plan.
As a Certified Financial Planner™ I create retirement spending plans for a living. The plans I create strive to re-create the feeling of a “salary” for my retired clients. We identify a sustainable distribution strategy based on their resources and their needs, then make sure that the income is distributed on a monthly basis. We revisit the retirement plan periodically to make sure that funds are not depleting too quickly. It can get a lot more complicated than it sounds, but that’s the idea. Such plans work very well for most people, most of the time.
However, let’s not kid ourselves – retirement planning is very different than being on a salary at work. For one thing, there is that big pool of money sitting out there. And sometimes it starts singing the siren’s song – “Spend me! Spend me!”. And the song becomes especially enticing when large and unexpected expenses come up. It is all too easy to simply tap the retirement funds and make the need go away.
But there are two problems with this approach. The big one is taxes. If you are in the 25% tax bracket (and let’s say 5% state tax bracket) then you need to withdraw $13,000 to cover a $10,000 need. And you might even kick your income up to the point where you have to pay an even HIGHER tax rate.
The second issue is sustainability of assets. Let’s say your detailed financial plan computed that you can sustain distributions of $3,000 per month. Combined with your pension and social security, your annual “income” in retirement was planned to be $85,000 – let’s say this is just a little less than what you were earning before you retired. According to the plan, if you earned a modest return, and allow for a modest inflation adjustment, your money would last for the rest of your life if you followed this strategy.
But what happens if you start making unplanned withdrawals? You not only have to pay taxes, but that money is no longer working for you, earning interest and dividends to fuel future distributions. That $13,000 over a 25 year retirement at a 3.5% yield would have generated a total of $11,375 in additional income. Once it is removed from the account, it is no longer generating income, which means your future distributions will be more principle, less earnings. Your account will deplete faster.
OK, you say, but I need $10,000 for a new roof! What do I do?
The question is – what would you have done BEFORE you retired? Maybe you would have been maintaining an emergency fund. Good idea to maintain one in retirement – and this would be a fine solution to the problem. If you happen not to have cash set aside, you may have taken out a home equity loan. So…why not do this in retirement?
What? Carry a mortgage in retirement? Does that really make sense? Well, maybe it does.
I ran the numbers to compare two scenarios. In the first case, you withdraw $13,000, pay $3000 in federal and state taxes to get the $10,000 you need. Total cost: $3000.
In the second scenario, you take out a home equity line of credit and borrow the $10,000. Based on your monthly retirement cash flow you figure you can pay the loan back over 5 years making payments of $186 per month. Assuming a 3.9% loan (about average right now) you would pay a total of $1199 in interest over the 5 years. But more importantly, that $13,000 is still in your retirement account, earning money to help sustain your future distributions.
In summary, a sound plan will have built in sufficient extra cash flow to allow for some unexpected monthly expenses. So it might be best to pay for those expenses out of that same monthly cash flow, rather than taking large, tax-expensive “one time” distributions.
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