It’s fascinating to me as a retirement-income planner to see how people decide when they’re going to retire, assuming that they plan on retiring one day. One of the more interesting approaches that I come across from time to time is what I refer to as the million-dollar payday. Although there are variations, it goes something like this, “When I have a million dollars in savings and investments, that’s when I’m going to retire.”
While I appreciate simplicity, bells and whistles immediately go off in my head when I hear this pat answer. Nine times out of 10, the individual or couple making this statement hasn’t had a retirement-income planning analysis prepared to determine whether this dollar amount will provide sufficient after-tax income to meet projected lifetime financial needs.
Although there are dozens of questions that need to be answered related to the optimal time to retire that are beyond the scope of this article, let’s simply focus on the goal of accumulating a million dollars in savings and investments. Assuming that this is attainable, there are three basic questions that come to mind, the answers to which are essential in determining whether this target makes sense in a particular situation:
- At what age are you projected to achieve your goal?
- What portion of the $1 million will be held in taxable vs. nontaxable investments?
- How long will your $1 million last?
At what age would you reach your goal?
This is the first and perhaps most important question to ask. It makes a huge difference if you have $1 million saved when you’re 55 vs. 75.
If you achieve your $1 million payday at age 55, you’re seven years too young to be eligible for even a reduced Social Security benefit. More important, assuming that you don’t have other sources of income you can count on, you may have 30 to 40 years or even more ahead of you to make your $1 million last.
If, on the other hand, it takes you until age 75 to accumulate $1 million, this amount, combined with Social Security benefits, especially if you receive a larger benefit as a result of delaying your start date to age 70, may be sufficient to meet your financial needs for the rest of your life.
Taxable vs. nontaxable investments
Talk about a million-dollar question. It’s not until retirement that many people realize that it can make a huge difference whether they’re taking withdrawals from taxable or tax-deferred investments vs. those that are tax-free such as a Roth IRA. Unless you’re in a zero tax bracket, a million dollars doesn’t equate to a million spendable dollars if it’s held in a 401(k) plan and/or traditional IRA accounts to which fully deductible contributions have been made, because you’re subject to income taxes on 100% of your distributions at ordinary tax rates.
Assuming that you’re in a 25% combined federal and state tax bracket and you have $1 million in your non-Roth 401(k) plan, and ignoring changes in investment value, required minimum distribution (“RMD”) rules, and federal income-tax savings from potential state income-tax deductions, $250,000 needs to be allocated for income taxes, leaving you with an after-tax nest egg of $750,000.
How long will your $1 Million last?
Assuming that you can project the age at which you will accumulate $1 million and you can also estimate the after-tax amount that you will have to work with, the final question that needs to be answered is: How long will your money last? Put another way, how long will the projected after-tax distributions from your investments, when combined with other projected sources of after-tax income, meet your ongoing projected inflation-adjusted financial needs, including unplanned health and long-term-care expenses?
The answer to this question, unlike the answer to the previous two questions which are more straightforward, is complicated, since it requires consideration of a host of assumptions and time-consuming financial analysis, including preparation of several what-if scenarios. The average person doesn’t have the training, expertise or inclination to undertake this key exercise.
If your goal is to retire when you have $1 million in savings and investments, until you answer the foregoing three questions to determine whether this target makes sense in your situation, the saying “Be careful what you wish for” comes to mind.