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Reverse Budgeting

How Much Do I Spend in Retirement?  Does it Really Matter?  What if I could budget without…budgeting?

At CapSouth, it is our mission to help clients define and live their One Best Financial Life™.  We challenge clients to consider their values and what is important to them, and then to develop actionable goals that we endeavor to help them achieve.  This leads to the need to have a sound financial plan in place that considers a client’s assets and resources, and projects their probability of meeting those stated goals.  We want clients to live with confidence in peace of mind, knowing that they are on track to live the life they want to live.  Sometimes the focus of planning needs to be encouraging a client to scale back and pace their spending to allow for a more secure retirement.  Other times that planning focus should be to urge a client to spend more, to travel, to take the family with them on vacations and make memories…to live their life more fully.  In all cases, we are looking for the client’s confidence zone in their plan to serve as guard rails, so that they are not worried about running out of money, and on the other end, they are not leaving significant assets behind that are unplanned for.

More often than not, it seems, we meet with clients who do not have a clear idea of how much they spend.  Particularly when a couple nearing retirement comes to us as a new prospect, a common answer is that they have just always lived within their means, or spent less than they made.  How much you spend in retirement is very important in planning.  Depending on your age at retirement and your assets, a seemingly small change in your annual spending can make a significant difference in the success of your plan.  Many people plan for thirty years or more in retirement – a long time for inflation and market fluctuations to catch up with you and to affect your probability of meeting all your goals and objectives.  We have invested in sophisticated software to factor in these variables for you, to allow you to simply think of how much you will need for retirement in today’s dollars.  That does require us, though, to have an accurate number for that element.  Whether we are planning for annual living expenses of $50,000 or $500,000, we need some assurance that this number is reliable.

But who wants to budget?  You should see some of the facial expressions we get when we mention that “B word”!  And if you are newly in, or approaching, retirement, how do you really know what your retirement lifestyle will be and what it will cost you?  Further, trying to look at past or future spending can be even more difficult when you have varying sources of income throughout the year.  Fear not, we have a solution.  Reverse Budgeting.  I believe in giving credit where it is due, so I will tell you this is not my concept; I learned it from CapSouth’s founder, Donald Bolden, years ago, and I have been recommending it to clients in retirement ever since. 

Here’s how it works:

  1. As best you can, come up with an idea of what you expect your basic living expenses to be in retirement.  This should not include other specified goals in your plan such as travel, new cars, etc., but your basic living expenses of utilities, groceries, fuel, clothing, dining out, and the like.  For illustration purposes, let’s say that number comes out to $5,000 per month.
  2. Now, figure up what regular income sources you have such as Social Security, pensions, rental income, etc.  For this number, let’s assume $3,000 per month.
  3. Set up an “operating account” for your household and start it with a cushion balance of your comfort level.  Let’s use $25,000. (Note:  You and your spouse may decide to have two operating accounts; the concept still works.)
  4. We would then work with you to establish a conservative Cash Management Account (CMA) among your accounts at Schwab, from which we would establish a recurring monthly transfer of the $2,000 per month to supplement your income and meet your expected expenses of $5,000 per month.  We typically recommend this transfer being set up to occur on the 5th of each month rather than the 1st, to help track which deposit was for which month and to not allow weekends or holidays to confuse things.
  5. What about those random sources of income throughout the year?  Still employed and have a varying income?  Receive additional bonuses?  It is so easy to allow yourself to quickly spend that seemingly “extra” income without realizing it, giving yourself (and us) an inaccurate picture of the cost of your lifestyle.  Under the Reverse Budgeting model, all variable income is deposited into the cash management account at Schwab, adding to the funds available to provide for your monthly transfers to your operating account.
  6. It is likely no surprise to you that some months will cost more than others.  You may have family visiting and spend more on groceries.  You might have an anniversary and treat yourself to a nice dinner and some gifts to celebrate.  Your refrigerator might need to be repaired or replaced.  However, if we look back at this operating account in six months, a year, or more, we can get an idea of what you were really spending. 

If that $25,000 cushion is down to $5,000, then we have a problem and need to make adjustments.  We would review to see if there were a number of non-recurring, unexpected expenses during that period, or if life just cost more than you thought.  We could increase the goal for living expenses in the plan to see if the new amount is still successful or what trade-offs need to be considered.  If your regular monthly expenses are $6,000 or $7,000, then maybe you need to consider reducing those big trips each year from three down to two. 

If that cushion is up to $50,000, we also have an inaccurate plan and need to make adjustments.  We might encourage you to consider what goals you had for retirement spending that you haven’t been doing and challenge you to do what you said that you valued.  It could also open the door for more travel, giving to charity or your family, upgrading your vehicle, buying a second home…whatever that looks like for you.  If you are doing everything you want to, then we need to acknowledge that you are going to likely leave more behind than you might have thought, and we may need to review your estate plan to make sure it aligns with your wishes.

This is a simplified example, and we recognize that yours may be more complex.  Life certainly will happen, and circumstances will change.  Planning is never complete, and we continue to monitor, review, and update assumptions over time.  Reverse Budgeting is a tool that can help to provide more confidence and reliability to your financial planning process, without having to focus on the “B word” of budgeting.  We may not be able to tell where the money is going, but we (and you) can tell how much is needed to maintain your lifestyle.

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

By: Scott McDowall, CFP®

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results.

IRA Strategy

IRA Strategy #1

The 50/50 Minimum Strategy:  Maintain 50% of your 401(k) and IRA money in Roth accounts

Why pay taxes today when you can postpone them until years later? The obvious answer is to delay paying taxes as long as possible.  But sometimes the obvious answer is not the best answer.  Let’s consider several assumptions that support the 50/50 Minimum Strategy.

First, if one invests the money that would have gone to taxes, it should compound over time and the total investments, less the eventual taxes to be paid, would potentially be greater than the amount of the Roth conversion, plus earnings.  The problem with this is most people will not diligently invest the money that would have gone to pay the tax.  It is more easily spent in the normal household budget.  And even if it were invested, the potential to keep it invested over a long period of time is dependent on many variables. 

Second is the assumption that a person’s income will be lower in retirement. This is true for many taxpayers.  However, many of our clients remain in a high tax bracket after retirement.  This is especially true if one has large IRA balances that require minimum distributions combined with large investment accounts that create capital gains. 

Third is the assumption that tax rates will remain relatively stable over time.  This is the most dangerous assumption.  Congress has the power to change the tax rates at any time and with the skyrocketing budget and related government debt, it appears likely that tax rates will be higher in the future. So, even if one’s income is lower, the tax rate could be higher. 

How high could tax rates go?  The following chart provides a history of the highest marginal tax rate for 1944 through 2022 for married couples filing jointly:

Years                                                 Highest Marginal Rate#                 Taxable Income Over#

1944 through 1951                           91%                                                 $200,000 (1950)

1952 through 1953                           92%                                                  $300,000 (1953)

1954 through 1963                           91%                                                   $300,000 (1958)

1964                                                  77%                                                   $200,000 (1964)

1965 through 1981                           70%                                                   $180,000 (1974)

1982 through 1986                           50%                                                   $108,300 (1984)

1987                                                  38.5%                                                $80,000 (1987)

1988 through 1990                          28%        (Bubble Rate 33%)           $78,400 (1988)

1991 through 1992                           31%                                                    $70,450 (1991)

1993 through 2000                          39.6%                                                  $288,350 (2000)

2001                                                  39.1%                                                  $297,350 (2001)

2002                                                 38.6%$                                                 $307,050(2002)                           

2003 through 2012                           35%                                                     $388,350 (2012)

2013 through 2017                           39.6%                                                  $444,550 (2017)

2018 through 2022                           37.0%                                                  $647,850 (2022)

#  Rate for Married Couples Filing Jointly

 Information provided by The Tax Foundation, Washington, DC. 20005

The strategy that we have continued to recommend to most of our clients is to approach retirement with a minimum of 50% of their IRA and 401(k) assets held in Roth accounts.  With this approach, an investor takes a balanced approach to the payment of taxes.  Pay taxes at the rates in effect now on the Roth contributions and conversion amounts while delaying the taxes on the non-Roth portion of their deferrals or contributions.  If we err on one side or the other, we prefer to convert more of the retirement assets and pay the taxes at today’s rates as opposed to leaving these assets subject to whatever future rate Congress enacts. 

If a client is charitably minded, we do not recommend converting ALL your IRA assets.  The preferred use of a portion of your IRA assets is to process Qualified Charitable Distributions (QCD) with the pre-tax IRA assets.  After age 70.5, taxpayers may donate money directly from their IRA to qualified charities utilizing the QCD provisions.  The annual limit on QCD donations is currently $100,000. 

ACTION:  Consider adopting the strategy of working towards a minimum Roth balance of 50% of your total retirement assets by your retirement date.  Work with your financial advisor to determine if you should convert a higher percentage. 

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

By: Donald P. Bolden, CFP®, CLU & Lewis Robinson, CPA

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results.

Taxation of Investments

Taxation of Investments

It’s nice to own stocks, bonds, and other investments. Nice, that is, until it’s time to fill out your federal income tax return. At that point, you may be left scratching your head. Just how do you report your investments and how are they taxed?

Is it ordinary income or a capital gain?

To determine how an investment vehicle is taxed in a given year, first ask yourself what went on with the investment that year. Did it generate interest income? If so, the income is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss is probably involved. (Certain investments can generate both ordinary income and capital gain income, but we won’t get into that here.)

If you receive dividend income, it may be taxed either at ordinary income tax rates or at the rates that apply to long-term capital gain income. Dividends paid to an individual shareholder from a domestic corporation or qualified foreign corporation are generally taxed at the same rates that apply to long-term capital gains. Long-term capital gains and qualified dividends are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income. (Some types of capital gains may be taxed as high as 25 percent or 28 percent.) The actual process of calculating tax on long-term capital gains and qualified dividends is extremely complicated and depends on the amount of your net capital gains and qualified dividends and your taxable income. But special rules and exclusions apply, and some dividends (such as those from money market mutual funds) continue to be treated as ordinary income.

The distinction between ordinary income and capital gain income is important because different tax rates may apply and different reporting procedures may be involved. Here are some of the things you need to know.

Categorizing your ordinary income

Investments often produce ordinary income. Examples of ordinary income include interest and rent. Many investments — including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock — can generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital gains) tax rates.

But not all ordinary income is taxable — and even if it is taxable, it may not be taxed immediately. If you receive ordinary income, the income can be categorized as taxable, tax exempt, or tax deferred.

  • Taxable income: This is income that’s not tax exempt or tax deferred. If you receive ordinary taxable income from your investments, you’ll report it on your federal income tax return. In some cases, you may have to detail your investments and income on Schedule B.
  • Tax-exempt income: This is income that’s free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that can generate tax-exempt income.
  • Tax-deferred income: This is income whose taxation is postponed until some point in the future. For example, with a 401(k) retirement plan, earnings are reinvested and taxed only when you take money out of the plan. The income earned in the 401(k) plan is tax deferred.

A quick word about ordinary losses: It’s possible for an investment to generate an ordinary loss, rather than ordinary income. In general, ordinary losses reduce ordinary income.

Understanding what basis means

Let’s move on to what happens when you sell an investment vehicle. Before getting into capital gains and losses, though, you need to understand an important term — basis. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell or exchange an asset, you must know how to determine both your initial basis and adjusted basis in the asset.

First, initial basis. Usually, your initial basis equals your cost — what you paid for the asset. For example, if you purchased one share of stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance, or in a tax-free exchange.

Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset, and which items decrease the basis of your asset. See IRS Publication 551 for details.

Calculating your capital gain or loss

If you sell stocks, bonds, or other capital assets, you’ll end up with a capital gain or loss. Special capital gains tax rates may apply. These rates may be lower than ordinary income tax rates.

Basically, capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis in the asset, you’ll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you’ll have a capital loss. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $8,000, your capital loss will be $2,000.

Schedule D of your income tax return is where you’ll calculate your short-term and long-term capital gains and losses, and figure the tax due, if any. You’ll need to know not only your adjusted basis and the amount realized from each sale, but also your holding period, your taxable income, and the type of asset(s) involved. See IRS Publication 544 for details.

  • Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less, and long term if the asset was held for more than one year. The tax rates applied to long-term capital gain income are generally lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income.
  • Taxable income: Long-term capital gains and qualified dividends are generally taxed at special capital gains tax rates of 0%, 15%, and 20% depending on your taxable income. (Some types of capital gains may be taxed as high as 25 percent or 28 percent.) The actual process of calculating tax on long-term capital gains and qualified dividends is extremely complicated and depends on the amount of your net capital gains and qualified dividends and your taxable income.
  • Type of asset: The type of asset that you sell will dictate the capital gain rate that applies, and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28 percent even if you held the antique for more than 12 months.

Using capital losses to reduce your tax liability

You can use capital losses from one investment to reduce the capital gains from other investments. You can also use a capital loss against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). Losses not used this year can offset future capital gains. Schedule D of your federal income tax return can lead you through this process.

New Medicare contribution tax on unearned income may apply

High-income individuals may be subject to a 3.8 percent Medicare contribution tax on unearned income (the tax, which first took effect in 2013, is also imposed on estates and trusts, although slightly different rules apply). The tax is equal to 3.8 percent of the lesser of:

  • Your net investment income (generally, net income from interest, dividends, annuities, royalties and rents, and capital gains, as well as income from a business that is considered a passive activity), or
  • The amount of your modified adjusted gross income that exceeds $200,000 ($250,000 if married filing a joint federal income tax return, $125,000 if married filing a separate return)

So, effectively, you’re subject to the additional 3.8 percent tax only if your adjusted gross income exceeds the dollar thresholds listed above. It’s worth noting that interest on tax-exempt bonds is not considered net investment income for purposes of the additional tax. Qualified retirement plan and IRA distributions are also not considered investment income.

Getting help when things get too complicated

The sales of some assets are more difficult to calculate and report than others, so you may need to consult an IRS publication or other tax references to properly calculate your capital gain or loss. Also, remember that you can always seek the assistance of an accountant or other tax professional. 

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results.

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