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Plan For a Longer Retirement

For once, the Internal Revenue Service (IRS) has thrown retirement savers a bone and delivered some good news. For the first time in decades, the IRS has updated its required minimum distribution (RMD) tables for traditional 401ks and IRAs. It’s significant because these tables determine what we are required to pull out from our retirement plans after we hit a certain age.

The good news is that life expectancies are longer and that means we aren’t required to withdraw as much as previously before.

However, what the IRS gives, they can take away. The calculations now pose a different problem for savers. Our retirement accounts now may need to last longer. This creates another set of headaches for investors and constitutes a bigger nest egg. In the end, we might need to plan for a much longer retirement.

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The Good News

Workplace 401(k)s and traditional IRA accounts are wonderful vehicles for long-term savers because they offer tax deferral. By deferring taxes on dividends, capital gains, and interest income, investors can keep more of their money compounding over time, leading to higher overall returns. The problem is, Uncle Sam will only let you defer those taxes for so long. Eventually, the IRS will force you to withdraw money from the accounts even if you don’t need it.

When a saver turns 72, the IRS forces you to take what’s called required minimum distributions (RMDs) from their traditional IRAs and 401(k)s. The amount you need to withdraw is based on your account balance at the end of the previous year and your life expectancy based on your age. That withdrawn amount is then taxed as ordinary income rates.

Savers have received some good news at the start of the new year. For the first time in 20 years, the IRS has updated its required minimum distribution tables. The verdict? You’re going to live longer. Under IRS Bulletin 2020-49, the agency has bumped back the average life expectancy by over two years. According to the new set of tables, life expectancy is now 84.6 years, versus 82.4 years in the old table.

The good news is that because you’re expected to live longer, the IRS expects a longer runway to pull taxes out of your account. As such, 401k and IRA RMDs are now lower on a percentage basis for retirement savers. The difference can be significant. Morningstar provides this example: a 77-year-old married woman with a $1 million IRA would have an RMD of $47,169.81 under the old table. The new table reduces the RMD to $43,668.12. That’s enough to keep you in a lower tax bracket.

The Bad News

The good news is that the IRS is giving us a bit of a break. However, it underscores a problem that’s been growing for years. We’re living longer lives.

Overall, life expectancies for Americans, and the rest of the world, have increased significantly over the last half-century. And while COVID-19 has thrown some of the numbers for a loop, the trend is still higher. For a married couple in the U.S., there’s a 72% chance that one of them will live to age 85 and a 45% chance that one will live to age 90. There’s even an 18% chance that one of them could live to 95. Moreover, some analysts are projecting that Americans born today could live to well into their 100s thanks to medicine and high-tech medical devices.

This is an issue for our already strained portfolios.

It’s easy to pass off the IRS increased tables as only being about two or three years. But putting a dollar value to that, it’s not an insignificant sum by any means. The general rule of thumb is that you live off 75% to 80% of your pretax income in retirement. On a $100,000 salary, you’re looking at having an extra $150,000 to $160,000 in your nest egg to cover those extra two years. That’s before inflation and the rising cost of medical care. Given the already underfunded state of most Americans’ retirements, this might be a daunting task to cover the extra.

And while Social Security can provide some of that, the full retirement age is now 67 and the program is looking at a potential haircut if Congress doesn’t act. Americans have the potential to spend more of their time in retirement than they do working.

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Saving More

So, while the IRS is providing us with a nice little break from RMDs, the agency is shining a light on a big problem. We’re living longer and have the capacity to keep longevity growing.

For savers, that simply means saving more. The numbers don’t lie. Even the slight uptick in the IRS’s calculations require a much bigger nest in a significant magnitude. That means we need to be proactive with our savings rates. This includes maxing out retirement plan contributions to using a taxable account for extra savings. Investors need to take advantage of all the tools available.

That could also mean rethinking our portfolios and how they are constructed. For example, you might have to hold a higher percentage of stocks—particularly dividend payers—than ever before. The longevity problem has some analysts posing whether or not the classic 60/40 portfolio is now dead. The IRS’s recent table upgrades could be the last nail in its coffin.

At the end of the day, the lower RMDs are nice, but they come at the cost of having to save even more for retirement.

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Jan 25, 2022