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How to deal with future inflation
In response to the Great Recession, the Federal Reserve has been printing lots of money. Indeed, the Fed is on track to raise the monetary base (the cumulative amount of money the Fed prints) by the end of 2010 by a factor of four compared to its value in 2007. Historically, money creation of this magnitude has spelled high inflation if not hyperinflation. Many households can get badly burned by inflation. It’s important to understand your exposure to inflation and how to limit this risk.
Is Uncle Sam broke; and if so, what does that mean to me?
Uncle Sam has commitments to pay for healthcare benefits, Social Security benefits, defense expenditure, and other types of government spending that far exceed his projected tax revenues. Printing money is one option, but it will result in inflation if not hyperinflation. Ultimately, the government will need to cut spending or raise taxes. It’s important to plan for both eventualities.
Remember that old saying—“The only thing you can count on is death and taxes.” Well, it’s not true. The only thing you can count on is death and higher taxes.
Just ask David Walker, former U.S. Comptroller General (head of the General Office of Accountability). He refers to the federal government as sitting on “a burning platform” and predicts a doubling of tax rates unless we dramatically cut spending.
How to plan for future tax hikes and benefit cuts.
ESPlanner lets you specify future tax hikes and Social Security benefit cuts. When you tell the program these problems are coming, it tells you how best to adjust in terms of how much to cut back your current spending and raise your current saving so that you spread the pain over your entire remaining lifetime rather than falling off a cliff in retirement.
Danilo and Gina Perez live in New York City. They are 30 years old and plan to have a child in five years and retire at 65. They are both busy bees with a typical, but also highly complex economic life with annual federal and state taxes to pay, mortgage payments to make, college expenses to meet, etc. Danilo and Gina want to have a stable living standard per household member over time, but don’t know how much to spend each year to make this happen. Figuring this out on their own would take them forever. Fortunately, ESPlanner can make these calculations in seconds taking into account all the Perez’s future taxes, Social Security benefits, life insurance premiums, Medicare Part B premiums, mortgage payments, and college expenses.
Economics-based financial planning
No one wants to splurge today and starve tomorrow, nor do the opposite. Economics-based planning helps you smooth your consumption, i.e., decide how much to spend each year to ensure a stable living standard per household member without going into debt. ESPlanner is the first and only commercially available personal financial planning program to do consumption smoothing. And since it’s a living standard machine, ESPlanner can help you figure out safe ways to raise your living standard such as contributing more to retirement accounts, refinancing your home, taking Social Security later, and deciding between Roth versus traditional IRAs.
All personal financial planning questions, from Can I retire early? to When should I take Social Security? to What can happen if I invest in risky assets? boil down to the impact on your living standard.
ESPlanner is the only financial planning program that directly calculates your living standard and helps you achieve the highest living standard that your current and future economic resources can support.
Take the example of Jack and Jill Sprat, a middle-aged couple.
Basic Profile:
Jack and Jill are 50. They live in Florida. Their children have already graduated from college. Jack and Jill will both retire in 14 years. Jack’s making $40,000 and Jill’s earning $50,000. They have $20,000 in a checking account and $400,000 in retirement accounts (to which they and their employers contribute $3,000 each per year) and a house worth $300,000. But they also have a $120,000 mortgage to pay off over the next 20 years with monthly payments of $792. And their property taxes and other housing expenses come to $4000 per month. Their maximum ages of life are 100. They need to plan to live that long for the simple reason that they might. Their monthly $3,000 combined Social Security checks, which they will start receiving at age 65 will help.
How much should Jack and Jill spend each year when they are both alive to ensure a stable living standard while still meeting all their off-the-top expenses and paying all their future federal and state taxes as well as Medicare Part B premiums over what may be 50 more years?
The answer, in today’s dollars, is $40,320.
How to save the most taxes using retirement accounts.
Contributing to retirement accounts can save you taxes. Contributions to an IRA or 401(k) plan are deductible from your pre-tax earnings. But once you start withdrawing these contributions plus any income earned on those contributions, you need to pay taxes on the withdraws. This is not a wash for two reasons. When you make your withdrawals you may be in a lower tax bracket (notwithstanding the likely tax hikes that are coming). Second, while your money is earning income it’s not subject to taxation.
Contributions to Roth retirement accounts don’t provide any immediate tax break, but the income earned on such accounts accumulates tax-free and future withdrawals aren’t taxed. So if you are worried about future tax hikes, the Roth may be a better option.
ESPlanner lets you explore how your living standard changes as you contribute more or less to your retirement accounts and it lets you see which type of retirement account is best to use.
Traditional financial planning is replete with “rules of thumb,” none of which provide a reliable basis for financial planning. No rule of thumb is repeated more often than the proposition that you need to target your retirement spending at 75-85 percent of your pre-retirement income. Some planners suggest you target to spend in retirement 100 percent of your pre-retirement income. For many households future spending targets this high are beyond their capacity to meet and they are then induced to meet “their” target by investing in securities that yield higher returns on average and raise the probability of making the target, but also raise the chances of losing one’s shirt. ESPlanner finds your spending targets for you based on your assumptions. And it encourages you to make conservative assumptions about how long you will work, how much you will earn, what medical and other special expenses you may incur, and what return you will receive on your savings.
Sixty years-old, single, with no children, and newly retired, Henry Potter has $1 million in regular assets and expects to collect $20,000 from Social Security starting at 62. He’s done well investing in large cap stocks. Since 1926 the S&P 500 has averaged 9.16 percent per year after inflation. If Henry could count on this return, he could spend $69,812 in today’s dollars for the rest of his life.
Maximizing your human wealth
For most people of working age, our future labor earnings – what economists call our human wealth – is our biggest asset. It’s important to make the most of that asset, i.e., to maximize one’s earnings capacity. This means determining which educational decisions and career/job choices will permit you to achieve a higher bottom line, namely a higher lifetime living standard. ESPlanner is ideal for helping you consider these moves. But in using the tool, make conservative assumptions. Your future earnings regardless of what path you take aren’t for sure.
Safe ways to raise your living standard
ESPlanner can help you raise your living standard by showing you the impact on your spending power of changing jobs, moving to another state, delaying retirement, paying off your mortgage, deciding which house to buy, contributing to Roth vs. regular IRAs, timing 401(k) withdrawals, taking Social Security at 70, buying an annuity, taking a reverse mortgage, downsizing your home, and much more.
“Some of the people I know lost millions,” he later wrote. “I was luckier. All I lost was two hundred and forty thousand dollars. I would have lost more, but that was all the money I had.”
—Groucho Marx, 1929
Roth and regular retirement accounts provide significant opportunities for saving taxes over your lifetime. But deciding how much to invest in each and which to withdrawal first is tricky without the right software.
Young Justin Thyme left Holland, Michigan and made off for Chicago, degree in hand, ready to make his way in the world. It took a few years to get on his feet, but at 33, he found himself making $50,000 per year and loving the big city. He also found himself pondering his economic future.
There are lots of ways to spend money in the Second City, and Justin has yet to save a penny for retirement. This is making him nervous. It should.
ESPlanner can show Justin the consequences of saving nothing, saving outside a retirement plan, and saving through his employer’s 401(k).
As indicated in prior case studies, using the 521 form (http://www.socialsecurity.gov/online/ssa-521.pdf), millions of elderly who opted to take Social Security early (e.g., at age 62) can raise their sustainable living standards significantly by replaying and reapplying for higher benefits.
Using Social Security's 521 form (http://www.socialsecurity.gov/online/ssa-521.pdf), millions of elderly who opted to take Social Security prior to age 70 can raise their sustainable living standards by repaying all the benefits they’ve received in the past and reapplying for higher benefits. The required repayment is gross of the Medicare Part B premiums paid in the past.* Bummer. On the other hand, no interest is charged on the repayment. And, get this, the repayment is tax deductible.
For people close to 70 who took their benefits early (e.g., at age 62), this can be a very big deal.
Meet Bill and Belinda Bates, residents of Mobile, Alabama. Bill and Belinda just retired at age 60. Their house is paid off, and their annual housing expenses are $5,500 a year. Paying for these and other expenses is a concern. Yes, they have assets, but they aren’t loaded. They own $400K in regular assets, $200K each in 401(k)s, and $200K each in Roth IRAs.
Jimmy and Rosalynn Carder are both 50, live in Planes, Georgia, and earn a combined $75,000. Thanks to the untimely death of Jimmy’s rich brother, Bilous, they also have $500,000 in financial assets. Jimmy and Rosalynn want to buy their dream house. It’s on the market for $437,500. But they don’t know whether to use their inheritance to buy it outright or use just 20 percent of their inheritance as a downpayment for a mortgage and save the rest. At the prevailing 7 percent rate for a fixed-rate, 30-year mortgage, they’ll pay $2,329 per month if they take out a mortgage.
01(k)s, ESPlanner says they can spend $59,692 each year in today’s dollars on consumption.
Janet is a 55-year-old heart surgeon earning $250,000 a year, and she is burned out working every day. Her husband Jack is also 55, but he spends his days “birding” and has only a modest earnings history. Their 16-year-old son will head off to college to study ornithology in three years. Janet can’t take the work load much longer and plans to retire at age 60.
Bert and Ernie have been pals for a long time. They have the same $80K annual salary, and their employer, PBS, matches their $4K contribution to a 403(b).
They live across the street from each other on Sesame Lane and each owns his $200K Tudor-style home outright. They pay annual property taxes ($2K) and insurance ($700) on their home. Their homes are identical save for one feature: Bert gets the morning sun and Ernie gets the evening sun. Alas, their envy of each other is palpable.
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