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« Numer, Number, Wherefore Art Thou or When is Enough Enough | Main | Resources for Our Retirement Flightplan »

The Number and How Debt Affects It

So, what is my number?  How much money do I need to secure the rest of my life?  My number  can be defined as that sum of money I will need to tap to fill the gap between the income I have from various sources (pensions, social security, and any earnings I may have in "retirement") and my monthly living expenses.  And, of course, I want that sum to last for the rest of my life.  My number will likely differ significantly from yours depending on many factors, not the least of which is the standard of living we expect to maintain in retirement.  Another factor that will affect our number is the amount of debt that we drag along with us into retirement.  That is what I want to focus on today.

The judicious use of debt no doubt served most of us well throughout our working lives as we enjoyed new cars, new homes, and other consumer products.  However, most experts urge folks to enter retirement with as little debt as possible.  This intuitively makes sense, but not everyone has the luxury of following this sage advice.  For myriad reasons many of us will enter retirement with various types of debt that we will still have to face.  Perhaps your plan was to have that mortgage paid off, but life got in the way.  Children had to go to school; you missed some work because of illness, injury, or downsizing; or divorce may have reared its ugly head and confounded your planning.  Others may choose to keep certain kinds of debt for tax reasons or because they wish to keep some of their assets in a more liquid form.  As we approach retirement however, we need to reassess how we relate to debt because it takes on some different characteristics when we retire.

So why is debt different after we retire, and how does it affect our number?  Let's take a $1000 mortgage payment as an example.  If you are still drawing a paycheck, you make the mortgage payment with current income.  No real problem.  If you retire with an income from a pension and/or Social Security that covers your mortgage payment and the rest of your monthly expenses: 1) you are very fortunate, and 2) still no problem.  When you must withdraw funds from your savings to meet your monthly expenses though, debt will affect you more than you may have realized.  If one has to withdraw money from a retirement account such as a 401k, traditional IRA, or some other tax advantaged retirement account that was funded with pre-tax money, he will have to withdraw enough to not only make the mortgage payment, but also enough to pay the taxes that will come due as a result of that withdrawal.  So now that $1000 payment becomes a $1250 payment for someone in the 25% tax bracket.  Also, that extra $250 is no longer available to compound and earn you more money as the goverment now has it!

In fact as you look at your nest egg from time to time, contemplating your number, remember that you are also looking at some of Uncle Sam's money.  Any money that you withdraw from a tax sheltered account will also bring along its tax payment obligation, and rest assured Uncle Sam intends to get his share.  Thus if your 401k holds $400,000, only $300,000 will actually be available for you to use as you see fit since $100,000 will go to pay taxes, again assuming you are in the 25% tax bracket.  This can be expressed as 1 - (your tax bracket) x (your 401k), i. e. (1 -.25 = .75 x $400,000 = $300,000) = what is actually yours.  Kind of sad, isn't it?  Of course this scenario changes if you are withdrawing funds from a taxable account as taxes have already been paid on some of that money, and hopefully the lower tax rate applicable to capital gains and dividends will apply to most of the rest.  And of course, if you are withdrawing from a ROTH IRA, no taxes will be due.  That ROTH IRA is a great idea!

So the bottom line is that yes, if at all possible, we will be better off in retirement with less debt if for no other reason than that we get to keep more of our asset to use as we see fit rather than to service debt.  But also, as I hope you now see, to withdraw money from tax advantaged accounts to pay debt costs us more than just the debt payment; it also costs us extra taxes.

As you contemplate all of the factors that will affect your "number," I encourage you to get a copy of Lee Eisenberg's book, The Number.  This book will give you much to think about and offer some advice as you flight plan for retirement.  I have a more thorough review posted under the "reviews" section of this site.

Fly Safe!

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    Retirementflightplans - Journal - The Number and How Debt Affects It
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    Response: Imperial Advance
    Retirementflightplans - Journal - The Number and How Debt Affects It

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