Planning Retirement Distributions from IRAs and Similar Accounts to Adjust for Cost of Living
Crommett, Alfred F., The CPA Journal
A sophisticated society claims to deplore the fate of retirees living on fixed incomes subject to the vicissitudes of inflation, but that same society continues to retire more and more people on fixed pensions, which will never change or change very little with inflation.
It also seems odd that while cost-of-living adjustments (COLAs) are readily available in IRAs and 401(K)s, few people are informed about their availability and concepts.
Consider These Facts
1. A House of Representatives subcommittee on retirement income and employment heard testimony that only 4% of American retirees have protection from inflation in their pensions!
2. The current IRS life expectancy tables indicate that two people, ages 65 and 63, can expect that one of them could live for 26 more years to age 91 or 89! (IRS Publication 575, page 63.)
3. One hundred thousand dollars invested at 8% could provide $705 fixed monthly retirement income to age 95 and beyond. Under a mild 4% inflation rate, however, the purchasing power of this plan would drop by 64% down to $254 per month after 25 years!
4. Conversely, by using the IRS Minimum Distribution Formula, the same $100,000 invested at 8% in an IRA could provide payments beginning at $321 per month, but these payments could rise to $1,419 per month in 25 years or $511 per month when adjusted for 4% inflation! (See Figure 1.)
Any mention of COLAs in retirement has usually been restricted to increases in social security benefits. Thus, the concept of a COLA in a qualified plan distribution has not been recognized.
COLA Effect of Minimum Distribution Method
Creation of COLAs in an IRA is dependent on an understanding of the various minimum distribution methods permitted by the IRS.
To calculate a minimum distribution at age 70-1/2; the IRS requires that life expectancy be divided into the December 31 balance in a tax-deferred fund. The desired COLA effect will not appear, however, until the next year's calculation. In the second and succeeding years, life expectancy values decline while in the early years the fund's year end balance increases because of earnings in excess of withdrawals, thus producing larger distributions each year.
Mr. Robert Preston, a CPA and actuary, pointed out in his retirement newsletter, The Preston Report for Mar/Apr 1990: "Each year, from age 70 onward, your distributions from any IRA will get larger and larger. The intent of Congress (in making distributions larger) was to assure all (or most) IRA monies are used up by death, i.e., IRAs are not to be used as a vehicle to transfer wealth between generations."
While mandatory at age 70. minimum formula withdrawals can be started at age 59-1/2 or even earlier, if permanent disability exists; or if a plan of "substantially equal periodic payments" and other IRS requirements are carefully evaluated.
The IRS minimum distribution method can be used with after-tax funds as a means of creating and managing any income plan. For example, a bank trust department charged with managing money for a retarded child or adult could use the formula to create a payment plan that would meet inflationary needs over a long term.
The IRS minimum formula may not be wise for all retirees. There is a trade-off. The fixed plan payment starts at a higher amount; while a minimum distribution payment begins at a lower amount.
After about 10 years of COLA increases, however, the minimum plan payments are about equal to the fixed plan payments and the COLA increases continue for about another 15 years.
This trade-off decision is typical of the human conflict between the demand for early gratification on the one hand and deferral of gratification in return for the prospects of a better life later on the other hand.
Those with limited retirement resources might want to start retirement with the higher, fixed plan. However, many of those with more discretionary retirement resources would probably opt for the COLA plan, because of the potential of higher pay-outs later. …