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How to Survive Retirement ? Even if You're Short on Savings

Over the past decade, financial experts have been busy figuring out how much retirees can safely spend each year without running out of money. The result? We now have a better grasp of the risks involved -- and a pretty good idea of what a sensible strategy looks like.

There's just one problem: Sensible won't cut it for most Americans.

Wrong answers. Spending down a portfolio in retirement is a treacherous business, because you don't know how long you will live, what the inflation rate will be or how financial markets will fare.

Faced with all this uncertainty, experts typically suggest two solutions. First, you might limit your initial portfolio withdrawal rate to just 3% or 4%, equal to $3,000 or $4,000 for every $100,000 saved. This is well below the 5% and 6% withdrawal rates that used to be advocated and reflects, in part, a concern about today's lofty stock valuations and low after-inflation bond yields.

"Two percent is bullet-proof, 3% is probably safe, 4% is pushing it and, at 5%, you're eating Alpo in your old age," reckons William Bernstein, an investment adviser in North Bend, Ore. "If you take out 5% and you live into your 90s, there's a 50% chance you will run out of money."

These withdrawal rates represent the percentage of your savings that you would pull out in the first year of retirement. Thereafter, you would step up the dollar amount withdrawn each year along with inflation. Sorry, the sums withdrawn would include any dividends and interest you receive, and a portion would have to go toward paying taxes.

Seem reasonable? Trouble is, the typical household headed by a 55- to 64-year-old has less than $90,000 in savings, so a 3% or 4% withdrawal rate would mean scant income. To make matters worse, if markets are kind, these folks may look back later in retirement and find they had pinched pennies unnecessarily.

That brings us to the second solution that's often advocated. Retirees with modest savings are frequently advised to buy income annuities. This involves handing over a wad of money to an insurer, in return for a healthy-sized check every month for life.

Retirees could also snag a handsome stream of lifetime income by delaying Social Security until their late 60s, while using savings to pay for their early retirement years. Prudent? I think so. But the fact is, most seniors balk at the idea of delaying Social Security and buying income annuities, because they fear they won't live long enough to reap the benefits.

Splitting up. What to do? Clearly, we need to come up with strategies that retirees can both afford and find palatable. My suggestion: Think about your retirement in two acts, the period until age 85 and the period after.

Suppose you retire at age 65. Plan on spending down 85% of your portfolio over the next 20 years. You might withdraw 1/20th in your first year of retirement, 1/19th in the second year and so on.

With this strategy, your initial annual withdrawal would be equal to 4.25% of your total savings. But if your investments perform well, your subsequent withdrawals would soar and you would end up with far more income than with a traditional approach, where you start at 3% or 4% and increase for inflation.

In case you live beyond age 85, you need a financial backstop. To that end, invest the other 15% of your savings in a mix of stocks and 20-year inflation-indexed Treasury bonds. If you are still alive at age 85, you can spend down this money gradually or use it to buy an income annuity. To supplement this income, plan on tapping your home's equity at age 85 by taking out a conventional or reverse mortgage.

I am not claiming the two-act retirement plan is ideal. But if you're short on savings, it will give you a fair amount of income, your heirs will inherit a decent sum if you die before age 85 and, if you live longer than that, you should be comfortable enough.

Cutting Your Capital-Gains Tax Bill to Zero

A tax break that could benefit many investors is scheduled to arrive next January, and it's not too soon to start planning ahead.

At first glance, the provision appears relevant only to lower-income taxpayers: Beginning in 2008, the tax rate on long-term capital gains from sales of stocks, mutual funds and other securities is scheduled to drop to zero -- yes, zero -- for people in the two lowest ordinary income brackets. (For higher-income taxpayers, the top long-term capital-gains rate is scheduled to remain at 15%.)

But financial planners say many people with higher income also may be able to take advantage of the zero tax rate if they can reduce their taxable income through deductions, such as mortgage interest and charitable donations, or by socking away money in tax-advantaged accounts, such as 401(k) plans.

"A lot of middle-income people will qualify for this," says Tony DeChellis, senior manager of product development at Thomson Corp.'s PPC/Quickfinder, a Fort Worth, Texas, publisher of tax information.

Families in an upper tax bracket may benefit, too, by making gifts of stock, mutual-fund shares and other securities that have increased in value over the years to low-income family members, such as their young-adult kids, grandchildren or parents, who may then be able to turn around and sell the securities tax free next year.

But use caution: Such gifts may cause problems for students applying for college financial aid, or to seniors seeking Medicaid eligibility, including for nursing-home care. They could make a senior's Social Security benefits subject to tax, or increase the tax on those benefits. Also, because of the recently expanded reach of the so-called kiddie tax, investment income above $1,700 for a child younger than 18 typically is charged at the parents' higher tax rates. It's always smart to check with a financial adviser before making a large transfer of shares.

Nadine Gordon Lee, president of Prosper Advisors LLC, an Armonk, N.Y., wealth-management firm, says she is already planning to take advantage of the upcoming 0% rate. She and her husband have begun transferring shares of equity-based mutual funds, purchased at a lower cost, to one of their sons, now 16. The plan is that he will begin selling them in 2008, when he turns 18, Ms. Lee says. The Lees also are giving highly appreciated stock to their other son, who is 19, and those shares are being sold this year at the current capital-gains-tax rate of 5% for lower-income brackets.

Giving appreciated stock "works nicely for funding the lifestyle of your college and graduate students who are not eligible for financial aid," Ms. Lee says.

Before making any such gifts, be sure to check with a tax adviser on any possible gift-tax or estate-tax consequences, or other possible hitches, Ms. Lee says. However, a gift of this type may be an efficient way to use the annual gift-tax exclusion, she says. That means you can give away as much as $12,000 this year to anyone else -- and to as many other people as you wish -- without any federal gift-tax consequences. (Gifts that exceed that amount typically must be reported to the Internal Revenue Service. Generally, there's a lifetime gift-tax exclusion of $1 million per donor. Gifts above that limit typically are subject to gift tax, and the top rate now is 45%. Gifts don't count as taxable income to the recipient. They also aren't deductible on the giver's income tax returns.)

Investors should never sell securities solely because of tax considerations. But if you're thinking of selling anyway, understanding the tax considerations can help you and your family keep more of the gains.

The 0% rate for lower-income taxpayers was part of the 2003 tax act passed by Congress that, among other things, set the maximum long-term capital-gains rate at 15%. But these rates are set to expire after 2010 unless Congress extends them. Many members of Congress are concerned that an extension could exacerbate the budget deficit.

How low must someone's income be to qualify for the 0% capital-gains-tax rate? Nobody knows for sure because income brackets are adjusted annually for inflation, and the IRS won't release the numbers for 2008 until late this year. But for 2007, a single person falls into the 15% bracket with taxable income of not more than $31,850. For joint filers, this figure is $63,700.

A few pointers: Favorable capital-gains rates apply only to "long-term" gains, or gains on shares held for more than a year. Short-term gains (on shares held a year or less) typically are taxed at regular federal income-tax rates, which can be as high as 35%. What's more, the low capital-gains-tax rates apply only to shares in taxable accounts. They also don't apply to sales of appreciated art and other collectibles; there, the top capital-gains rate typically is 28%.

If you do decide to sell, make sure to unload the shares that will result in the best tax result. This can get tricky. For example, suppose you own 300 shares of a stock purchased many years ago. You bought 100 shares at $5 a share, another 100 shares at $10, and another 100 shares at $50. Now you decide to sell 100 shares. Unless you specify otherwise, the shares of a stock that you bought first are considered to be the ones sold first. If you prefer to sell more-recent shares, make sure to notify your broker at the time of sale and get a confirmation. With mutual funds, you can use the average cost of the shares purchased. There are two averaging methods. See IRS Publication 564 for details.

If you still have confidence in your investment, but you want to take advantage of the zero rate next year, here's a strategy to consider: Sell some of the investment at a gain in 2008, and then immediately buy back shares of the same investment. That means you can still enjoy that zero rate, maintain your position in the security but have a higher basis when you eventually sell the new shares. (The strategy doesn't run afoul of so-called wash-sale rules, because these only apply when selling an investment at a loss, not for gains.)

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THE IRS OPENS its doors to electronic filing this year -- for most people.

Opening day for e-filing your federal income-tax return for 2006 generally was this past Friday, the IRS said. But you can't e-file until Feb. 3 if you're claiming key tax provisions enacted last month. Both e-filed returns and paper returns claiming these provisions -- deductions for state and local sales taxes, higher education tuition and fees, and educator expenses for classroom supplies -- won't be processed if submitted before Feb. 3.

Tax returns filed on paper will be accepted but won't be processed until after IRS systems are updated Feb. 3, the IRS said.

IRS officials strongly urge taxpayers to file electronically. E-filing is "the fastest, safest and most accurate way" to file, said IRS Commissioner Mark W. Everson. He said people will get their refunds more quickly that way than filing the old-fashioned paper way. E-filing also "greatly reduces the chances for making an error."

Last year the IRS received more than 73 million returns electronically, up 7% from the prior year. A spokesman said almost 54% of all returns were filed electronically.

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BRIEFS: Taxing reading: A handy new publication with an overview of the federal tax system is available free on the Web site of Congress's Joint Committee on Taxation, or JCT (www.house.gov/jct/x-2-07.pdf). ... A separate JCT publication lists tax provisions scheduled to expire through the year 2020.

Email Tom Herman at taxreport@wsj.com