This diagram is what I visualize when I make a recommendation for a client, or when I put together a financial plan for them.  I found that I was hand drawing this diagram when I would meet with new and existing clients to help them better understand how all of the pieces fit together, and why one investment choice would be better than another, given their overall investment financial plan and goals.  After having this diagram (even a hand drawn one), my clients have found it very useful in helping them visualize where in the diagram their various accounts are.

The most important thing to remember when viewing this diagram is that this diagram is simply a generalization used to illustrate how money and assets are held, and how the various accounts are normally taxed when you withdraw money from them for your retirement income.  How these assets are taxed directly affects the bottom line as to what is available for you to spend when you are in retirement.

Traditionally, retirement planning has been represented as a "Three-Legged" Stool.  The three legs have been represented as being 1) your pension, profit sharing plans, or 401k plans, 2) Your Social Security benefits, and 3) your other personal assets. 

The reason it is important to understand is that everyone still needs all three legs to have a comfortable retirement.  A common mistake most people have is the mistaken assumption that they can live a comfortable life in retirement entirely off of their Social Security benefits.  Social Security was designed to replace only about 45% of your working income, up to the maximum income taxed by Social Security (the 2009 limit is $106,800 in income).  The maximum Social Security benefit payment for 2009 is $2,323 for someone at full retirement age (FRA).  If your annual income is higher than the maximum of $106,800, then you will need even more retirment account and personal assets to provide the additional income during retirement.  The diagram at the end of this discussion shows an approximation of  this replacement gap for both social security and  a 401k. .

The investments shown under the Retirement accounts (#1) and under the Individual and Joint  Assets (#3) are just showing a range of investments that can be held.  One box  under #1 shows REITS, UIT's, Alternative investments.  Due to more limited space on the #3 side, those same investments would have been included in the "Other Investments" box.  Another duality in the diagram is the concept of "Managed or Fee Based" accounts.  You can have the entire asset base be "Managed for a Fee", or in our practice we separate out only the assets that make the most economic sense to be managed on a fee basis.

Because this is a generalization, it is impossible to list all of the exceptions and special circumstance.   I have tried to asterik (*) the account examples that have the greatest likelyhood of having special rules.  That is why it is important to deal with a professional financial planner, accountant or Certified Public Accountant (CPA), and legal counsel to totally understand your own unique situation. 

As an example, a Health Savings Account is an exception.  It is shown under "Special Accounts" which generally are created with "After Tax" dollars.  The exception is that an HSA is created with pre-tax dollars, but is a "Special Account" because  as long as the principal and growth is used for qualified medical expenses, both the principal and growth will be tax free. 

Another example is Muni Bonds or Muni Bond Funds.  Generally, they are always tax free on your Federal Taxes.  Also they are generally tax free at the State level, if the bonds are issued in your state or a federal territory.  If the bonds are issued in another state, they may be taxed at the state level.  In Colorado, that would mean that they would be approximately 95% tax free.  The major exception with Muni Bond interest is if your income is large enough to  trigger an "Alternative Minimum Tax".

Another benefit of understanding this flow diagram is also understanding how these each of these accounts are owned, and who the beneficiary designations are (primary and secondary).  This is extremely important as it dictates how these assets are passed, potential changes to income in  retirement after a death, and who will be responsible for the estate taxes and taxes on future withdrawals from those accounts.

As stated several times, this is a generalization and it is extremely important that you deal with a professional financial planner, CPA, attorney, etc. to make sure that you have the right plan for your own unique circumstances.

Retirement Income GAP


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