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Mike Piper: Delaying Social Security Not Always a Good Deal

The author and Social Security expert discusses the best and worst times to claim Social Security, Roth versus traditional IRAs, and how retirees can protect against a weak market.

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Our guest on the podcast today is Mike Piper. He is the author of several personal finance books, including Social Security Made Simple, Taxes Made Simple, Accounting Made Simple, and Can I Retire? His blog, Oblivious Investor, covers Social Security, taxes, and investing. Piper has also developed a free tool for exploring Social Security-claiming decisions called Open Social Security. He is a certified public accountant.

Background

Bio

Mike Piper's Books

Oblivious Investor

Open Social Security

Social Security

"How Is Social Security Taxed?" by Mike Piper, Oblivious Investor, Jan. 1, 2019.

 "Does Delaying Social Security Deliver an 8% Return?" by Christine Benz, Morningstar.com, May 14, 2020.

"Philosophy of Social Security Claiming Strategies," by Wade Pfau, Retirement Researcher.

Social Security Solutions

Maximize My Social Security

"Steve Vernon: 'Older Workers Become Targets' in Tough Economic Environments," The Long View podcast, Morningstar.com, Sept. 9, 2020.

"Boost Your Risk-Protected Retirement Income With a Social Security Bridge Payment," by Steve Vernon, Forbes, May 26, 2020.

Retirement Planning

"An Ideal Retirement Spending Strategy? "by Mike Piper, Oblivious Investor, March 12, 2018.

"Building a Safe Floor of Retirement Income--in Advance," by Mike Piper, Oblivious Investor, July 2, 2018.

"A Rough, General-Purpose Retirement Plan," by Mike Piper, Oblivious Investor, Jan. 28, 2019.

"Simplifying a Retirement Bucket Portfolio," by Mike Piper, Oblivious Investor, July 8, 2019.

"What's in My Portfolio?" by Mike Piper, Oblivious Investor, Dec. 11, 2019.

"Single Premium Immediate Annuity: Why They're Useful and When to Buy Them," by Mike Piper, Oblivious Investor, Jan. 1, 2020.

"From Assets to Income: A Goals-Based Approach to Retirement Spending," by Colleen Jaconetti, Michael DiJoseph, Francis Kinniry, David Pakula, and Hank Lobel, Vanguard, April 2020.

"Father of 4% Rule Says it Was Really More of a Guideline," by Ginger Szala, ThinkAdvisor, Oct. 19, 2020.

Retirement Accounts

"Marginal Tax Rate or Effective Tax Rate?," by Mike Piper, Oblivious Investor, Dec. 7, 2020.

"Marginal Tax Rate: Not (Necessarily) the Same as Your Tax Bracket," by Mike Piper, Oblivious Investor, March 15, 2021.

"Taxes in Retirement: What Happens After Your Husband or Wife Dies?" by Mike Piper, MarketWatch, Feb. 6, 2021.

"Long-Term Tax Planning Requires Guessing. Focus on the Near Term," by Mike Piper, Oblivious Investor, Feb. 2, 2021.

"Retirement Tax-Planning Error: Not Planning for Widow(er)hood," by Mike Piper, Oblivious Investor, Jan. 4, 2021.

Target-Date Funds

"Don't Judge a Fund by Its Cover," by Mike Piper, The Wall Street Journal, Aug. 8, 2013.

"Why Would an Experienced Investor Buy a Target-Date Fund?" by Mike Piper, Oblivious Investor, May 11, 2015.

"Why I (Still) Like All-in-One Mutual Funds," by Mike Piper, Oblivious Investor, Sept. 14, 2015.

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.

Ptak: Our guest on the podcast today is Mike Piper. Mike is the author of several personal finance books, including Social Security Made Simple, Taxes Made Simple, Accounting Made Simple, and Can I Retire? His blog, "Oblivious Investor," covers Social Security, taxes, and investing. He has also developed a free tool for exploring Social Security-claiming decisions called "Open Social Security." Mike is a certified public accountant.

Mike, welcome to The Long View.

Mike Piper: Thank you for having me.

Ptak: Your books are really inexpensive. Your Social Security calculator is free. Your website is free. You clearly operate with the philosophy that you want to give people easy access to your expertise. Can you discuss your thinking and your business model?

Piper: Sure. As far as the business model, it's very straightforward. It's just selling books on Amazon. Bringing in traffic through an assortment of places and then selling books on Amazon. As far as the line of thinking, a lot of the best financial advisors out there cost a lot of money, which makes sense, because they can provide a lot of value to their clients. But I was just hoping to be able to provide value to people who might not be able to afford $450 an hour sort of thing.

Benz: Are you mainly serving individual investors do you think through your books? Or do you think financial advisors are also reading your books and your other content? Can you tell who is consuming your products?

Piper: It's definitely both. By percentage, it's primarily individual investors, which makes sense just because there's a lot more individual investors out there than advisors. But there's quite a lot of CFPs and CPAs, who will email me with questions about a particular Social Security situation or just want confirmation about how a particular tax provision works or the financial-planning implications of that.

Ptak: Let's shift and talk about Social Security, which is one of your areas of expertise. Everyone who pays even passing attention to Social Security has heard the advice to delay filing for Social Security until some later date. So, let's discuss the benefit one gets when delaying. Can you talk about that?

Piper: Sure. It's pretty straightforward. The longer you wait, the larger your monthly benefit will be. If you wait all the way until age 70, your monthly benefit will be roughly three quarters more than it would be if you filed as early as possible at age 62. But, of course, that's a trade-off. The longer you wait, the fewer the number of months that you'll be collecting that larger benefit.

Benz: We sometimes hear the benefits increase you get by delaying Social Security described as a return. In fact, you even called me on this, Mike, one time. You said stop saying that. People may have heard you pick up an 8% benefits increase for each year you delay past full retirement age. Why do you think that's the wrong way to frame it as some sort of a return pickup? And even just plain wrong that you get that 8% return increase. How can people quantify the benefit enhancement they get from delaying?

Piper: The reason it's not a return is because in order to calculate a rate of return we need to know how long you're going to be receiving the series of cash flows in question. And if you think of an easy example, imagine somebody who decides to wait until age 70. So, if they don't file for benefits and then they die at age 69. Well, they obviously didn't get an 8% return. They got a negative return, because they never collected any cash flows. They gave up cash flows that never received any cash flows in return. So, it's clearly not a positive return at all. And so, we can calculate expected rates of return given various mortality assumptions, or in hindsight, we can calculate what a person's rate of return would have been once we know how long they ended up living. But the only way for it to be an 8% rate of return would be if you lived forever. Then it would be an 8% rate of return.

Benz: So, I sometimes hear people talk about break-even analysis for Social Security. The thinking is, "Well, if I live until X age, then delaying will have been worth it." Is that a constructive way to think about Social Security filing?

Piper: I think, I would say, yes, it's constructive. It's intuitive. It's pretty easy to understand. But it's not the best way, because by definition, a break-even analysis, you're only comparing two options at once. You're comparing filing at one age as opposed to filing at another age. And what you can do instead is just use a tool that does the present value calculation of all of the possible filing options and that's going to be a much more thorough analysis. Also, of course, by doing a present value analysis, you're including foregone investment returns. Because if you delay filing, that means that you are probably spending down your portfolio at a faster rate. So, those dollars that are no longer in your portfolio, you're missing out on the returns that you otherwise would have earned from them. So, the present value calculation accounts for that.

Ptak: And so, that's a tool you've developed and made available, is that correct?

Piper: My calculator, Open Social Security, does do that. It's not the only calculator that does that. Social Security Solutions and Maximize My Social Security are two other calculators that both follow the same approach of doing present-value calculation.

Ptak: What are some situations when it makes sense to claim sooner rather than delay?

Piper: The most obvious one is, imagine a single person who is in very poor health. If you're 62 and you have a particular diagnosis that says that you're unlikely to live until age 70. Well, you probably don't want to wait until age 70 to file for benefits. Another very common example is just that, frankly, in most married couples, the lower earner, it usually doesn't make sense for them to wait all the way until age 70. The reason for that if you want to get into it is that when the lower earner waits to file for benefits, it increases the household benefit as long as both people are still alive. So, in other words, the larger benefit that results from this person delaying, from the lower earner delaying, that larger benefit will end as soon as either person has died. And so, we're looking at a joint-life expectancy, but it's a first-to-die joint-life expectancy, which is by definition shorter than either of the two individual spouses' individual life expectancies. And so, because it's a shorter life expectancy, it's a shorter period of time that we're on average going to be receiving this benefit. So, it's not usually advantageous for that person to delay for very long. But, of course, the age differences between the two spouses and other various factors can come into play.

Benz: Well, that's helpful, Mike. And you've referenced just now a couple of situations when it might not make sense to delay. Let's talk about a couple of other common scenarios. How about a single person who is in pretty good health? Would it usually make sense to delay in that situation?

Piper: Yes. Yes, it does. For a single person in average health even, it typically makes sense to file anywhere from age 68 to 70, and that's purely looking at it actuarially. So, we're not accounting for the fact that it's usually advantageous from a tax standpoint to delay benefits. It's also not accounting for the fact that delaying benefits is helpful from a risk-reduction standpoint, because you're getting longevity risk protection when you delay benefits. So, for a single person in better-than-average health, yes, it almost always is going to make sense for that person to wait until 70. There are some uncommon exceptions, but it will usually make sense for that person to wait until 70.

Ptak: What about married couples and how they should approach this? You just brought up one scenario where there's a disparity in the earnings level of the couple. But what about earnings, histories, age, health? How does that fit in?

Piper: The earnings history, I think, broadly speaking, a good default plan is for the higher earner to wait all the way until age 70 and for the lower earner to file early, not necessarily as early as possible, but usually not waiting all the way until age 70 and often not waiting even until their full retirement age. The reason for that is that when the higher earner delays benefits, it increases the amount that the couple gets as long as either person is still alive. So, in this case, we're talking about a joint-life expectancy, but it's a second-to-die in joint-life expectancy. It's a longer joint life expectancy. And so, this makes it especially advantageous for that person to wait for benefits. In other words, we're increasing that person's own retirement benefit, but we're also increasing the survivor benefit that the other person, the lower earner, would get if the lower earner were to outlive the higher earner. So, it's especially advantageous for the higher earner to wait.

But that exact fact is the reason why it's less advantageous for the lower earner to wait. So, that's just dealing with respective earnings histories. Once you look at age differences, essentially, the younger your spouse is relative to you, the more advantageous it is for you to delay benefits. Because let's imagine you're age 62, if your spouse is 10 years younger than you, they are age 52, well, that makes the applicable joint-life expectancy somewhat longer. If they're 10 years older than you, so they are age 72, that makes the applicable joint-life expectancy somewhat shorter. So, again, just the older you are relative to your spouse, the more advantageous it is for you to delay benefits.

And then, as far as health, with that it's a question of, again, how long will it be before one spouse has died? That's the question that's relevant for the lower earner. Whereas for the higher earner the question is, how long will it be until both spouses have died? So, for the lower earner, if either person is in poor health, that's a point in favor of that person filing early. Whereas for the higher earner to want to delay, both people will have to be in very poor health.

Benz: So, delayed filing doesn't mean that you're doing this in a vacuum. You have to get your money from somewhere assuming that you're retired. So, let's talk about how this works with an actual investment portfolio. So, if someone is delaying filing, that means that their portfolio withdrawals early on in retirement might be higher. What happens if that scenario coincides with a bad market environment? How would you suggest that people approach that? Obviously, you'd tell them to de-risk their portfolio, so they are not in the situation where they are having to withdraw from depreciating equity assets. But what's your counsel there in thinking about how the portfolio interacts with these withdrawals with filing from Social Security?

Piper: What a lot of people have started to talk about in the last few years--Steve Vernon, for instance, is an actuary who has talked about this concept is creating a Social Security bridge with the idea being that in advance if you know you're going to be retiring at a certain age and then not starting Social Security until some later age, in advance you will allocate a portion of your portfolio to safe assets to very confidently be able to provide that extra spending from the portfolio until that Social Security benefit kicks in. So, for instance, if it's going to be seven years between the date you retire and the date your Social Security benefit is going to start, then you might create a seven-year bond ladder or a seven-year CD ladder to be able to very safely provide that additional level of spending from the portfolio, so that that way you're not risking this very bad outcome where you're spending from an equity portfolio at a high rate and at the same time, the equity portfolio is declining rapidly, just because you get unlucky in terms of the timing of a bear market. So, by creating a portion of the portfolio that's specifically dedicated to the extra level of spending until Social Security kicks in, you're essentially alleviating that risk.

Ptak: And I would actually point out that Steve Vernon, someone you just mentioned, we interviewed him on a previous episode of The Long View, I think it was Episode 73. So, those interested in his work can listen to Episode 73 and hear more about some of the strategies that he has written about and talked about previously. I wanted to switch gears and talk about variables, your calculator, which you referenced earlier, that it factors in that some of the other calculators that you mentioned before wouldn't factor in, what some of your secret sauce, so to speak, when it comes to your calculator.

Piper: There's a lot of calculators out there that, frankly, are not very good at all. That's what most of the free ones are. For instance, a lot of them don't account for survivor benefits at all, which it's effectively worthless for a married couple. But there are two very good ones other than mine that I know of. They're both paid. One is Social Security Solutions and the other is Maximize My Social Security, and they are both created by people who are very knowledgeable about Social Security and they account for all various complications that my calculator accounts for--the windfall-elimination provision, government-pension offset, minor children or adult disabled children, and so on.

The one thing, though, that I think my calculator does better than any of the other calculators at least that I have seen is that it doesn't force you to pick the age at which you're going to die. It lets you use an option. Basically, you can pick different mortality tables. And so, it can account for the fact that you don't know when you're going to die. It can account for the uncertainty involved. And for a single person, frankly, this difference isn't terribly important, because what you can do is you could just look up your life expectancy and then use that as the assumed age at death in one of the other calculators. But for a married couple, an intuitive way to use the other types of calculators where you pick how long you're going to live, an intuitive way to use that is to look up your life expectancy and look up your spouse's life expectancy and plug those in as the ages at which you're going to be assumed that you're going to die. But what that does is that it dramatically understates the value of the higher-earning spouse delaying benefits, and it dramatically overstates the value of the lower-earning spouse delaying benefits.

And the reason for that--there is one example that I use frequently, just because the numbers are easy to remember--if you imagine a same-sex couple, let's say they're both men, and they're exactly the same age. And now, they're exactly age 62. So, they're trying to decide whether to file for benefits or not. For this couple, for a male an average health at age 62, the remaining life expectancy is pretty much exactly 20 years, so until age 82. So, if you put that in, you assume that both spouses are going to die at age 82. That's not actually the most likely outcome. Most people don't die exactly at their life expectancy, right? And what's actually more likely is that once 15 years have elapsed, so once they are 77, it's more likely than not that one of the two spouses has died by that point. But on the other hand, the most likely outcome is that one of the two spouses is alive at least for 25 years, so at least until age 87. So, the lower benefit is going to be collected on average until age 77 and the higher benefit is going to be collected, on average, until age 87. And if you're just using the individual life expectancies, you are assuming that both of those benefits end at age 82. And in each case, that's going to be off by approximately five years, on average. So, a calculator that forces you to pick the age at which you're going to die, it can't really accurately reflect joint life expectancies, unfortunately.

Benz: That's interesting. I want to talk more about taxes later on. And Mike, you know a lot about taxes. But I wanted to talk a little bit about Social Security taxes, specifically, because I think that many people do not know how this works. So, what should people know as they are thinking about Social Security with respect to taxes, and also, what should they know about whether they can manage the taxes in any way that will eventually come due on their Social Security benefits?

Piper: The thing to know about Social Security, and the way it is taxed, is that if your income is low enough, then none of your Social Security benefits will be included in your taxable income. But as your income proceeds through a certain range, and that range depends on whether you're single or married, filing jointly and then also, the size of that range depends on the amount of your benefits. As your income proceeds through this range, then every additional dollar of income causes either $0.50 or $0.85 of Social Security benefits to become taxable. And the reason this is so important is because it means that during this window of income, this range of income, your marginal tax rate is way higher than just the tax bracket that you're in, because every dollar of income is causing the normal amount of income tax due to your tax bracket, but it's also causing some Social Security to become taxable, so it's causing even more income tax. So, your marginal tax rate through this range of income is considerably higher than just your tax bracket, which has an assortment of tax-planning ramifications.

Ptak: Maybe we will switch gears and talk retirement planning for the next few minutes. You have a book called Can I Retire? and a lot of people in their 50s and 60s are probably asking that question these days because balances have grown, thanks to the market. But there's also a fair bit of concern among planners that new retirees could be walking headlong into a very difficult environment given valuations are very full and yields are low and so forth. Do you share that concern?

Piper: Yes, unfortunately, I think it would be hard not to, just with valuations being as high as they are and interest rates, real interest rates, being as low as they are, it's hard to imagine anything other than poor to modest expected returns. So, unfortunately, yes, I would not be as confident in a particular percentage of spending today as I would have been several years ago.

Benz: Can we talk about the tools that you think retirees have to confront what you expect will be a challenging environment?

Piper: The tools as far as ways to increase the amount they could spend from a portfolio?

Benz: Yeah, just the strategies that they could employ to figure out how to address a lousy market environment occurring early on in their retirements?

Piper: So, we've been talking about Social Security, that's one of them. For single people as well as higher-earners and married couples delaying Social Security is anywhere from a pretty good deal to a very good deal. And be part of your portfolio that you end up spending down, essentially, in order to delay Social Security, it will end up funding a higher level of spending than it would have been able to fund if you just kept it invested in typical fixed-income assets.

Beyond that, there's obviously the option of lifetime annuities, single-premium immediate lifetime annuities. The unfortunate thing there is that since 2019, I guess, it hasn't been possible to buy an inflation-adjusted lifetime annuity. So, you're going to be stuck with inflation risk if you purchase one of them, but they still can be useful. Because of mortality credits, essentially risk-pooling, they are still going to allow you to spend a greater amount than you could safely spend from a nonannuitized fixed-income portfolio.

Ptak: You've researched all the main systems for in-retirement withdrawals from the fixed real-consumption method that Bill Bengen initially used to more flexible methods. Do you have a favorite method for withdrawal rates, so not just, should it be 3% or 4%, but also how flexible you should be?

Piper: I wouldn't say that I have a favorite method. I don't think that there's any one method that's best. Really, it's just the trade-off. Back in 2016, I think, Colleen Jaconetti of Vanguard wrote a paper talking about a spectrum of retirement-spending strategies with at one end of the spectrum you have the classic 4% rule, the idea that you pick an initial dollar amount of spending, and then you either keep spending that same dollar amount, or you keep spending that same dollar amount adjusted for inflation. And so, with that type of strategy, you're not adjusting your spending at all based on how the portfolio performs. And then, all the way at the other end of the spectrum, you have strategies where you really do spend a percentage of the portfolio per year. So, with that type of strategy, a 4% percent spending rate means that every year you spend 4% of the portfolio, so your spending is going up when the portfolio goes up and it's going down when the portfolio goes down.

And so, the advantage of the constant dollar amount spending strategies like the classic 4% rule is that they make it easier to plan. It's easier to budget when you know how much you're going to be spending this year and next year and the next year. But the disadvantage is that you're more likely to deplete the portfolio because you don't cut spending when the portfolio declines. And then, at the other end of the spectrum, with the more flexible strategies, the advantage is that you're less likely to deplete the portfolio. The other advantage is that assuming the portfolio does grow over time, which is what typically happens if you start with a conservative initial spending rate, then your spending would be allowed to grow with it. So, those are the advantages. And the disadvantage is that your spending isn't going to be very predictable. It can move quite a bit from one year to the next. And so, I don't think there is a best strategy, because it's just the trade-off. And so, what's best for one person would not be best for another person.

Benz: How about the asset allocation in retirement? I think that there has been a lot of discussion about what retiree portfolios should look like today. Obviously, if you maintain a really high allocation to safe assets today, you're setting yourself up for poor returns. But what do you think about in-retirement glide paths? What should they look like, especially if we're concerned about maybe an equity-market shock and its implications for decumulation?

Piper: Yeah, that's, unfortunately, especially tricky question. There aren't a lot of great answers right now. With valuations high, it makes sense to be concerned about a bear market. But on the other hand, you move more into bonds, and there's not going to be great returns there either. I think it does make a lot of sense, as I was talking about earlier, to dedicate portions of the portfolio to essentially alleviate the risk that comes from higher spending in early retirement, because most people, they retire at a given age, and perhaps they don't start Social Security until later. So, there's higher spending from the portfolio during the early years for that reason. But then, for a lot of people, there's also just the fact that people want to spend more in the first years of their retirement. So, for those additional amounts of spending that are going to be coming from the portfolio during the early years, I think it makes sense to dedicate assets in something low risk, so CD ladder, bond ladder, something that's a good fit for the length of time in question. And so, you will be depleting that portion of the portfolio, that's the plan. But it's not then an additional source of risk, because you're not relying on equity returns for that portion of the portfolio to satisfy this piece of spending, essentially.

So, what that ends up resulting in is often an increasing equity allocation over time. But that's not necessarily because that's the goal. The goal isn't increasing equity allocation over time, it's rather just that you have specific fixed-income assets that you are intentionally spending down during the early stage of retirement. And because you're spending down fixed-income assets at a faster rate, then it typically does result in the percentage of the portfolio that is in equities going up over time.

Ptak: In what area of retirement planning would you say you go against the grain where you think the conventional wisdom doesn't hold water?

Piper: This is a tricky one. I think the biggest one, I wouldn't necessarily say that this is conventional wisdom, but it drives me bananas, how often you will see people say that, if you're married, that's the point in favor of delaying Social Security. And it's just like we've been talking about for half of married people, that's a point in favor of delaying Social Security but for the other half of married people that's the point against delaying Social Security. I tend to focus on Social Security. That's what comes to mind just because that's what I deal with the most.

Another thing that I really think is just nonsense--a lot of people you will see sometimes, and I don't see this among financial-planning professionals, frankly, very often, but you will see it on the Bogleheads Forum, for instance, is this idea that Social Security is longevity insurance, that's its purpose. And therefore, you should get the most out of it that you can. You should automatically delay until 70. And I've always found that to be nonsensical on its face. Because just the fact that a type of insurance exists, doesn't mean that you want to buy it--you can think of a million different examples where that's not true. Somebody in their early 20s, for instance, they're not married, they have no dependents, they could buy life insurance, but it doesn't mean that they should. We talk about long-term-care insurance all the time. Most people in retirement are exposed to long-term-care risk. But that doesn't mean that everybody should be buying that insurance. Or just when you buy a television at Best Buy or on Amazon, they're going to try to sell you essentially a tiny insurance policy on that television. But probably it doesn't make sense to buy it because it's profitable for them and you don't need insurance on your television. Most likely, you're going to be fine if the television dies and you need to buy a new one.

So, just because the type of insurance exists doesn't mean you want to buy it. We need to assess the need that you have for that type of insurance and whether or not it's a good deal. And in a lot of cases, delaying Social Security is a good deal. But in a lot of cases, it isn't. It's a minority of cases. But we're not talking for 1% or 2% of people. It's a significant number of people for whom delaying Social Security is not a good deal, and sometimes it's a terrible deal. I think it's important to actually do that analysis rather than making assumptions that you should automatically buy this insurance because that's available to you.

Benz: You mentioned bond or CD ladders, Mike. And I hear about them a lot. And I get that they are precise, that they could address sort of a specific time frame. But the question is, do you think they're worth the complexity? Or could I get there by holding cash and maybe a short-term bond fund, and maybe not have the precision, but also just take some work out of the picture for myself?

Piper: I think it would be reasonable to hold a bond fund that has an average duration that approximately matches the average duration of the spending in question. So, for instance, if it's a five-year period of spending, you're going to be spending more from the portfolio during these five years, instead of a five-year bond ladder or a five-year CD ladder, you could use a fund with an average duration of about two-and-a-half years, and it won't be as precise just like you said, but it will be close and it will be less work. So, sure.

Ptak: Let's switch over to discuss the intersection between taxes and retirement planning. One of the key decisions for retirement savers is whether to fund traditional or Roth accounts. You've written that you shouldn't bother trying to compare your marginal tax rate today with what it's likely to be in the future. So, what should people do instead?

Piper: To back up a step, I do think that that is the analysis that you should be doing--how does your current marginal tax rate compare to your future marginal tax rate. But I think it's important to be realistic in that if you are in your 20s, or you're in your 30s, any detailed analysis to calculate what your marginal tax rate will be in your 60s or 70s, it's pointless, it's just a guess. Because you don't know how your career is going to go, you don't know what level of savings you're going to accumulate, you don't know how your portfolio will perform. And so, you don't know what size the portfolio will be for that reason. You don't know what legislative changes will happen between now and then. You don't necessarily know what your filing status will be, for instance. There's so much uncertainty involved that when we're talking decades in the future, there's really no way to say this is exactly what my marginal tax rate would be. I think it's entirely reasonable to just make a reasonable guess rather than even bothering with anything that you could call a calculation.

And on the flip side, a lot of people ignore the actual calculation for this year. A lot of people just assume that I'm in a particular tax bracket. I'm in the 22% tax bracket. So, that means that I must have a 22% marginal tax rate. But that's not how it works necessarily. There's all kinds of cases where your marginal tax rate is different, or often very different from the tax bracket that you're in. Because our tax code is filled with provisions where a particular credit or deduction phases out over a certain income range, or a new type of tax kicks in once you hit a certain income range. And your marginal tax rate is going to be different than your tax bracket.

One example is the American Opportunity Credit. It's a $2,500 credit for paying higher education expenses for somebody in their first four years of college basically. And for a single taxpayer, it phases out over a $10,000 window of income. So, you're losing a $2,500 credit over a $10,000 window of income. In other words, your marginal tax rate through this range of income is whatever would normally be plus 25%. And the kicker is that this tax credit is per student. So, let's say, if you have a freshman and a junior in college, and you're paying college expenses for both of them, then your marginal tax rate through this window of income will be whatever it is normally plus 50%. And if you're married, then the credit phases out over a $20,000 window rather than a $10,000 window. So, it's half of the percentages we just talked about. But it's still quite significant. And a lot of people just don't even bother with that analysis. They only look at the tax bracket that they're in. They completely miss out on the fact that if they, for instance, did a little bit more tax-deferred contributing this year instead of Roth contributing, then maybe they would qualify for some other credit or some other deduction or something like that. And so, I think people spend not enough time on the analysis for this year, doing a really good detailed, thorough analysis and too much time trying to calculate what their tax rate will be 20 years from now, when really, that calculation is not any more useful than just a guess.

Benz: Well, in terms of that, going back to the question about should I make Roth, should I make traditional IRA, 401(k) contributions, what do you think of a strategy where you just say, I'm not going to try to overthink this at all, I'm just going to put money in both and have tax diversification on my side and hope for the best? Is that a sane way to approach it?

Piper: Is it sane? Yes. I definitely think it's sane. I wouldn't criticize anybody for doing that. There probably will be some years in which doing entirely tax-deferred would have been preferable, because you would have been able to qualify for something that you won't qualify for if you had just reduced your income by a little bit by doing entirely tax-deferred contributions. Then there's also, for a lot of people, this is less of a thing now, because so many 401(k)s offer Roth contributions, but that's relatively newer. So, for a lot of people, the tax-deferred balances are way higher than the existing Roth balances, because they've been saving tax-deferred for so many years, and much smaller amounts in Roth. And so, for those people, I would just say that, it probably makes sense, not necessarily, but if you're going to do a no-calculation sort of plan, just to pick-something-easy-and-do-it sort of plan, I would just go all the way in favor of Roth. But again, you're likely going to be missing out on some things in certain years, and there is no way to know that without actually doing an analysis.

Ptak: If you were to generalize how can people figure out whether it makes sense to convert traditional IRA balances to Roth? I know that you've been speaking to different elements of the thought process that goes into that. But maybe you can speak more specifically to that question, if that's OK?

Piper: Sure. It is primarily the question of marginal tax rates. It's essentially the flip side of the contribution question. In other words, if your marginal tax rate right now is lower than you expect it to be when these dollars would come out of the account later if you were not converting them, then it is advantageous to do a Roth conversion of these dollars. And on the other hand, if your marginal tax rate is higher than you expect it to be later, whenever these dollars will come out of the account, then it doesn't make sense to do a Roth conversion in most cases.

There is one exception, which is, if you're using money from a taxable account to pay the tax on the conversion, then that's the point in favor of doing the conversion aside from the marginal tax rate analysis. So, if you are many, many years away from spending this money, and you think--of course, it's a huge question mark for all the reasons we've been talking about--but if you think that your marginal tax rate later is roughly the same or possibly even a little bit lower, it could still make sense to do a Roth conversion if you're paying the tax on the conversion by using taxable dollars. Because essentially, what you are doing when you're using taxable dollars, is you are using nonretirement account money to buy more space in your retirement accounts and that, in itself is advantageous. So, in some cases, that can outweigh the marginal tax rate analysis.

Benz: How about IRA conversions later in life? I sometimes hear older adults say, "Oh, I'm probably too old to convert my traditional IRA to Roth." What sort of thinking should go on if an older adult, maybe even one who is already subject to required minimum distributions, what should factor into their thinking?

Piper: The analysis, it's the same idea. It's about current marginal tax rate versus future marginal tax rate. And admittedly, it's less common for Roth conversions during that age window to make sense. The age window, when they most often make sense, is somebody who has already retired, but they haven't yet started Social Security and RMDs haven't yet started. So, there is this period of time where their income is relatively low. And so, it often makes sense to take advantage of Roth conversions during those years. But it can make sense even after RMDs have started to do Roth conversions.

One example that I see probably more often than any other example that would make it make sense during those years is, if you're pretty sure that this portfolio is not going to be spent down during your lifetime, so you're pretty sure that you're going to be leaving it to your kids or grandkids or whoever it is, well, then you're no longer comparing your current marginal tax rate to your future marginal tax rate. Now, the comparison should be your current marginal tax rate as compared to the marginal tax rate that your heirs would have when they would be taking the money out of the account. So, if your tax rate right now is something relatively modest, and let's say, you'd be leaving it to your kids who are both very highly paid physicians, for instance, well, then it likely makes sense to be doing Roth conversions now, because you will be leaving them a smaller account, but it's a Roth account, and in this case, they would prefer to receive that Roth account because they have very high tax rates. And so, that way, then they won't have to pay tax at their high tax rate. You are paying tax now at your lower tax rate instead of them paying tax later at their higher tax rate.

Ptak: Some of our listeners are likely in a fortunate position of having all the assets they will need for their own lifetime. So, they are saving and investing for the next generation. What strategies should they consider to ensure that their assets will pass to their heirs while paying the last amount of taxes owed?

Piper: Well, one is exactly what we are talking about--thinking about Roth conversions through the duration of your life. Another thought is thinking about which assets to be spending every year. Typically, tax planning is always case by case. But in most cases, taxable accounts are the least tax-efficient accounts. So, they are generally the ones that you would want to spend down first. And the reason they are the least tax-efficient in most cases is because you have to pay tax on the interest and dividends that you earn in those accounts, so they grow at a slower rate. And so, it often makes sense to spend down those accounts first, while prioritizing leaving the other accounts to your heirs. But one major exception is if you have assets in a taxable account that have significantly gone up in value from when you bought them, so you have big unrealized capital gains, then it often makes sense to try not to spend those assets--leave them to your heirs, and then they will get a step up in cost basis.

Benz: A follow-up question on that, Mike, is one of the proposals under--I don't know if it's formally under consideration--but the idea that that step up would go away. And I want to broaden out the question just to discuss perspective tax changes. How much should people be spending time thinking about changes in the tax code before they are actually turned into law? What do you think about that?

Piper: I love this question because so many people ask this question, and when I talk to tax professionals, overwhelmingly, they--we, so myself included--we struggle sometimes just to keep up with the current tax law. There have been so many changes this year that it's hard just to keep up to date with current law. We're not creating a million different analyses for what if this changes and what if that changes and what if that changes, because there's so many different possible changes that could happen. And the reality is that it's the details that matter.

One example: We were talking about Social Security-benefit taxation, and the thresholds that apply for that, they are not indexed for inflation. They've been what they are, I think, since 1983, if I'm remembering correctly. And so, that's the thing that people mention sometimes, well, maybe they will increase that threshold. Well, in terms of tax planning, you would need to know what they are going to increase the threshold to. And the details make all of the difference. And so, there's not really a lot to be gained from trying to guess what's going to be done with our tax code. Because even if you get it 80% right, the 20% you got wrong could make the planning that you did harmful rather than helpful.

So, I don't think it makes a lot of sense, frankly, to be guessing at what changes are going to be made. And in fact, it's extremely hard. It's just like with the stock market where people think in hindsight, “Oh, yeah, I saw that bear market coming.” OK, so, the 2008-09 bear market, if you were predicting it from three years in advance, that's not really useful. You had to get the timing right. It's the same thing here. If you're predicting particular change, but you're predicting it every year for 10 years, and then they do it, well, that's still not that helpful. You have to get the timing right. And so, it's so hard to guess at these things. And unless you can somehow successfully guess what they're going to change and when, it's not really very productive to be spending time on it, in my opinion.

Ptak: Point taken. But in terms of overall trajectory, taxes are quite low relative to where they've been in history. So, is it reasonable to expect that they will go higher? And if so, what kind of adjustments to a financial or portfolio plan might make sense realizing that one wants to avoid false precision?

Piper: Yes, it's reasonable to think that taxes will be higher in the future. But it's hard to know what to do with that. Does it make sense likely to do somewhat more Roth conversions now or tax-deferred spending now? Yes, likely. Or Roth contributions? Yes, likely. But exactly how much? There's no way to know. It's so much uncertainty involved that I really don't think it's worth spending a great deal of time on. That's like I was saying with this analysis, it makes sense to be pretty precise with your calculations this year, because it's actually calculations, you know what the tax code is for this year. But if we're talking about 20 years from now, there's no such thing as a calculation; it's just a guess.

Benz: I wanted to ask about a really small-bore tax question. In retirement, there is this Medicare surcharge called IRMAA, that comes into play, especially for higher-income retirees. This one seems to catch a lot of people off guard. What should they know about it with respect to their retirement plans?

Piper: That's a great question. Medicare IRMAA, Income Related Monthly Adjustment Amount. What this is, is it has to do with your Medicare premiums. And every year, your premiums depend on your income level from two years prior. So, a person's 2021 premiums are based on their 2019 income level. And the critical thing to know about this is that it's not a gradual effect. There's just specific thresholds. And once your income crosses that threshold, your Medicare premiums two years from now go up dramatically, by several hundred dollars or more than a thousand dollars over the course of the year. So, you can have cases where the $1 of income that puts you over that threshold costs you hundreds, or literally thousands of dollars in some cases. So, it's another one of those things that when you're doing your tax planning from one year to the next, if you can keep your income just below that threshold rather than just above it, that would be very advantageous to do so.

Ptak: Lots of financial experts recommend target-date funds or other simple solutions for the masses, so to speak, but then have more complicated personal portfolios. You, on the other hand, have a single holding. Can you tell our listeners what that is and what your thinking is behind that?

Piper: My portfolio, our portfolio, is entirely Vanguard LifeStrategy Growth Fund. And it's not as if I think that the underlying allocation there is exactly the perfect asset allocation. It's good enough for us, it's close enough for us. And yes, our expenses would be somewhat lower if we were using individual ETFs. But I really like the behavioral finance, behavioral economics advantages that it provides. By which I mean, I don't ever have to think about it, really. I never have to go rebalance. So, that's helpful when the market is going down. It might be hard to rebalance. It's doing it for me. I never have to think about whenever we make contributions, there's no thinking necessary. And I remember before using this fund, that's when I would always be tempted to tinker, so to speak. Like thinking, “Well, OK, so I'm about to make this contribution, should I just put it exactly according to my investment policy statement, or maybe doing it a little bit differently like this in one way or another would make sense.” And that's when I was always tempted, so to speak, to stray from the path, I guess you could say. And this, it's just so easy. You just put the money in the same fund every single time, nothing really to think about. And it's lower stress, that's less work. And for me, that's worth the extra cost that we are paying.

Benz: How about a target-date fund? Why would you opt for a static allocation fund versus one that will definitely get more conservative as you get closer to your retirement date?

Piper: I think target-date funds are great. So, it's not a knock on them. Sorry, I should preface that. As long as they are low-cost target-date funds and they have a reasonable asset allocation. But, for us, prefer the static asset allocation, because I don't particularly anticipate broadly shifting the whole portfolio toward bonds as we get closer to retirement. But instead, building a separate piece of the portfolio or separate pieces, just like we were talking about--separate pieces to allocate toward specific amounts of spending. So, it's more of an asset-dedication approach. And this piece of the portfolio will still be the equity piece of the portfolio, and it will still be there doing its thing. So, I don't anticipate a need to gradually shift the portfolio toward bonds over time according to our own personal plan. But that's not to say that target-date funds are not a good idea. I think they are a great idea for a lot of people.

Ptak: Well, Mike, this has been a really informative and enjoyable conversation. Thanks so much for sharing your time and insights with our listeners. We really appreciate it.

Piper: Thank you for having me.

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(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)