Jane Young, CFP, EA
When it comes to retirement there are many preconceived notions and myths on how you should handle your finances. Avoid falling into the trap of what retirees are “supposed to do”. Instead, logically evaluate your situation and make decisions accordingly. Below are some common financial mistakes to avoid with regard to your retirement.
- Don’t underestimate your life expectancy and how many years you will spend in retirement. It is reasonable to spend 20 to 30 years in retirement. Most retiree’s should plan to cover expenses well into their 90’s.
- Avoid overestimating your ability and opportunity to work during retirement. Be cautious about including too much income for work during retirement in your cash flow projections. You may lose your job or have trouble finding a good paying position. Additionally, your ability and desire to work during retirement may be hindered by health issues or the need to care for a spouse.
- Many retirees invest too conservatively and fail to consider the impact of inflation on their nest egg. Maintain a diversified portfolio that supports the time frame in which you will need money. Money needed in the short term should be in safer, fixed income investments. Alternatively, long term money can be invested in stock mutual funds where you have a better chance to earning returns that will outpace inflation.
- Resist the temptation to take Social Security early. Most people should wait and take Social Security at their full retirement age or later, full retirement is between 66 and 67 for most individuals. Taking Social Security early results in a reduced benefit. If you can delay taking Social Security you can earn a higher benefit that increases 8% per year up to age 70. This can provide nice longevity insurance if you live beyond the normal life expectancy. You also want to avoid taking Social Security early if you are still working. In 2016 you will lose $1 for every $2 earned over $15,720, prior to reaching your full Social Security retirement age.
- Avoid spending too much on your adult children. The desire to help your children is natural but many retirees need this money to cover their own expenses. You may be on a fixed income and no longer able to earn a living, your children should have the ability to continue working for many years.
One of the biggest retirement mistakes is the failure to do any retirement planning. Crunch some numbers to determine how much you need to put away, when you can retire, and what kind of budget you will need to follow. Without proper planning many retirees pull too much from their investments early on leaving them strapped later in life. It’s advisable to have your own customized retirement plan done to determine how much you can annually pull from your investments. As a general rule, annual distributions should not exceed 3-4% of your retirement portfolio.
Jane Young, CFP, EA
As the average life expectancy increases retirement is starting to look very different. We may be less likely to completely stop working on a fixed, predetermined date. As the traditional retirement age of 65 approaches many are considering a more gradual transition into retirement.
One advantage of easing into retirement includes the ability to supplement your cash flow and reduce the amount needed to be withdrawn from your retirement savings. If you continue working after 65 you may be able to earn enough to delay taking Social Security until 70. This will provide additional financial security because your Social Security benefit increases 8% per year from your normal retirement age to age 70. The normal Social Security retirement age is between 66 and 67.
Abruptly going into retirement can be very traumatic because careers provide us with a sense of purpose, a feeling of accomplishment and self-esteem. Your social structure can also be closely tied to work. By working part time before completely retiring, you can gradually transition into the new phase of your life. As you approach retirement age the grind of working 40 to 50 hours per week can become very trying. Working part time allows you to stay engaged with your career while taking some time to relax and pursue other interests.
According to a 2012 study by the Bureau of Labor Statistics, more people are working beyond age 65. In 2012 about 18.5% of Americans over 65 were still working vs. only 10.8% in 1985. A study reported by the Journal of Occupational Health and Psychology stated there are health benefits from working part time during retirement. This may be attributed to less stress and a more balanced life while experiencing the mental stimulation gained from continued engagement at work.
Gradually transitioning into retirement may be more practical for someone who is self-employed. However, the concept of phased retirement is a hot topic among human relations firms and departments. Phased retirement programs usually involve working about 20 hours a week with some element of mentoring less experienced workers. Formal phased retirement programs are still rare but they are gaining popularity. A 2010 study by AARP and the Society for Human Resources Management found that about 20% of the organizations polled had a phased retirement program or were planning to start a one. In fact, the federal government just launched a phased retirement program.
Before signing up for a phased retirement plan, take steps to fully understand the impact it may have on your benefits. If you are under 65 there may be restrictions on your health insurance. Additionally, some pension calculations are based on your final years of salary, working fewer hours at this time could negatively impact your benefit. Also avoid situations where you are only paid for 20 hours a week but still work 30 or 40 hours to get your job done.
Jane Young, CFP, EA
Most investors understand the importance of maintaining a well-diversified asset allocation consisting of a wide variety of stock mutual funds, fixed income investments and real estate. But you may be less aware of the importance of building a portfolio that provides you with tax diversification.
Tax diversification is achieved by investing money in a variety of accounts that will be taxed differently in retirement. With traditional retirement vehicles such as 401k plans and traditional IRAs, your contribution is currently deductible from your taxable income, your contribution will grow tax deferred and you will pay regular income taxes upon distribution in retirement. Generally, you can’t access this money without a penalty before 59 ½ and you must take Required Minimum Distributions at 70 ½. This may be a good option during your peak earning years when your current tax bracket may be higher than it will be in retirement.
Another great vehicle for retirement savings is a Roth IRA or a Roth 401k which is not deductible from your current earnings. Roth accounts grow tax free and can be withheld tax free in retirement, if held for at least five years. If possible everyone should contribute some money to a Roth and they are especially good for investors who are currently in their lower earning years.
A third common way to save for retirement is in a taxable account. You invest in a taxable account with after tax money and pay taxes on interest and dividends as they are earned. Capital gains are generally paid at a lower rate upon the sale of the investment. In addition to liquidity, some benefits of a taxable account include the absence of limits on contributions, the absence of penalties for early withdrawals and absence of required minimum distributions.
Once you reach retirement it’s beneficial to have some flexibility in the type of account from which you pull retirement funds. In some years you can minimize income taxes by pulling from a combination of 401k, Roth and taxable accounts to avoid going into a higher income tax bracket. This may be especially helpful in years when you earn outside income, sell taxable property or take large withdrawals to cover big ticket items like a car. Another way to save taxes is to spread large taxable distributions over two years.
Additionally, by strategically managing your taxable distributions you may be able to minimize tax on your Social Security benefit. Your taxable income can also have an impact on deductions for medical expenses and miscellaneous itemized deductions, which must exceed a set percentage of your income to become deductible. In years with large unreimbursed medical or dental expenses you may want to withdraw less from your taxable accounts.
Finally, there may be major changes to tax rates or the tax code in the future. A Tax diversified portfolio can provide a hedge against major changes from future tax legislation.
Jane Young, CFP, EA
After years of contributing money to 401k plans and Roth IRAs you are finally ready for retirement and face the dilemma of how to best withdraw your retirement savings. Many retirees have several sources of income such as pensions, social security and real estate investments to help cover their retirement needs. Review your annual expenses and determine how much you need to pull from your nest egg for expenses that aren’t covered by other income sources.
One way to manage your retirement income needs is to create three buckets of money. The first bucket is for money that will be needed in the next twelve months. This money should be fully liquid in a checking, savings or money market account. The second bucket is money that will be needed over the next five years. At a minimum, hold money needed in the next five years in fixed income investments such as CDs and short term bond funds. By investing this money in fixed income investments it is shielded from the fluctuations in the stock market; avoiding the agonizing possibility of having to sell stock mutual funds when the market is down.
Consider buying a rolling CD ladder where a CD covering one year of expenses will mature every year for the next four to five years. After you spend your cash during the current year a new CD will mature to provide liquidity for the coming year.
The third bucket of money is your long term investment portfolio. This should be a diversified portfolio made up of a combination stock mutual funds and fixed income investments. Every year you will need to re-position investments from this bucket to your CD ladder or short term bond funds to cover five years of expenses. Rebalance your long term portfolio on an annual basis to keep it well diversified.
In conjunction with positioning your asset allocation for short term needs, you need to decide from which account you should withdraw money. Conventional wisdom tells us to draw down taxable accounts first to allow our retirement accounts to grow and compound tax deferred, for as long as possible. Gains on money withdrawn from a taxable account are taxed at capital gains rates where withdrawals from a traditional retirement account are taxed at regular income tax rates and withdrawals from Roth IRAs are generally tax free.
Withdrawing all your money from taxable accounts first isn’t always the best solution. You need to analyze your income tax situation and strategically manage your withdrawals to avoid unnecessarily going into a higher tax bracket. Additionally, the taxation of Social Security is graduated based on income. After starting Social Security, you may be able to minimize taxation of your benefit by taking withdrawals from a combination of taxable, traditional retirement and Roth accounts. Do some tax and financial planning to strategically minimize taxes and maximize your retirement portfolio.