5 Reasons Why I Think Everyone Needs Their Own Financial Plan

January 28, 2019

Does everyone need a financial plan? Apparently Wealthfront’s co-founder and CEO doesn’t think so. He claims that young people don’t really need a plan if they’re either single and currently saving money, or married, currently saving money, and not planning to have kids, or are single and can’t save. He argues that the first two should generally be okay even without a plan and the last would benefit more from a budgeting app.

However, here are some reasons that even young people in these situations probably need a financial plan:

1) They need insurance and estate planning.

Financial planning isn’t just about saving. In fact, one of the most important things for many young people is having adequate health, property and casualty, and disability insurance. This is especially true if they haven’t had enough time to build up enough savings to help cope with these risks.

Estate planning may seem like something just for older and wealthier people, but let’s not forget that Terri Schiavo was only 26 years old when she fell into a vegetative state without proper planning. That’s why it’s never too early to get the basic documents in place like an advance health care directive, durable power of attorney, beneficiary designations, and a will. Many employers even offer legal benefits to draft these documents for free or at a reduced cost.

2) They may need help prioritizing debt vs saving.

Many young people are tempted to pay down low interest student loans when they may be better off building emergency savings, capturing the match in their retirement plan, paying down higher interest debt, and/or saving for a down payment on a home. Of course, there are situations when paying down those students loans is the better course of action. That’s where financial planning comes in.

3) They may not be saving enough for retirement.

Many young people just stick to the default contribution rate in their retirement plans or contribute just enough to get the match. This could put them on track to be woefully unprepared for retirement, while even a small increase in their contribution rate could mean early retirement after decades of compounding.

4) They may not be fully utilizing tax-advantaged accounts.

I’ve seen many young people investing in a taxable robo-advisor account (like Wealthfront’s) when they could be benefiting from tax-free growth in a Roth IRA and/or HSA or just contributing more to their 401(k). Many are simply unaware of the benefits or how flexible these accounts can be.

5) Their investments may be improperly diversified or too expensive.

Many young people are either investing too conservatively for their time horizon or aren’t adequately diversified in their attempt to invest more aggressively. They also often don’t realize the impact of fees on their long term investment performance or even what fees they’re paying.

This is not to say that everyone needs to pay thousands of dollars for a 100-page “financial plan” that they probably won’t even read. However, practically everyone can benefit from having a chat with an unbiased financial planner who can help them uncover what they’re missing and what they should focus on at this stage in their financial life. (If they’re really fortunate, they may even be able to get this for free from their employer as part of a workplace financial wellness program.)

4 Red Flags To Watch Out For Before Buying An Annuity

January 25, 2019

Annuities – the word itself can start WWIII in a room full of financial advisors. Some advisors think of annuities as the financial instrument of Satan and other advisors believe it is the Holy Grail for anyone in retirement. I am in the middle.

For the right person in the right situation, they work

I think for the right person, the right annuity can help someone generate the income needed to maintain his or her lifestyle in retirement. For the wrong person, an annuity can tie up money unnecessarily for years. The key (and the challenge) is for the consumer to fully understand both the benefits and risks of an annuity and to assess if the benefits outweigh the risks for their particular needs.

Does anybody really know how these things work?

The problem is that annuities are so complicated that most consumers and most advisors do not completely understand them. The training on annuities at most financial institutions centers on selling them. When I first became an advisor, my company assigned me to an area with a high elderly population. Big surprise – this area also had many annuity sales people.

After a few months in my new location, a client would stop by with a friend who wanted a second opinion on an annuity. Most of the annuities I reviewed were good and a great fit for the owner. Unfortunately, there also annuity contracts I reviewed that did not match the benefits the annuity owner thought they were getting.

Other annuities I reviewed did not match the needs or even long term goals of the annuity owner. These experiences gave me a unique window as to the “red flags” of a potentially bogus annuity salesperson and new perspective on how to help consumers.

Red Flag #1

Your advisor pressures you to sign an annuity contract before fully explaining the contract to you

When you get the annuity contract to sign, have the advisor go over all of your discussed benefits in the contract. Make sure that all of the promised benefits are listed in your contract (your advisor should be able to point them out). If anything that was promised is not in the print of the contract, do not sign. If needed, your advisor can have the contract redone to include your discussed benefits.

Once you sign, no matter what you thought you were getting, you are pretty much stuck with the annuity. Most states have a “free look” provision that gives you the option to get out of your annuity within typically 10-30 days (varies by state), but once that period has passed, it’s yours, even if it’s not what you thought it was.

Red Flag #2

You do not know your advisor’s background

There is an inherent trust people have in anyone presenting himself or herself as a financial professional. One of my friends was told by an aspiring financial advisor that, “All I really have to do is put on a tie and show up, and people are willing to trust me.” The only qualification needed to sell an annuity for most is an insurance license, which requires 20-40 hours of general insurance courses, 6-12 hours of ethics courses and passing an exam. No financial or retirement planning knowledge required.

To sell variable annuities, an advisor would also need at a minimum a Series 6 license. The qualification to getting a Series 6  is for the advisor to be affiliated with an organization that will sponsor them to sit for the exam and for them to pass the 100-question exam with at least a 70% passing score. In most states, an advisor may also have to pass a Series 63, which I personally studied for and passed within a 48-hour period.

This means someone can graduate from high school June 1, go through all of the training, pass the exams and hang a shingle outside of an office as a financial professional by July 1 with absolutely no experience. Ask about the professional experience of anyone managing your money and do background checks by going to your state’s Department of Insurance website and/or by using the Broker Check website.

Red Flag #3

Your advisor did not clearly explain to you why the annuity he or she wants you to purchase is a good fit for you

If you are switching annuities, make sure you understand exactly why switching is such as good idea. I reviewed an annuity sales proposal from a woman who was getting ready to switch from an old annuity to a new one (called a 1035 exchange). The advisor told her it was a good idea, but the client could not explain to me why it was.

Upon reading the proposal, I knew it was because there was no good reason for the exchange except for the commission the advisor would receive. The change would increase her surrender period and cost her more money in fees and the annuity actually had fewer benefits. Make sure you clearly understand how and why the annuity purchase meets your financial goals.

Red Flag #4

The advisor tells you that it is a “no risk” investment

No matter how good an investment is, there are always risks. The risk may be your money being tied up or your money going up or down with the market or getting a low rate of return, or it could be the risk that the annuity company goes out of business. The key is for the benefits to outweigh the risk and for some, the risk may be a deal breaker.

I reviewed an annuity for a friend of a client who wanted to withdraw the money for his child’s education. His advisor told him about all of the benefits but left out the 10% surrender charge for withdrawing his funds. What angered him about this is that he told me that he explicitly told the advisor that he planned to use some of the funds for his child’s education.

The bottom line

Do not sign anything you do not understand. If you don’t understand an annuity, ask questions until you do. Just like Smokey the Bear’s famous quote, “Only you can prevent wildfires,” you are your own best defense against bogus financial professionals.

Why A Roth IRA Makes A Great Emergency Fund

January 23, 2019

Financial planners generally say that one of the most important financial goals should be to have enough emergency savings to cover at least 3-6 months of necessary expenses. As long as you meet the income limits (or can get around them without tax issues), one option to consider for your emergency fund is a Roth IRA. Here are 3 reasons why:

No penalty on early withdrawal of contributions

Unlike other tax-advantaged retirement accounts like a 401(k) and a traditional IRA, early (before age 59 ½) withdrawals of contributions to a Roth IRA are not subject to taxes or penalties. Early withdrawals of earnings may be subject to taxes and penalties, but the contributions come out first.

As an example, if you contribute $5,500 to a Roth IRA and that $5,500 grows to $6,000, you can withdraw the $5,500 at any time and for any purpose without tax or penalty but not the $500 of earnings. (Note that any money you convert to a Roth IRA has a 5 year waiting period before it can be withdrawn tax and penalty-free.)

Your money is more protected

The main benefit of a Roth IRA is that those earnings can grow to be tax and penalty free once the account has been open for at least 5 years and you’re age 59 ½. This can essentially shield your earnings from taxes. In the meantime, Roth IRAs also have stronger protections from creditors and can avoid probate when you pass away.

You’re less likely to use it frivolously

More important than protecting your money from creditors, probate, or even the IRS might be protecting it from you. Because of the benefits of keeping it saved in the IRA, you’re probably less likely to spend your Roth IRA frivolously than if that money was in a regular account. (It also doesn’t hurt that you have to fill out a form for each withdrawal).

By contributing your emergency savings to a Roth IRA, you can build your emergency fund without missing the annual Roth IRA contribution limits. One last thing to keep in mind is that you’ll still want to put your Roth IRA money in something safe like a bank account or money market fund if it’s part of your emergency fund. Once you’ve accumulated enough savings somewhere else, you can then invest it more aggressively for retirement.

How To Withdraw Over $100k From Your 401(k) Tax-Free During Retirement

January 11, 2019

Do you know how your retirement accounts will be taxed at retirement? If not, you might want to get up to speed with the IRS tax code (or work with an advisor who is) otherwise you may be missing out on some significant tax savings. Let’s start with the basics of how different sources of retirement income are taxed:

Common retirement income sources taxed as ordinary income

Traditional retirement accounts, including deductible IRAs, pre-tax 401(k)s, and inherited traditional retirement accounts are taxed as ordinary income in the year of distribution and pension benefits are taxed as ordinary income in the year received. (which means it will be taxed as if you earned it working during that year.)

Another source of taxable ordinary income during retirement is Social Security, but only a portion depending on the amount of total income from other sources. To estimate the taxable portion of Social Security benefits, check out this helpful calculator.

Common retirement income sources taxed as capital gains

Some sources of income during retirement may be taxed at preferential capital gains tax rates (basically lower rates than you pay on income that you earn working, aka “ordinary income”.) These sources include proceeds from the sale of stocks and mutual funds that are NOT held in a retirement account, which are subject to long-term capital gains tax treatment if held for over one year prior to sale. (Losses may be used to offset gains in the same year. Up to $3,000 in net losses may be deducted from income and losses that exceed $3,000 may be carried forward.)

Qualified dividends are a special type of dividend that also receives capital gains tax treatment (aka most people only pay 15% tax on dividends, even if they are in, say, the 32% tax bracket.)

Real estate is also subject to capital gains tax treatment when sold. There is, however, a special exclusion that applies to the sale of a primary residence. If a taxpayer lives in a primary residence for at least 2 of the previous 5 years before sale, the taxpayer may exclude up to $250,000 ($500,000 if married filing jointly) in capital gains from tax.

Common tax-free sources of retirement income

Not all sources of retirement income are taxable. Roth IRAs and Roth 401(k)s are tax-free when the account has been open for at least five years and the owner is at least age 59½. This is referred to as a qualified distribution. Inherited Roth accounts are also tax free as long as the deceased owned the account for at least five years.

Health Savings Accounts (HSA) are tax-free if funds are used for qualified expenses. Funds used for non-qualified expenses are taxed as ordinary income and subject to a 20% penalty tax if withdrawn before age 65 (after age 65, it’s just taxed as income when not spent on medical expenses.)

Finally, withdrawals from your regular savings account may be spent without incurring additional tax liability, although as you probably know, you pay taxes on any interest as you earn it.

Running a few ‘what if’ scenarios

Once you have a general understanding of how your different income sources will be taxed during retirement, you can run a few different “what if” scenarios. For example, let’s assume Hank and Cindy each are age 61 and recently retired at the beginning of the year. They would like to delay the start of their Social Security benefits until full retirement age or later (66 since they were born in 1954). They both have retirement plans from their former employers and can start making distributions penalty-free now that they are over 59½.

Their goal is to minimize taxes as much as possible and to take out just enough from their 401(k) accounts to stay in the safe zone of not outliving their money during retirement. Here is a quick snapshot of their retirement savings:

  • Hank’s 401(k) = $325,000
  • Cindy’s 403(b) = $275,000
  • Emergency savings/“rainy day” fund (checking, savings, CDs) = $150,000

Now, let’s assume that Hank and Cindy have an annual retirement spending goal of $42,000 per year ($3,500 per month). The mortgage is paid off and they are completely debt-free. Based on a generally accepted but widely debated 4% “safe withdrawal rate” rule, they could actually withdraw up to $24,000 in Year 1 of retirement. In this example we’ll stick with a $20,000 withdrawal from Hank’s 401(k), which is realistic based on this How Long Will it Last Calculator. The remaining $22,000 in annual income would come from their checking and savings accounts.

Looking at how their withdrawals will be taxed

How will Hank and Cindy be taxed using the 2018 income tax tables? The $20,000 retirement plan distributions are included as taxable income. The $22,000 coming from their regular checking and savings is after-tax return of principal and would not be taxed. (Only interest earned would be included as taxable income).

Hank and Cindy choose a married filing jointly tax status and their total income tax for 2018 will be a grand total of $0. Yes, that is zero. Here is how they will be taxed:

A quick review of the current Income Tax Rate Table shows us that a married couple filing jointly is taxed at the 12% marginal tax bracket for income over $19,050 but less than $77,400. But keep in mind that your total deductions and exemptions are subtracted from your income to determine your taxable income. The total deductions amount is either your standard deduction or your itemized deductions, whichever amount is greater.

The standard deduction is a fixed amount based on your age and filing status (e.g., $24,000 for married couples filing jointly in 2018). Hank and Cindy’s taxable income will look something like this:

Total Income: $20,000

–        Total Deductions: $24,000

=       Taxable Income: $0

Note: Hank and Cindy benefited from maintaining an emergency savings account that eventually transitioned into their short-term retirement income bucket. Most financial planners would suggest keeping assets that will be needed within a 3 to 5 year time horizon in safe, conservative investments such as cash equivalents, savings, CDs, or short-term fixed income instruments. This is sometimes referred to as the “safety bucket.

Using a Roth account instead of a savings account

In this example, a similar result could be obtained if the additional $22,000 retirement income was funded through tax-free sources such as a Roth IRA or Roth 401(k).

A similar result with taxable investments

If this couple held taxable investments in a brokerage account, they could also take advantage of historically low long-term capital gains rates (currently 0% for the 10% and 12% marginal tax brackets).

In essence, they could “fill up” the 12% income tax bracket with long-term capital gains up to the marginal tax bracket cap of $77,400 and not have to pay a dime of federal income taxes on that growth. But they would still want to invest that money in tax-efficient investments such as passively managed mutual funds or ETFs with relatively low turnover and low costs.

Remaining tax-free until Social Security starts

In summary, this type of retirement funding strategy could be replicated for the next 5 years until this couple has reached full retirement age for Social Security purposes. By that time, they could realistically take out over $100,000 from their retirement nest egg completely tax-free.

The secret is found within a simple concept known as tax diversification. Having multiple retirement income sources that are each taxed in a different manner can help you legally use the complicated IRS tax code to your advantage.

This is an example of just one of many different ways to minimize taxes during retirement. As you approach retirement, go ahead and run a few different “what-if” scenarios to examine your projected taxes. You can use this simple TaxCaster tool from TurboTax if you want to run a quick estimate using the current tax tables.

Keep taking full advantage of your retirement plan at work, especially up to the max to get the match. But take a second look at Roth IRAs, taxable accounts, HSAs, and good old-fashioned savings as well to help you obtain optimal tax diversification.

8 Ideas To Make The Biggest Impact With Your Bonus

January 08, 2019

This time of year, we often talk with people who are preparing to receive a bonus at work, either about how to make the most of it or how to best handle the taxes, or ideally, both!

Depending on your line of work, earning a bonus may come along often or only rarely, but regardless, when it does, it’s easy to start dreaming of a bigger home, nicer car or even just a fancier wardrobe. Sometimes, the money is literally spent on material things before we actually receive the deposit in our account.

Will it make a big difference? Could it?

At the extreme, many of us think that having more money will make our lives easier, only to find that when we look back over the years we’ve received the bonuses, we realize that the extra money was nice, but nothing really changed in the way we feel about our financial situation. Or we start expecting bonuses so that when they go away, we are financially unprepared for the loss of income.

Hitting the pause button

The next time you find yourself preparing to receive a bonus, before you start bookmarking properties or loading up your shopping cart, PAUSE. This is the perfect opportunity to make a huge impact on your future finances (yes, often by forgoing the immediate spending) and to ultimately make sure that you never have to revisit these thoughts again.

Here are eight suggestions that may not sound very exciting, but when taken seriously, can get you to the point of NOT depending too heavily on bonuses in order to have the life you dream of.

1. Accelerate debt pay-off – Use the Debt Blaster calculator to find out just how much sooner you can get those lingering student loans or credit cards paid off by making a big lump sum payment.

2. Bump up your emergency fund – If you don’t yet have several months of expenses set aside in a separate account, this is your chance to check that off your financial priority list.

3. Max out your Health Savings Account (HSA) – If you are enrolled in a High Deductible Health Plan (HDHP) but aren’t funding it to the maximum amount allowed, this is a good opportunity to do so. Not only will it reduce your taxes, but if you can avoid spending the money on everyday stuff and save it for potential bigger expenses down the road, it can serve as a back-up to your emergency fund.

If you haven’t contributed enough to hit the maximum allowed for last year, you actually have until the tax filing deadline in the spring to send a check or make a deposit directly to the financial institution where your HSA account is held and have it count as a deduction from last year’s income.

4. Contribute more to your 401(k) – Retirement may seem way off (especially if it literally is), but saving more in your earlier years will give you more options for later years. Use the Retirement Estimator calculator as a way to gauge how even just one percent more saved at a young age could mean retiring a year or more earlier than you expect, then consider using some of your bonus to allow you to bump up your per-paycheck contributions.

5. Save for short and/or long-term goals in a Roth IRA – You can put an extra $5,500 into a Roth IRA for 2018 ($6000 for 2019), and even more if you’re 50 or older. When just starting out, a lot of people actually use a Roth IRA as another back-up emergency savings account. Since whatever you contribute can always be taken out tax-free and penalty-free, it can be a way to build up an emergency fund, while also boosting your long-term savings if you end up not having an emergency.

Check out these 12 benefits of a Roth IRA on top of that. (By the way, you can still make a 2018 contribution to a Roth IRA by the tax filing deadline of April 15, 2019.)

6. Purchase some stock through your Employee Stock Purchase Plan (ESPP) at work – If your employer offers an ESPP, it’s a great way to get more bang for your buck because you purchase shares of your employer’s stock at a discounted price (or least without having to pay a brokerage commission). You can leave that money alone until retirement or some people prefer to sell right away to take the earnings from the discount, then put that money toward their next big vacation (or one of the other 7 options here).

7. Set it aside for future education needs – This is a great opportunity to boost savings for your kids’ (or other loved ones’) education expenses. If you don’t already have a 529 account, that’s one way to get started. There are other ways to save as well, which are included here.

8. Accelerate your mortgage pay-off – Maybe you dream of paying your mortgage off early – your bonus can help you make extra principal payments and get you closer to achieving that goal. You can run the numbers with this calculator (scroll down to see the impact of an extra payment or two each year.)

Beware of lifestyle creep

At the end of the day, the point is to enjoy life and a part of enjoying life is having enough money to pay the bills and save for the future while still living in the moment! Beware of lifestyle inflation: our “needs” tend to grow as our income grows. I’m not suggesting that you continue to live like a college student, but living below your means is the key difference between most “everyday” millionaires and those who may earn the same salary, but spend every dime they have.

Like I said before, be careful you don’t become dependent on your bonus for living expenses and instead use them as an opportunity to supercharge goals you’re already working toward. You put in the hard work needed to earn those bonus checks. Now, make the most of it by making sure you are financially stable in the future.

 

8 Things To Do When You’re Worried About The Stock Market

December 28, 2018

It’s been a rough ride lately in the U.S. markets. As I write this, the S&P 500 index fell about 5.8 percent during a short trading week, leaving investors feeling jittery. Part of the yield curve inverted, which means that short term interest rates are higher than some longer term interest rates. Is the powerful bull market we’ve had since the Great Recession beginning to wind down? If so, what should you do to prepare?

Whether this is normal volatility in a market that has room to grow or the beginning of the next economic downturn, recent events are a reminder that financial markets don’t go up in a straight line. Eventually, we’re going to have a bear market because that’s how the business cycle works. Over my adult lifetime, I’ve seen plenty of market bubbles and busts. Consider your worry about the market a sign that it’s time for a check-in on your investments.

1. Measure returns from where you started, not from the highest balance

It’s a natural tendency to look at the highest number on your 401(k) or brokerage account statement and then feel like you lost money when the statement balance is subsequently lower. You feel like you were counting on that sum, and now it’s not there anymore. Unless you sold at the exact moment when your balance was the highest, however, you wouldn’t have realized the gain, so it’s not very helpful to measure that way.

How did you do against your goals?

A more realistic approach is to measure your success vs. your goals. Has your account balance grown since you originally invested the money? Did you require a certain average annual rate of return or that your balance grow by a certain amount by a certain date to fund your goal?

What’s your progress so far? Are you trying to match or beat a benchmark using one or more market indices? (See Why Is An Index Important In Investing?) If you’re saving for a house down payment or an early retirement, and you’re still on track to meet that goal, that’s what matters – not whether you’re down 10 percent from the all time high.

2. Run a retirement projection

For most of us, funding a future retirement is a primary reason we’re investing. Now is an excellent time to run an updated retirement calculator to check your progress, given your savings and reasonable projections for your rate of return and inflation. You can use the Retirement Estimator for a basic check in to see if you are on track. You can also use the calculator to model different scenarios using different rates of return to see what happens.

Make sure you’re using a reasonable expected rate of return

When updating your retirement projections, it’s better to use a conservative expected rate of return. Research from the McKinsey Global Institute suggests investors lower their expectations for average annual US stock returns to 4 to 6.5%. If they’re wrong about it, you’ll be happily surprised, but if they’re right, you’ll be adequately prepared.

3. Check your risk tolerance

Try downloading our risk tolerance and asset allocation worksheet or use the questionnaire from your brokerage firm or retirement plan provider. Compare the results to your current portfolio mix. If they line up, you may not need to re-balance your investments. If there is a big discrepancy between your current investment mix and your ideal one, you may want to make some changes.

Know the difference between risk and volatility

One note about “risk” and “volatility.” Risk is typically measured in portfolio management by standard deviation. The more spread out daily prices are from the average price – either higher or lower — the higher the standard deviation of an investment.

If it were just math, it would be easier to stomach the volatility. But it’s your money! When most people think about risk, they think only about the downside risk – the risk that they’ll lose money and not be able to achieve their goals.

Try putting a dollar number on your risk tolerance. How much would you be willing to see your portfolio value drop in the short run before you’d throw in the towel? For example, if you need $50,000 in ten years to take a sabbatical, would you be comfortable seeing the interim value of your account drop to $45,000 (a 10 percent drop) in return for the possibility of a ten percent gain? How about $40,000 (a 20 percent drop)? If the thought of seeing your balance temporarily drop to $40,000 causes you indigestion, then maybe it’s time to lower your stock exposure.

4. Rebalance your portfolio if needed

Rebalancing back to a target mix of investments helps you keep the level of risk in your portfolio stable by taking some profits from those investment types that grew faster in value and buying more of the investment types that didn’t grow as fast or fell in value. Think about rebalancing as buying low and selling high.

Once you’ve re-checked your risk tolerance and run projections to see if you’re on track to meet your goals, you may or may not need to make some changes in your investment mix:

Examples of rebalancing:

  • If your current investment mix reflects your goals and risk tolerance, you probably don’t need to rebalance. For example: you’re planning to retire in 22 years, have a moderate risk tolerance and you’re in a 2040 target date fund.
  • If your investment mix is out of whack with your target mix, rebalance. During the past decade, many investors have become overweighted in stocks due to strong stock market performance. If your goal is to maintain 60 percent in stocks and you’ve got 80 percent in stock funds, it’s time to rebalance and move 20% back to bonds.
  • If your risk tolerance has changed and your target investment mix is different than before, that’s also a very good reason to rebalance.
  • If you’re within 5 years of retirement, consider building up a much larger cash position. In pre-retirement years, it’s generally a good idea to move at least 3 years of anticipated expenses to cash-type investments (think savings, money market funds, CDs, etc.). That way, if the markets are in a slump when you retire, you won’t have to sell investments at a loss to pay your bills and can wait for a market recovery. Make sure you’ve updated your risk tolerance. Many pre-retirees find that they want to take a lot less risk in their investments during the transition to retirement.

Not sure of the best ways to rebalance your portfolio? See 4 Different Ways To Rebalance Your 401k.

5. Put together a simple investment policy statement (IPS)

You may also find it helpful to put together a brief, written outline of your target investment strategy to use across all your accounts. An IPS doesn’t have to be fancy. Just set some targets for types of stocks, bonds and other investments (like real estate or commodities) that you want to maintain over time. See this Investment Policy Statement Template for some ideas and/or dive deeper here: Morningstar Course (free): Creating Your Investment Policy Statement and Investment Policy Worksheet.

6. Diversify

Are your investments as diversified as they could be? Diversification mixes different types of investments so that the gains of some investments offset the losses on others. That reduces risk (although doesn’t eliminate it). Different types of investments historically have delivered gains at different times – think U.S. stocks vs. international stocks or stocks vs. bonds.

If you’ve got a “plain vanilla” portfolio, consider the pros and cons of incorporating different types of investments to reduce volatility. Many investors are just in the S&P 500 index, for example, or only in stocks and bonds. If it fits your risk tolerance and goals, incorporating some non-correlating investments like real estate, commodities and hedge fund proxies (e.g., market neutral funds, managed futures, long/short funds, hedge fund ETFs, etc.) can help reduce risk and smooth out returns.

7. Build up your emergency cash

You may not know when the next recession will hit, but you can still be prepared. Recessions don’t just bring bear markets. For some people, they also bring layoffs. If you don’t already have 6 months in living expenses in an emergency fund, work to build up that account.

8. Take advantage of volatility IF you’re aggressive

Are you a hands-on investor with an aggressive risk tolerance? Periods of high market volatility also present opportunities, but only for those who are comfortable with the financial equivalent of skydiving. There are new ways to “trade volatility,” including volatility ETFs, futures on the VIX (the volatility index) and options on market indices. My husband, Steve, spent time this past week using his mighty math powers to successfully trade volatility ETFs. I’m not that hands-on, nor am I that much of an aggressive investor, so it’s not something I’d do myself.

What’s the bottom line? Recent market volatility is an alarm clock reminding us that it’s been a great bull run, but there may be some roller coaster times ahead. Make sure you’re buckled in.

5 Steps To Determine Your Financial Priorities

December 17, 2018

Do you ever find yourself wondering what you should be doing to manage your finances? What’s the right next step? What should you focus on first?

Well, you’re not alone. This is a regular conversation I have with people. To help, I’ve created this step-by-step guide to help you get things in order and see what you should focus on next. 

STEP ONE: Do you have at least $1,000 in savings to cover emergency expenses?

Got it: Great. You can use that money to cover unexpected medical, auto, or home costs that come up. Go to STEP 2.

Not there: Now is the perfect time to create a monthly spending plan via paper/excel or maybe even an app if you haven’t already. Look for ways to cut back on things killing the budget and find ways to improve how you manage your spending. If you need help paying bills or covering the basics, check out these ideas.

STEP TWO: Are you saving enough in your 401(k) to get 100% of your employer’s match?

I’m getting the match: Perfect. You’re getting “free money” and tax benefits at the same time. Move on to STEP 3.

  • For guidance on how to invest the money you’re contributing in your 401(k), go here.

I’m not: Increase your contribution to at least get the match. If money is tight, consider bumping up your contribution just 1% or more per year until you hit what’s needed to get the match

  • Your 401k might have an auto-escalator tool, which let’s you set a schedule of automatic increases – set it up for the same time you get your annual raise and you won’t even notice the difference.

STEP THREE: Do you have any high interest rate debt? (greater than 4%?)

I don’t: Great. Move to STEP 4. Just remember that not all debt is created equal. Interest you pay on student loans and mortgage debt may be tax deductible. However, try to keep these total payments under 25% of your monthly income.

I do: You finished STEP 2 above, so you already made sure you’re contributing enough to get the match from your employer in your 401(k). Now it’s time to make a plan to eliminate that debt. You can choose to pay off your debt starting with the lowest balance first OR starting with the debt with the highest interest rate.

STEP FOUR: Do you have enough savings to cover 3-6 months of necessary expenses?

Yes. Got it under control: Nice. On to STEP 5. This also helps in the event you find yourself looking for work. (It typically takes 1 month to find a job for every $10,000 you make.)

Not yet: Pay yourself first.You can set up an automatic transfer from your paycheck into a separate savings account until you’ve built up enough savings. Here’s how to start or boost your emergency fund. 

STEP FIVE: Are you on track to replace at least 80% of your income in retirement?

Yes, I’m on track: Congrats. Expenses tend to drop in retirement, but make sure to run a projection yearly to stay on track.

  • Not sure how you much you’ll need for retirement? The sources of income you’ll have in retirement, what your likely retirement expenses will be, how much of a gap there is (if any), and how long you might spend in retirement all come into play. Go here to find your retirement number.
  • Have a Health Savings Account (HSA)? Check this out first.

Not yet: Use the Retirement Calculator to see where you stand and try to increase contributions as needed.

  • Remember, just like in STEP 2, consider bumping your contribution up just 1% or more per year until you hit the percentage you need to contribute to get on track for retirement.

Trying ‘softer’

Figure out where you are on this guide and start working on your finances from there. I heard someone quote an author once stating that instead of trying harder, we should “try softer” to make one simple change or focus on one step at a time. Some of the best advice ever.

5 Steps To Creating Your Retirement Budget

December 06, 2018

Preparing for retirement is a career-long endeavor requiring a lot of planning and saving over many years. For most of that time, we use some form of a retirement calculator to see how we are tracking in terms of being able to replace 75-80% of our pre-retirement income. But once we reach 5-10 years out from retirement, we need to focus on our specific expenses in retirement and make sure our income sources are adequate to meet those needs. That’s where having a retirement budget comes into play.

Making sure we live below our means does not lose importance once we decide to call it a career. If anything, understanding our expenses becomes more important than ever in retirement. Taking time to think through your expenses in retirement will help insure you can do all the things you have planned and that your money lasts for the long run.

Step 1 – What are you spending now?

The best way to start is to look at what you are spending now. This gives you a baseline to work from.

Step 2 – What will your lifestyle look like in retirement?

Thinking through how you want to spend your time and what that may cost is important to factor into your budget. Try to be as specific as you can. Some examples include:

  • Travel – Many retirees plan to travel more, especially in the early portion of retirement. But what does that look like for you? Is it travelling the world? Loading up the RV and hitting the road? Or maybe something in between?
  • Housing – This is a biggie. Do you plan to stay in your current home when you retire? Are you planning to relocate to a warmer climate or to be closer to family? Maybe you want to downsize to a smaller home.
  • Hobbies and entertainment – How you spend your time can impact your budget. If you want to play more golf for instance, does that include a club membership? If you decide to take up a new hobby, what will that mean for your spending?

Step 3 – Going up or down?

Most retirees find they don’t spend more when they retire. But every case is different, and you may find you may not spend much less once you retire. Some expenses will go up in retirement – health care as we age (click here for help with how to estimate those costs), perhaps your entertainment spending (travel, dining out, etc.). Other categories of spending may go down. Perhaps you intend to pay off your home, which would have a significant impact on your cash flow.

Certainly, things like 401(k) or other retirement account savings will stop, as will payroll taxes (assuming you are not working part time into retirement). Adjusting these categories based on how they may change will crystallize your expenses.

Step 4 – Monitor and adjust

Your expenses are likely to change throughout retirement, so it is important to monitor your spending and adjust your budget periodically. Many find that as they age in retirement, items like travel will decrease over time, while health care expenses increase.

Step 5 – Structure your nest egg

Once you have your expenses documented, consider having 5 years’ worth of those expenses available in cash or other safe vehicles. Having next month’s housing or grocery money invested in the stock market can leave you in a bad position if the market enters a downturn. Keeping your short-term funds safe will ensure the money is there when you need it.

Having other funds invested for income and still others invested for growth will help replenish the cash you spend and still provide the longevity your nest egg needs for the long haul.

Having a detailed budget in place 5-10 years out will allow you to adjust while you are still working (if necessary). This planning will set you up to enjoy the lifestyle you want during your retirement!

3 Different Lanes To Financial Independence For Early Career Workers

November 30, 2018

You’ve heard the cliché: When it comes to saving for retirement, young people have time on their side. The earlier they start saving, the better. So what would happen if you started saving for retirement at age 22? A lot can happen in the years between, but here’s a look at three different retirement roadmaps that a 22-yr old earning $50k a year (with no raises) and earning an 8% average annualized return on their investments might take:

The slow lane

How you’d save

In the “slow lane,” let’s say you contribute 6% to your 401(k) to get your employer’s full 3% match. You’d retire at age 65 with $1,678,104. Yes, you’re a millionaire, but before you get too excited, that would only be about $716k in today’s dollars assuming a 2% inflation rate.

What that will look like in retirement

Using a 4% withdrawal rate, that 401(k) would produce about $29k of annual income. You would also receive about $15k in Social Security benefits at age 65 or about $11k if we factor in Social Security’s projected shortfall. Your total income would be $40k or about 80% of your current income, which is in the range of what most retirement experts figure the average retiree will need.

What to do if you are getting your match but don’t think you’re on track

If you’re getting your match but think that a comfortable retirement is out of reach, you may be underestimating the power of compound interest over long time periods and may actually be on track to retirement. On the other hand, it’s more likely that you got to a later start and didn’t start saving to your match at 22. The best way for you to find out is to run a retirement calculator and see if you’re on track. If not, you can see how much more you would need to save to get on track.

This all sounds okay, but who wants to drive in the slow lane and work until 65? Keep reading.

The center lane

How you’d save

In the “center lane,” you would max out an HSA (health savings account) and contribute 10% to your 401(k) with a 1% automatic annual increase. You retire at age 55 with $1,937,807. In today’s dollars, that would be about $1 million or enough to produce $40k of income, which hits that magical 80% mark even without the Social Security benefits you would later receive!

How to make it happen

To make this happen, you would need to be eligible for an HSA by choosing a high-deductible health insurance plan, which are becoming increasingly common. It also makes sense to try to max it out after getting the match in the 401(k) because the money goes into an HSA pre-tax, can be invested and grow tax-deferred, and can then be taken out tax-free for qualified medical expenses. No other account has that triple tax benefit.

Finally, you would need to use the HSA as a retirement account by not dipping into it even for medical expenses. One other note about HSAs, in addition to tax-free distributions for medical expenses in retirement (including Medicare and long term care insurance premiums) you can also take taxable distributions without penalty for non-medical purposes starting at age 65—i.e., it can be another source of retirement income.

Things to think about in the center lane

There are a couple of possible concerns with retiring early though. First, you would need to cover the cost of health insurance until qualifying for Medicare at age 65, but with access to the Affordable Care Act exchanges this shouldn’t be too much of a problem. In fact, if you have tax-free money in a Roth account, you can qualify for higher health insurance subsidies since eligibility is based on taxable income.

This brings us to the second potential issue. Isn’t there a 10% penalty on retirement plan withdrawals before age 59½? Yes, but there’s also an exception that as long as you work until the year you turn age 55 or older, you can withdraw money from your then current employer’s 401(k) with no penalties. (This doesn’t apply to a prior employer’s 401(k) or IRAs so keep that in mind before you roll money into one.)

The fast lane

How you’d save

As exciting as retiring at 55 sounds, how about retiring at 50? In the “fast lane,” you would max out both your HSA and your 401(k). At age 50, you would have $2,111,194—or about $1.2 million in today’s dollars—in retirement! That produces 97% of your working salary plus you’d still get Social Security later. (To avoid early withdrawal penalties, you can take “substantially equal periodic payments” under Rule 72(t) until age 59½.)

Of course, the challenge to driving in the fast lane is being able to save that much. The key is to max out those accounts before you even have a chance to spend that money and live on the rest of your income. If that sounds impossible, keep in mind that lots of people are living on much less.

Things to think about in the fast lane

The hardest part is potentially having to downscale your standard of living. This is where being 22-yrs old really has an advantage. After all, you may have just been recently living with no income at all in a dorm room or in your parents’ home so less of an adjustment might be needed.

Finally, keep in mind that our calculations assumed no raises, which is probably not realistic, especially for someone so young in their career. That means any income from raises or promotions could be used to finance a growing lifestyle. The upside for delaying that lifestyle is being financially independent at age 50 and having an extra 15 years to do whatever you want. In the meantime, your extra savings would provide a greater level of financial security and freedom.

So if you’re just getting started in your career, which lane will you drive in? Do you want to take the slow and easy approach to retire comfortably at age 65? Would you rather drive a little faster to retire early at 55? Or are you up to the challenge of life in the fast lane?

The Thing That Retirees Regret The Most And How To Avoid It

November 08, 2018

It is said that no one on their death bed ever wished they had worked just a little longer. The same may not be said for U.S. retirees, however. Among average earners, Social Security payments are likely to make up more than half of their retirement income. The odds seem pretty good that more than a few of them wish they had worked a little longer – or at least waited longer before claiming their Social Security benefits.

Maturity and Social Security

As a financial planner, I spend much of my time talking with people about their concerns regarding retirement. One of my favorite questions to ask is, “At what age do you plan to claim your Social Security retirement benefit?” More often than not, they tell me, “As soon as I can get it,” which is age 62 (unless you are a widow or widower, then it can be as early as 60). While earlier may not always be better, they have plenty of company. As many as 57% of recent retirees chose to claim this benefit prior to full retirement age, locking themselves into a lifetime of 25%-30% smaller Social Security payments.

Claiming Social Security early may turn out to be one of your biggest regrets in retirement.

A recent study conducted by the National Bureau of Economic Research concluded that early Social Security claims are linked to increased likelihood of living in poverty in one’s old age. Why do so many people willingly limit themselves to a smaller Social Security payment, when they could be receiving so much more by waiting a few more years to claim? Oddly, only about 4% of retirees delay collecting Social Security beyond their full retirement age.

Why people retire when they do

The reality is people retire and claim Social Security retirement benefits for a variety of reasons. A combination of individual circumstances, knowledge, economic conditions, and even personal emotions influence our decisions about retirement. While some factors are largely uncontrollable, two of them – knowledge and emotion – are well within our ability to master.

Employers downsize, family members require care, or our own declining health forces us to leave behind the world of work, company benefits, and steady paychecks. Not having sufficient emergency savings or a backup plan for retirement would be regrettable when these unforeseen events happen.

What they regret

Our personal economics also can drive retirement decisions. Waiting too late to contribute to a retirement plan can lead us to regret working longer than we expected. Hoping our health holds out long enough to catch up (and really regretting things if our health falters), or carrying large amounts of debt for many years can drag down our ability to save and invest, leading to more retirement regret.

The combination of what we do or don’t know about retirement can shape our decisions. For example, everyone “knows” the typical retirement age is 65, right (or is it 62)? Not so fast. The Social Security retirement age for full unreduced benefits has changed. Depending upon your birth year, it may be as late as 67. Accordingly, the age at which you claim Social Security can make a significant difference in your retirement lifestyle.

Getting in touch with your emotions

As you might imagine, emotions (positive and negative) also play a role in making regret-free retirement decisions. For example, the mere fact that Social Security is available at age 62 (though reduced by 25%-30%) can influence how we feel about working at that point. Work may suddenly seem optional – we now have a guaranteed way to receive money without working, which appears to encourage earlier retirement.

As with most major decisions, though, letting our emotions be our primary retirement guide can lead to more regrets later. What if I do live to be 95 years old, like the folks at Livingto100.com recently suggested? Do I want to be stuck with the smallest possible Social Security check for 30 years?

No regrets

The emotional or “affective behavior” aspect of retirement decisions has and continues to be of great interest to me; so much so that I made it the subject of my doctoral dissertation regarding the influence of emotional states upon Social Security retirement decisions. My own research concluded that a combination of both emotion and education can have a measurable effect upon when people choose to make important retirement decisions.

What you can do to make the best decision for yourself

Fortunately, among the many factors that influence retirement, our knowledge and our emotions are two conditions over which we also have some individual levels of control. Among the many retirees whom I’ve counseled and guided over the years, those who eased most successfully into retirement:

  • Made time to be as informed as possible, reading up on their own, consulting with trusted financial professionals, or utilizing their financial wellness benefits at work. They sought knowledge.
  • Tuned into their emotions. I’m not going to get all touchy-feely, but it is critical to recognize when our feelings begin to overshadow our logic and lead us down decisional paths that may not be in our best long-term interest.

The American Psychological Association encourages people to consider their psychological portfolios along with their financial portfolios when preparing for retirement. My financial planner colleague, Doug Spencer, also recently wrote about ways to be mentally prepared for retirement which includes even more tips on how to fill your retirement with more memories and fewer regrets.

How To Invest For Income In Retirement

October 26, 2018

All your working life you’ve been saving and investing some of your income for retirement. Now you are getting ready to leave full time work and begin to spend it. How do you figure out how to invest so that your money lasts for what is hopefully a long and happy life? Whether you are a DIY investor or working with an advisor, consider these general guidelines for investing to generate retirement income:

Create both fixed and flexible sources of income

Right now, you have investments that you own. If you are like many retirees, it may make you nervous to spend your assets. Income, on the other hand, is psychologically easier to spend. Rather than spending them down, think about how you can invest some of your assets to create income.

One possible goal of retirement income planning is to create both fixed and flexible income. Fixed income is income you can rely on to arrive at predictable times and in predictable amounts. Social Security is fixed, for example. Ideally, you would create enough fixed income to cover all your fixed, must-pay monthly expenses like housing, transportation and food.

Ways to create fixed income besides Social Security

Pension annuity: Most pension plans have distribution options that include several level monthly payment options as well as a lump sum distribution. Choosing the annuity will offer you level monthly payments, which you cannot outlive in most cases. Married couples can choose a “joint and survivor” option, which makes monthly payments until the death of the second spouse. Not sure if it makes sense to take the monthly annuity or the lump sum? See this blog post for guidance.

Create your own pension by buying an annuity: The traditional pension is an endangered species, so if you don’t have one, you can create your own personal “pension” by purchasing an immediate annuity with some of your retirement savings. Per ImmediateAnnuity.com, a 65-year old man in North Carolina would receive $527/month in exchange for $100,000. This turns your lump sum into a monthly income stream.

Immediate annuities vary from insurance company to insurance company, so run the numbers and do your research before you sign on the dotted line. Remember, you’re looking for consistent monthly income that covers just your fixed expenses. Don’t use all your assets to purchase an annuity. Otherwise you may not leave yourself enough flexibility to meet variable expenses like vacations and entertainment, or unexpected larger expenses like a dental emergency, a new car or a new furnace. Click here to learn more about the ABCs of annuities and here for some situations where they might make sense.

Bonds: A bond is a fixed income investment where the investor is essentially loaning money to a corporation or government entity for a fixed period of time at a fixed or variable rate of interest. There are many types of bonds, with different features and different levels of investment risk. You can invest in them directly or through bond mutual funds, closed end funds or exchange traded funds.

Bond interest is often paid semi-annually, so retirement income investors typically look for a diverse portfolio of bonds so there is some interest coming in every month. The base of a diversified bond portfolio should be “investment grade” bonds, which are issued by companies with a high credit quality, and U.S. Treasury securities, which are bonds issued by the U.S. government. Click here to learn more about how bonds work and how to build a bond ladder.

Dividend-paying stocks: Dividends are a share of company profits paid out regularly to shareholders. High quality, dividend-paying stocks can provide quarterly income, as well as the potential for appreciation. Like bonds, there are several types of dividend-paying stocks, with different features and different levels of investment risk. Dividends from preferred stock (which generally don’t have voting rights) tend to be higher than dividends from common stock.

You can invest in dividend-paying stocks directly or through stock mutual funds, closed end funds or exchange traded funds that focus on dividends. Funds in this category are usually described as “dividend income,” “dividend,” or “preferred stock” funds. Make sure to do your research and read the prospectus before investing.

If you hold dividend-paying stocks in a taxable brokerage account, look for shares which pay “qualified dividends.” Those are taxed at lower long-term capital gains tax rates of 0 to 20 percent, depending on your total income. Learn more about dividend-paying stocks here.

Real Estate Investment Trusts: A Real Estate Investment Trust (REIT) is a company which owns or finances income-producing real estate. Most REITs are publicly traded on major stock exchanges, but some are private. By law, REITs must pay out 90% of their taxable income in dividends annually. REIT dividends are usually taxed as ordinary income. You can invest in publicly traded REITs individually and through closed end funds, exchange traded funds and mutual funds.

While REITs hold portfolios of rental real estate or mortgages, remember that they have many of the same risks as investing in stocks. Generally, it’s a good idea to limit your REIT exposure to 5 to 10 percent of your portfolio, and just like stocks, REITs aren’t a fit for every investor. Adding real estate to a diversified portfolio of stocks and bonds can usually reduce portfolio volatility though.

Maintain purchasing power over the long term

Inflation has been low for the past two decades, but it hasn’t always been that way. Remember the interest rates on passbook savings accounts in the seventies? When you were working, you could rely on your salary increasing (at least somewhat) to keep pace with inflation.

In retirement, if you don’t include investments that generally move up when inflation does, you’ll be losing purchasing power. Click here to read more about protecting your portfolio from the effects of inflation. Investments that can help your portfolio from the inevitable rising cost of living include:

Stocks: A well-diversified portfolio of individual stocks, stock mutual funds or exchange traded funds that grows in value over time can offer a hedge or partial hedge against inflation. Some of the hedging effects come from dividends and some from growth. Wharton School professor Jeremy Siegel suggests that to best insulate a portfolio against inflation, it is necessary to invest internationally. For many retirees, some growth will be required to maintain purchasing power given that a typical retirement could last twenty to forty years.

Treasury-inflation protected securities: TIPS are treasury bonds that are indexed to inflation. The interest rate remains fixed, and the principal increases with inflation and decreases with deflation. It’s best to hold TIPS in a retirement account to protect against paying taxes on phantom income if the bonds adjust upwards.

Inflation adjusted annuities: If you have chosen to purchase an annuity, consider purchasing one where the payment is indexed to inflation. Like a traditional annuity, an inflation-protected annuity pays you income for the rest of your life, but unlike a traditional annuity, the payment rises if inflation rises. Consequently, the initial payout is likely to be lower than with a traditional annuity.

Rental real estate: Real estate tends to perform well with rising inflation. Rental income generally keeps pace with inflation, and inflation can increase the value of your property. However, being a landlord is not for everyone, and it’s difficult to get a diversified rental income portfolio without a large investment. Direct real estate investing has both advantages and challenges. If you are considering rental real estate, take this quiz first.

Prepare for longevity

According to the Social Security Administration, the average 65 year old man today is expected to live until age 84.3, and the average 65 year old woman until age 86.6. Since these are averages, that means some of these 65 year olds will live longer. That’s going to cost some money.

A longevity annuity is a new financial product that helps protect you against the risk of outliving your money. It typically requires you to wait until very late in retirement to begin receiving payment – e.g., age 85 or later. Once the payout period begins, it offers income for the rest of your life. The IRS permits the purchase of longevity annuities within retirement accounts, subject to certain limitations, and they are excluded from the calculation of required minimum distributions (RMDs).

 

A version of this post was originally published on Forbes

Figuring Out How Long Your Retirement Will Last

October 24, 2018

We’ve all probably seen those commercials that ask us, “What’s your number?” They mean, of course, how much money will you need to save before you can retire. There are several ways to answer that question (we prefer to consider the question, “How much retirement income can you generate?), but I often get another question when I talk with people about retirement: “How long will my money last?”

The answer depends on your lifestyle and longevity. Stated another way, “How long will your retirement last?” Retirement is sometimes described as a really long unpaid vacation. Although we usually know how long a two week vacation is going to last, predicting the length of retirement is not so obvious.

How long do I have, Doc?

Fortunately, there are some tools to help us figure that out. Just as knowing how many vacation days we have helps us budget for that next trip, so too does a better understanding of our own longevity help with retirement and related plans. As you have probably heard, Americans as a group are living longer than they did 40 years ago. That means more retirement time in general, but what does it mean for us individually?

According to the Society of Actuaries (SOA), among people in their middle fifties, 1 in 2 women and 1 in 3 men can expect to celebrate a 90th birthday. In addition to considering how long your grandparents and parents lived, you can also use modern technology to zero in on your own life expectancy. Here are two calculators that make this task easier than you might think:

  • SOA Longevity Illustrator – answer just four questions (age, gender, smoking, general health) to see your probabilities for living to various ages.
  • Living to 100 – This calculator asks quite a few more detailed health and lifestyle questions, and it helps if you’ve been to the doctor recently and have a fresh copy of your cholesterol numbers and blood pressure readings handy.

Running my own numbers

It just so happens I recently had a medical checkup, so I ran both calculators for myself to see what they had to say regarding my fate. I was surprised (somewhat disturbingly) to see that Livingto100.com projected my life expectancy all the way out to 95 years! I’m healthy, but certainly no athlete (hello, dad bod), and there is some history of heart disease among my family members (but not me – not yet). I also don’t smoke, which is a huge health asset, in addition to saving me a bundle of cash.

The SOA’s longevity illustrator provides a more general result, showing the probability of living a specified number of additional years from today. Due to the limited number of variables – it only asked 4 questions – I expected the outcome to be a bit more pessimistic, and I was right. Even if I assumed the option for “excellent” health, the longevity illustrator gave me a better than average chance of seeing age 85 (66%), a less than average probability of celebrating age 90 (44%) and a gloomier 1-in-4 chance of reaching age 95 (25%).

Why the odds matter

Taken together, one calculator tells me that a long life out to age 95 is possible (www.livingto100.com), and the other calculator (www.longevityillustrator.org) tells me the likelihood that I’ll reach that 95th birthday, along with probabilities for all the other ages along the way. As a rather old English saying reminds us, “There are three kinds of falsehoods: lies, damned lies, and statistics.”

How I’m planning for a longer retirement

While no calculator or crystal ball can tell me exactly how long I may be around, these probabilities do give me a track to run on so I know what my trade-offs are as I make various financial decisions. For example, given the possibility and significant probability that I may be facing a very long retirement, I’ve decided that my retirement goals include the following:

  • Contribute to my 401(k) plan at work to the maximum annual IRS limit.
  • Work as long as I enjoy what I’m doing and physically can; I likely will need those additional years of 401(k) contributions.
  • Delay Social Security to age 70 and maximize this payment.
  • Pay off all my debts – including our mortgage – before I retire.
  • Consider converting some of my retirement nest egg to an income annuity as an additional guaranteed lifetime income supplement to my Social Security to make sure basic living expenses are more or less met no matter what.
  • Consider a reverse mortgage line of credit as a financial lifeboat if long term care or other unexpected and severe expenses begin to prematurely drain my retirement savings.

When the numbers show a shorter retirement

Of course, if my projections were not so long lived, I would focus on spending more early on, not working quite so long, cashing in Social Security a few years sooner, and not worrying too much about buying an annuity. These are highly personal choices, and your priorities are likely not the same as someone else, which makes this a good conversation to have with a financial planner.

If you want to keep your retirement goals really simple: save, pay off debt, and invest as if you will be that 90-something with a four-alarm flaming birthday cake. Your future self will thank you if you live that long and if not, your heirs and/or a beloved charity will thank you for the generous financial legacy you leave behind.

However, if your planning efforts demand more precision, use the calculators to dial in your own probabilities. Keep in mind, no calculator is perfect, and medical science is improving all the time. You might want to keep a little something in reserve so you can still enjoy that 90-somethingth birthday celebration.

How To Make Early Retirement A Reality For You

October 19, 2018

Retirement means different things to different people. For some, retirement means a second chapter of a “fill in the blank” opportunity. For others, it’s the choice to work or not to work.

In any case, retirement is a destination we all aspire to reach. The age we want to reach retirement varies though. The US Census Bureau calculates the current average age of retirement to be 63. But there are always the overachievers who want to retire by 55.

Early retirement is possible with the right plan

If this is your dream, it is possible. It just requires a lot of planning. Use the list below as a starting point to create a strategy to retire early:

Create AND test drive your retirement budget

Do a reality check on your savings by creating a retirement spending plan to account for all of the projected expenses and spending you may have in retirement. Be honest with yourself when doing this. If you can’t live below your means now, what makes you think you can do it once you retire? If your new budget includes big drops in expenses like eating out, clothing or entertainment, test-drive the changes now to see if you can stick with them into retirement.

Don’t forget to factor in travel

Thinking about travel? Great, first think of how often you want to travel. Next, use websites like Travelocity to estimate how much your dream destinations will cost annually, divide that number by 12, and use that amount in the vacation category of your spending plan.

Make a game plan for healthcare

First, make sure you understand your estimated health insurance costs until you qualify for Medicare. According to ehealthinsurance.com,the average cost of health insurance for an individual aged 55-64 years old is $790/month in 2018. This number can change dramatically depending on where you live. For some, it’s a pretty big financial gap to cover if you plan on retiring at 55.

Second, contact your HR department regarding retiree healthcare benefits and the rules to use them. The last thing you want is to retire at 54 only to later realize you could have gotten healthcare benefits if you’d waited to retire at 55. If you retire without healthcare benefits, consider working part-time. More employers are offering healthcare benefits for part-time workers.

Finally, consider maxing out your health savings account. Contributions are pre-tax and qualified medical withdrawals are tax-free. After age 65, you can withdraw from your HSA for any reason and avoid penalties, but you will pay taxes on non-qualified withdrawals.

Run and review your retirement estimates

Now that you have an idea of your expenses, run a retirement estimate to gauge how on track you are to replace your income when you retire. If there is a gap, consider bumping up your 401(k) plan contributions. Also review your investment mix to make sure your money is working as hard as you are. If you are married, review each other’s 401(k) plans.

If you have a pension, run an estimate to see the difference in the amount you’ll receive if you retire early, by 65, or later. The difference can be substantial depending on where you work. If you are married, find out how much of a pension your spouse gets at retirement and how much you are entitled to if they pass away.

Lower your expenses

If you have debt, consider using a debt calculator to come up with a debt payoff game plan prior to your retirement. In addition, make it your mantra to not take on any new debts or expenses within 5 years of retirement. This may sound obvious, but I’ve worked with so many employees that have actually increased their debts prior to retirement.

I spoke to one woman who treated herself to her “retirement car,” which was an expensive luxury car. She told me that she thought the purchase was a good idea since she planned on having the car paid off by the time she retires. First, I told her that she missed out on an opportunity to add an additional $45K to her retirement plan by making the car payments instead.

When I tacked on premium gas and the extra maintenance that came along with the car, I told her she could have knocked out the remaining balance on her mortgage. Additionally, she now has to factor in the additional cost of maintenance into her retirement plan.

If you find your expenses exceed your retirement income, consider moving to another state. States tax retiree income differently so look for retirement tax friendly states. If you are thinking of moving, compare the cost of living. Also factor in possible additional expenses like traveling to see the family and friends.

Map out your life game plan for the next 30 years

There are only so many golf games and naps you can take before you are bored out of your mind. Our careers are so entwined with our identities that you may find it harder than you think not having a career. Take some time and create a plan for life after retirement.

For example, now you can have the job you always wanted but could not do because it paid so little. Volunteer your time and talents to causes you care about. You have decades of talents most nonprofits cannot afford. Your experience is valuable and desperately needed.

Early retirement can be planned for. The name of the game is to stretch your income for as long as you can. Use the strategies above to not only get you to early retirement, but keep you retired.

 

How One Couple Survived 2008 & What We Can All Learn From How

October 16, 2018

It’s hard to believe it’s been ten years since we experienced the Great Recession – for some people, the events tied to that period in our economic history changed their lives forever. I think of all the people who were planning to work just a few more years so that they could pay off debts who found themselves out of a job and unable to get back in. Thousands of people were forced into retirement before they were ready simply because their jobs ceased to exist.

A story of survival

While the probability of another major recession like that is unlikely to happen again during my working years, I talk to plenty of people who have that fear. Going forward, whenever I hear someone express that fear, I’m going to share this story with them:

I talked with a couple the other day who are looking forward to retiring next summer. I’m glad I asked about how they accomplished their retirement plan – there were some bumps and unexpected turns along the way, but how they handled them is a lesson for us all.

A late career lay-off

The husband told me how he did not see the 2008 real estate crash as being anywhere as bad as it ended being. Then in 2009 he was laid off – the company he worked for was in the mortgage industry and eventually went out of business. This situation played out with thousands and thousands – there’s a reason that some people called it the Great “He-“cession. Many of those who lost their jobs where men in their final decade or so of working.

The good news is that he had limited his exposure to company stock in the 401(k) – he had always been told not to put too much in company stock within his 401(k), which turned out to be a very good thing. But while his retirement savings to date was as intact as possible, he was worried about his ability to continue saving for the future. He had worked for this company for a while and was not confident that he would find something that would pay anywhere close to what he was making.

Although their immediate future was uncertain, he and his spouse had done several things that put themselves in a good position.

  1. They always spent less than they made.
  2. Their daughters went to a public university and were able to graduate without any student loan debt. They were also both working and on their own financially at that point.
  3. They had only a small balance left on their mortgage.
  4. They had used some of their stock options (that they didn’t need for college) to invest in a rental property.
  5. They diversified their 401(k)’s; he only had 10% company stock in his 401(k) (see above).
  6. They had no debt and a cash reserve of 5 month’s expenses.
  7. His spouse’s job was not impacted, and she would be able to work remotely if they needed to move.

The first thing he did upon losing his job was to network aggressively. That lead to reconnecting with a former colleague, who told him about a position that paid less and would require him to move to another state. While it wasn’t ideal, they felt strongly that a bird in hand was better than two in the bush. He took the offer.

Making tough decisions

They sold the house they had raised their kids in, moved to another state and rented an apartment. Eventually they found a condo to purchase with the proceeds from their house sale. His spouse worked from home and after a few years he started getting promotions at his new firm. It wasn’t easy to make these decisions, but they kept the long view in mind.

The pay-off

Ten years later, they are moving to a town closer to their children, selling the rental home for a small family vacation home and looking forward to retirement. I asked if they missed their old home and he said, “it would be too much for us in retirement, we would have sold it eventually. No regrets.” Making concessions to their short-term life allowed them to stay on track with the long-term plan.

There is a lot of concern about the markets now, as there always is. If you’re worried about being a casualty of the next recession (should one happen soon), then now is the time to prepare. Here are the takeaways to prepare yourself if a layoff comes your way:

  1. Have a spending plan and spend less than you make.
  2. Make sure you don’t not have too much credit card debt and your mortgage is affordable.
  3. Diversify your investments.
  4. Remain flexible in where you live, which opens options that are not available if you are inflexible.
  5. Make room for a reduction in income – holding off for an income that matches your highest income means you may be without an income for a longer time.
  6. Maintain cash reserves of a least 6 months, more if you’re in a unique industry or have a non-earning spouse.

The best time to prepare for the worst is when times are good. Take some time this fall to make sure your financial house is in order. At best, things will continue as they are and you may be able to retire earlier than you think. At worst, you’ll be in a better position to recover from financial hits should they come. As we like to joke on our team, one of our favorite quotes is, “Gosh, I really regret making a budget and saving for emergencies,” – said no one ever.

How To Know If You’re Really Saving Enough For Retirement Based On Your Situation

October 09, 2018

Ever wonder if that 6.2% of each paycheck (or so) that you are socking away into your 401(k) at work is really going to be enough to help you retire comfortable someday? That’s roughly the average amount working Americans set aside in their employer sponsored retirement plans but is it realistic? Will those 401(k) dollars cover your future income needs when you are old and Social Security and your own savings are all you have?

This is one of the more common questions we get as financial planners, and there’s not a straight “yes” or “no” answer – we are the ones who will respond with that annoying, “it depends,” answer when asked. Rather than annoy you further, let’s explore some ideas that might help you see if your efforts are on track and what you can do about it if not.

Who saves what?

First, let’s consider what everyone else is doing – we all like to know where we stand against our peers, no? I ran across a rather disturbing headline lately claiming that approximately one third of Americans have saved less than $5,000 for retirement. This gloomy information comes to us from a Northwestern Mutual 2018 study that also found around one-in-five of us have nothing saved yet for retirement. Depressing. But what does this information mean, really?

When you consider the entire working population, that includes the youngest end of the workforce too, many of whom are busy paying off student loans and racking up consumer debt, so of course they aren’t saving much (if anything) for retirement just yet. I know, because I talk with quite a few of them on a daily basis and help them turn that statistic around.

The National Institute for Retirement Security also backs me up on this observation, citing their own research showing 66% of the Millennial generation has nothing saved for retirement, and 95% of this group are not yet on track with retirement savings. So when you consider that, then it makes sense that the overall statistic seems dire.

Older = wiser (and save-ier?)

I pondered this further and wondered if things get better as we get older, more experienced at life in general, and (hopefully) earn more money as our careers progress. Logically that makes sense, but my own experience reminds me that logic and human behavior are not always closely correlated. A study from the Economic Policy Institute does support the notion that retirement savings are noticeably higher after age 31 and generally increase as we approach retirement age. However, this same study also suggests retirement savings rates across the board are lower than they should be.

How much IS enough?

A common and helpful rule-of-thumb suggested by many financial planners is a 70%-80% income replacement ratio is the right amount to save. If you can retire with enough income from both Social Security and your retirement savings to replace between 70% and 80% of your pre-retirement before-tax income, you are likely on track with your retirement savings. People with lower incomes or considerable amounts of debt when entering retirement may need a higher ratio of 90% or even 100%. Those with more frugal lifestyles, greater savings, higher working incomes or less (no) debt might find a 60% income replacement ratio works just fine.

The tricky part is estimating your potential income so far out in the future. Fortunately, several handy online calculators are available. Here at Financial Finesse, we are rather fond of our Retirement Estimator Calculator. Similar retirement income calculators are available online as well, such as these:

Taking your next steps

If you find your savings efforts are on track, awesome! Keep doing what you are doing.

But what if there is a gap? What can you do beyond the obvious (and highly recommended) moves of spending less, saving (or earning) more money, or planning to work longer? Based on data and observations compiled within Prudential’s 2018 Retirement Preparedness Survey, an important step is finding ways to become more mindful of and focused upon our controllable financial behaviors, such as:

  • Becoming more knowledgeable about investments and how they work. Understanding market dynamics can not only help us make better investment decisions, but we can also avoid getting panicky and making a wrong move when investment markets become uncertain.
  • Being willing to take reasonable investment risks. While keeping your money out of the stock market altogether may seem like a safe bet, inflation then becomes your enemy and robs you of purchasing power as the cost of living outpaces your modest investment earnings. Asset allocation, on the other hand, becomes your friend as you spread the investment risk among a mix of cash, bonds, and stocks.
  • Consider working with a financial planner. A financial professional who focuses on you first can help you get and stay on track. Ideally, your employer offers access to a planner through a workplace financial wellness benefit, but if not, you can always find a planner on your own.

Making a plan is most of the battle

Wherever you are on your retirement preparedness path, having a clear path to follow is key. As our own Financial Finesse Think Tank’s 2017 Year in Review report concluded, people who commit to making repeated and positive financial changes over time tend to be more confident, twice as likely to be on track for retirement, and half as likely to suffer from unmanageable financial stress. Any time is a good time to check on your retirement planning progress and take your next step.

 

NUA – One Overlooked Benefit Of Employer Stock In Your 401(k)

October 03, 2018

Should you own stock in your current or former employer? There are mixed opinions out there regarding the risk of holding too much stock in the same company that provides your paycheck, but before you liquidate a large holding in your 401(k), keep reading.

One little known benefit of holding company stock in a 401(k) plan is the ability to have the “net unrealized appreciation” of the stock or “NUA” taxed at a lower tax rate. Normally, when you take money out of a traditional 401(k), it’s taxed at your ordinary income tax rate. However, the gain in employer stock can be taxed at the lower long term capital gains rate if you meet several conditions:

Here’s how NUA works

1) You have to reach a triggering event. This can be death, disability, separation from service, or reaching age 59 ½. You can’t take advantage of this at any time. Most people take advantage of it upon retirement or after.

2) You have to take a lump sum distribution of the entire account. You can’t just withdraw the shares of stock. However, you can choose to roll the rest of the money into an IRA or another retirement account, while moving the company stock shares to a regular brokerage account.

3) The employer stock has to be distributed “in kind.” Basically, this means you can’t sell the shares and then withdraw the cash as you would typically withdraw money from a 401(k). Instead, you have to transfer the shares of stock into a brokerage firm.

If you meet the criteria above, then when you do a withdrawal of the company stock, you would pay ordinary income taxes on the cost basis of the stock (essentially the value of the stock when you purchased or received it) at that time. You may choose to hold the stock or liquidate some or all of it at that point. When you do so, you’ll pay taxes at the lower long term capital gains rate on any growth in the value of the shares beyond what you paid for them (regardless of how long you actually held them).

Be aware that withdrawing a large amount of stock could push you into a higher tax bracket for that year, so you’ll want to be strategic about when you make this move. However, removing the stock from your retirement account would also reduce the amount of required minimum distributions you’d have to take starting at age 70 ½. (Incidentally, the capital gain would not be subject to the 3.8% Medicare surtax on investment income, but the stock would not benefit from a step-up in basis when you pass away.)

It’s about more than just the taxes

As I always like to say, don’t let the tax tail wag the dog though. This is not a reason to load up on company stock. After all, individual stocks are always a lot riskier than diversified mutual funds since an individual stock can go to zero and never recover. This is even more true when it’s the company that your job is tied to. A good rule of thumb is to never have more than 10-15% of your portfolio in any one stock, especially your employer’s.

That being said, it could be a good reason to keep some money in company stock, especially if you already have shares that have appreciated quite a bit. In fact, this is one of the main reasons I would suggest someone not roll a former employer’s retirement plan into an IRA or a new retirement plan while they are still working.

How to decide whether NUA is right for you

You can calculate the value of doing an NUA distribution vs an IRA rollover here. If you’re still not sure whether this makes sense for you, see if your employer offers access to an unbiased financial planner who can help you with what can be a complex decision, or consult your own financial advisor if not.

3 Financial ‘Truths’ For Young People That Might Be Wrong

September 21, 2018

One of the things I most often hear from people about personal finance is how much they wish they had learned about it when they were younger. In talking to younger people, I do see a lot of awareness about the importance of financial wellness. Unfortunately, there are also a lot of myths and generalities circulating around about how young people should manage their money.

Here are three of the most common:

1. Common financial “truth” that might not be right for you: Focus on paying off your student loans early.

I get it. No one likes paying student loans and we’d all like the day to come as soon as possible when we no longer have to make those payments. However, student loans typically have relatively low interest rates (at least for undergrads) so any extra cash you have would probably be better off used to pay down higher interest debt like credit cards or invested for a greater expected rate of return (especially if you can get matching contributions in your employer’s retirement plan).

A good rule of thumb I suggest is to pay down debts early if the interest rate is above 6% since you may not earn as much by investing extra savings instead. If the interest rate is below 4%, you should probably just make the minimum payments since you can likely earn more by investing the extra money. If it’s between 4-6%, you can go either way depending on how comfortable you feel with debt vs. your risk tolerance with investing. (The more conservative you are, the more it makes sense to pay down debt vs investing.)

Alternatives to paying it off ASAP

So, what should you do with your student loans? First, see if you can refinance your debt to get a lower interest rate. (Just be careful about switching from government to private loans since you lose a number of benefits.) If the rate is low, you might even want to switch to an extended payment plan since the lower payments will free up savings you can use for other goals like saving for emergencies, buying a home or retirement. If the rate is high, try to pay it down early after building up an emergency fund, getting the full match in your retirement plan and paying down any higher interest debt.

2. Common financial “truth” that might not be right for you: Roth accounts are better for young people.

Unlike traditional pre-tax accounts, Roth accounts don’t give you any tax break now, but the earnings can grow to be withdrawn tax-free after age 59 ½ as long as you have the account at least 5 years. The argument here is that young people have more time to grow those tax-free earnings. They’re also early in their careers so they may be in a higher tax bracket in retirement.

Why you might not want to use Roth at this point

However, if you’re trying to save for emergencies or a home purchase and are just contributing to your retirement plan to get the match, you may want to make pre-tax contributions and use the tax savings for your other goals. Even if you’re focused on retirement rather than more immediate goals, a traditional pre-tax account may still be better for you if you’ll end up paying a lower tax rate in retirement.

If you plan to go back to school full-time, you can also convert those pre-tax dollars to Roth at a time when you’re in a fairly low tax bracket. If you’re not sure which makes sense, you can split your contributions between pre-tax and Roth or contribute to your employer’s plan pre-tax (it may even be the only option) and to a Roth IRA (which has additional benefits).

3. Common financial “truth” that might not be right for you: Invest aggressively while you’re young.

There is some truth in this. The longer your time frame, the more aggressively you can generally afford to invest your money and young people tend to have long time horizons before retirement. There are a couple of important caveats here though.

Consider your time frame

The first is that not all of your money has a long time frame. For example, financial planners generally recommend that one of your first goals should be to accumulate enough emergency savings to cover at least 3-6 months of necessary expenses. This is especially important for young people who are more likely to change jobs and haven’t had as much time to accumulate other assets like home equity or retirement plan balances to tap into.

You may have other short term goals to save for like a vacation or home purchase. Any money you may need in the next 5 years should be someplace safe like a savings account or money market fund since you won’t have much time to recover from a downturn in the market.

Don’t forget your own personal risk tolerance

Speaking of downturns, the second problem is that this advice ignores risk tolerance. Many young people are new to investing and may panic and sell at the next significant market decline. If this sounds like you, consider a more conservative portfolio (but not TOO conservative). If you have access to target date funds, you may want to pick a fund with a year earlier than your planned retirement date. You can also see if your retirement plan or investment firm offers free online tools to help you design a portfolio customized to your personal risk tolerance.

It all depends on your personal situation

Of course, there are plenty of young people who should pay down their student loans early, contribute to Roth accounts and invest aggressively. The key is to figure out what makes the most sense for your situation. If you want help, see if your employer offers free access to unbiased financial planners as an employee benefit or consider hiring an advisor who charges a flat fee for advice rather than someone who sells investments for a commission or requires a high asset minimum that you may not be able to meet.

In any case, you don’t want to make the wrong choice now, and regret it when you’re older.

 

A version of this post was originally published on Forbes

How To Be Mentally Prepared For Retirement

September 20, 2018

As a CFP® and financial coach, I talk to people every day to see if they are financially prepared for retirement. While that is extremely important, that is really only half of the equation. If you aren’t mentally and emotionally prepared for retirement, then you really aren’t ready.

Thinking about the why

I have seen several instances, including my dad, where people are financially ready to hang it up but they don’t know what it is they are retiring for. Do you know why you want to retire?

A changing landscape

First of all, retirement is changing. People are living longer,so lots of people do work longer, either full-time or part-time and that is OK. Even then, all of us will eventually cut back or completely step away so we have to know what we’re going to do with the rest of our life.

Asking the right questions

If you’re one of the many who find themselves financially ready to call it quits on the workforce, but not quite mentally ready, you’re not alone. To help get there, let’s look at two basic questions:

  1. What am I passionate about?
  2. What do I enjoy doing?

If you can answer those two questions, then you have the start of a plan.

Clarifying your passions and interests

When we look at what we’re passionate about, it is usually going to be anywhere from one to three things. It could be as fun and simple as investing in the lives of your grandchildren to getting involved in community service.

Translating what you love about work into retirement activities

For me, I’m blessed that one of my passions is helping people be financially well, so I get to do that at work. That also means I can do this after I retire. When I retire from getting paid to be a financial coach, I intend to volunteer with financial coaching ministries at our church and in financial literacy classes at our local high school.

To prepare for that, even though retirement is 15 – 20 years away, I’m doing those things at very small levels so that getting more involved will be an easy transition. So, think of the things you do at work and how they may translate to serving others when you don’t need to work for a paycheck.

It’s gotta be fun

We also want to know what we enjoy. Over the last few years I have gotten very interested in barbecue. I mean, I do live in Kansas City, where we may have a borderline unhealthy obsession with good barbecue. For me, it has been fun to learn a new skill, tinker with recipes, take pride in making a delicious meal and most importantly, it’s an excuse to be social. Hey, we can’t eat a whole brisket alone – we “have to” invite some friends over to share. So, whether I ever enter a barbecue competition or not, I’ve got a fun habit that can easily fill up one day a week.

Your hobby could even become a second career of sorts

Now my friend Jon is also into barbecue – big time. Someday I hope to be half as good with a smoker as he is. He started doing competitions years ago. For him, he had found a fun hobby too, but it has turned into much more. When a massive tornado hit Joplin, MO, in 2011, Jon was one of several BBQ competition teams that volunteered to drive down to Joplin and make meals for first responders and people impacted by the tornado. They ended up serving 120,000 meals over 13 days!

That effort turned into Operation BBQ Relief. They now go anywhere in the US that a natural disaster strikes. To date, they have served nearly 1.8 million meals to disaster victims and responders! It has become such a passion for Jon that he now rarely competes as so much of his free time is spent supporting disaster response.

It’s not likely that you’re going to get in on the ground floor of a successful charity, but the key is testing those passions now to see where it takes you.

So, keep saving and investing wisely, but also invest your time in figuring out what you are passionate about and what you enjoy doing. Now I’ve got to go figure out what is on sale for me to throw on the smoker this weekend!

How To Figure Out What You Can Safely Withdraw In Retirement

September 14, 2018

In conversations with people who are very close to retiring (within the next 3-6 months), the financial planning rule of thumb of a 4% “safe withdrawal rate” often comes up in our discussion. It seems as though it’s become an almost universally accepted “rule” and is rarely questioned. To combat complacency and willing acceptance, I routinely question it, making it the starting point for conversations regarding retirement income.

How the “4% rule” works

First, let’s do a quick review of the 4% rule, which is a guideline that people like to use to determine how much they can safely withdraw from retirement savings without risking that they’ll run out in the future.

The rule says that if you have $500,000 in your investment portfolio (401k, IRA, taxable accounts – all combined), you can withdraw 4% of that – $20,000 in Year 1 of retirement. In Year 2, if inflation is 3%, you would withdraw $20,600 (your 4% starting withdrawal PLUS a 3% inflation adjustment).

You continue increasing your withdrawals annually until you are leaving the balance as an inheritance to your heirs and/or charitable organizations. It’s worth noting that the person who “invented” the 4% rule (Bill Bengen) retired a few year years ago and his retirement strategy is very close to using the 4% rule.

Doing a reality check

When talking with almost-retirees, I like to give them a look at the first year under this scenario. If pension income will be $900/month, Social Security will be $2,100 and investment withdrawals add up to $1,667 from the 4% example, I like to do a “back of the napkin” reality check with them. Can they really get by on $4,667 before taxes each month?

We look at their after-tax income as a result of that question and also review their current budget categories and expected level of spending. Some expenses will inevitably decrease (dry cleaning or gasoline, maybe housing) and some will inevitably increase (like health care). Of course, this is merely a starting point for conversation, providing a situation to discuss the limitations of the 4% rule and provide other ways to figure out a “safe withdrawal.”

Reviewing the flaws of the “4% rule”

An article with an economist discussing the limitations of the 4% rule points out a few of the flaws inherent in using that rule for all retirees:

  • Retirement isn’t a “one size fits all” proposition. Everyone has a different scenario and different goals. Is your goal to spend every last dollar before you die or is it to leave a significant legacy? The answer to that question, amongst others, will help you determine if the 4% rule might be an appropriate starting point.
    • My take: Don’t retire and start a distribution stream without having serious conversations about your most important life goals with a financial professional and developing a strategy for distribution of your assets.
  • Sequence of returns is critical in the simple 4% strategy. What happened to someone who retired in 2008 & had a 4% withdrawal on top of a 40% market loss? Chances are they ran out of money much sooner than planned. The early years of retirement are exceedingly important for someone considering a flat withdrawal rate.
    • My take: You can minimize the impact of a potential market drop through asset allocation and by having a surplus of cash on hand. I talk with soon-to-be-retirees about the concept of having 3 YEARS worth of expenses in cash or very short-term fixed income to start retirement. Most market downturns won’t last more than 3 years and using that liquid surplus to live on during down markets can allow you to ride out the storm from a position of relative safety.

Looking at different models

In the New York Times article, Wade Pfau (the economist mentioned earlier) looks at a few different models (constant spending, floor & ceiling rules, and a complicated set of “decision rules”) that various financial professionals have developed to deal with weaknesses and limitations in the 4% rule. The part of the article that I find most interesting is that in every model, people almost always UNDERSPEND in retirement, leaving a significant inheritance (which my kids better not be expecting to happen in my life!!!).

While most of the models show a significant sum left at life expectancy, there are scenarios in each model where the portfolio is depleted. There are no “sure things” when it comes to projecting future returns and future expenses and no one knows (or probably should know) the exact date of their own death.

How I plan to make withdrawals in retirement

Here’s the conservative approach that I plan to use when I retire. I’ll start with the 4% rule in mind, but I’ll have a safety net of 3 years worth of cash sitting in a money market account. In years where the market has gone up, I’ll withdraw 4% or more if I want to travel or have large expenses, up to the amount of investment gain that year.

In down markets, I’ll use the cash on hand & suspend any withdrawals from the portfolio. That can virtually eliminate the sequence of returns/early years risk and build in some margin for error. It won’t assure that I don’t run out of money, but it does provide some upward latitude in good years and some protection in down years.

Everyone’s approach will be different

While that’s my planned approach, at least as of today, it may not be right for you. Have you had conversations with your advisors and/or your spouse about your approach? Are you more concerned with running out of money later in life, or not having enough money to spend early in retirement when you’re at your most active?

Retirement clearly is not a one-size fits all approach and I strongly suggest looking at several scenarios based on your assets, income streams and current spending levels. Once you retire, it’s usually permanent. Taking the time to work through your specific situation BEFORE you retire can save you mountains of financial stress during retirement.

 

A version of this post was originally published on Forbes.

Should You Contribute To Pre-Tax Or Roth 401k?

September 13, 2018

For all the efforts that companies undertake to make participating in their retirement plan benefits easy, there’s no simple way to help employees decide whether the money they contribute from their own paychecks should be traditional (also called pre-tax) or Roth (also sometimes called after-tax Roth). The answer can be very nuanced depending on your situation, and for the most part, we won’t know whether we chose correctly until it’s too late – we’ll only really know if we got the answer right when it comes time to withdraw and we actually know our taxable income, current tax brackets and lifestyle needs.

Since my crystal ball seems to be broken, I’ve attempted to distill the various factors in a way that makes more sense. Keep in mind that many of the factors listed in the chart below are just different ways of saying the same thing, but the intention is to present it in the way that makes the most sense to you.

The biggest factor affecting this decision: taxes

If we all could just know what tax rates will be when we retire and start withdrawing from our retirement savings, along with what our own income will be at that point, this would be a simple choice – if you knew your tax rate would be lower when withdrawing from your retirement account, you’d choose pre-tax and avoid paying taxes on the money today so that you could pay at a lower rate in the future.

On the flip side, if you knew that tax rates would be higher when you’re withdrawing and that you’d be paying more in taxes, then you’d choose Roth so that you can pay today’s lower rates, then enjoy your savings without tax consequences in the future. (keep in mind that I could be wrong about this – reason tells me that tax rates will have to go up in the future, but Congress has surprised us before!)

I like that I can change this strategy at any time. For example, when my husband sold some stock he’d been given as a child for a big capital gain, I switched to pre-tax for the rest of that year in an effort to lower our overall taxable income.

Income limits and the ability to withdraw without taxes

I also like the idea of having investments available to me in retirement that I can liquidate and withdraw without concern for the tax consequences, and my husband and I have too high of a combined income to contribute to Roth IRAs, so I like that the Roth 401(k) doesn’t have an income limit.

Now, there is a way around those income limits using a “back-door” Roth IRA, but that doesn’t work for me because I also have a rather large rollover traditional IRA.

Predicting the future of tax rates

I’m personally making Roth contributions right now in my 401(k) because I believe that we are currently experiencing the lowest tax rates I’ll see in my lifetime. And while I very well may have a lower income in retirement, the tax brackets themselves may be different, so even if I have a lower income, I think I might have a higher tax rate in the future.

I like that I can change this strategy at any time. For example, when my husband sold some stock he’d been given as a child for a big capital gain, I switched to pre-tax for the rest of that year in an effort to lower our overall taxable income.

Income limits and the ability to withdraw without taxes

I also like the idea of having investments available to me in retirement that I can liquidate and withdraw without concern for the tax consequences, and my husband and I have too high of a combined income to contribute to Roth IRAs, so I like that the Roth 401(k) doesn’t have an income limit.

Another consideration: access to the contributions for early retirement

While I can’t withdraw my Roth 401(k) contributions before I’m 59 1/2 without penalty (I COULD withdraw contributions to a Roth IRA early), if I’m lucky enough to retire before then, I can always roll my Roth 401(k) into a Roth IRA, then tap those contributions if I need to, without concern for taxes or early withdrawal penalties. That’s another reason that I want to at least have some of my retirement savings as Roth, regardless of tax rates.

Factors to consider:

Factor: Traditional (pre-tax) Roth (after-tax)
You think your taxes are higher today than they’ll be when you withdraw Makes more sense Makes less sense
You think your taxes are lower today than they’ll be when you withdraw Makes less sense Makes more sense
You want to avoid required distributions after age 70 1/2 Makes less sense Makes more sense, as long as you roll to a Roth IRA
You think your income tax bracket will be lower when you withdraw Makes more sense Makes less sense
You think your income tax bracket will be higher when you withdraw Makes less sense Makes more sense
You need more tax deductions today Makes more sense Makes less sense
You have a long time until withdrawal and plan to invest aggressively Makes less sense Makes more sense
You’d like access to your contributions before the traditional retirement age Doesn’t make sense Makes sense

Splitting the difference

If you’re just not sure or thinking about it makes your head hurt, you could always split your contributions between the two. In other words, if you’re putting 10% away, you could do 5% pre-tax and 5% Roth. The total $19,500 (plus $6,000 catch-up for over 50) applies as a total to both, but there’s no rule that says you have to put all your money into just one bucket or the other at a time.

One more thing to know

No matter what you choose for your own contributions, you should know that any matching dollars or other contributions from your employer will always be pre-tax, per IRS rules. So even if you put all your own contributions into Roth, you’ll still have pre-tax money if you receive any from your job. Now, you may be able to convert those contributions to Roth depending on plan rules, but if you do that, know that you’ll have to pay taxes on the amount converted, so plan carefully.