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.

 

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.

How An Indirect Retirement Account Rollover Can Go Wrong And How To Avoid It

September 11, 2018

Late last week I received a panicked phone call from my sister. She had received an unsolicited check from a financial institution with no letter explaining what it was for or why she received it.

After we did some investigating, it turns out it was a full distribution from her traditional IRA because the mutual fund it was invested in had been closed by the fund company. Because she did not want to take a distribution from her IRA, she will need to deposit that check into another traditional IRA within 60 days to avoid paying taxes and early withdrawal penalties (she is not yet age 59 ½) on the amount of her IRA.

While a hassle, that process is not difficult or time consuming. But here’s the rub: the fund company withheld 10% for federal income taxes. We’re not sure why 10% was withheld as it is not required to withhold from an IRA, but it is important to note that distributions from an employer plan, like a 401(k), require 20% mandatory withholding for federal taxes.

Why the unnecessary withholding is an issue

To avoid taxes and penalties on the amount withheld, she will need to come up with that 10% amount to make the indirect rollover a complete rollover. Otherwise, she will incur taxes and penalties for the amount withheld that won’t get into the new IRA within the 60 day deadline.

Let’s break it down further

The details

For simplicity sake, I am going to use round numbers to illustrate the problem.

  • The full amount of the distribution was $50,000.
  • $5,000 was withheld, so my sister received a check payable to her for $45,000.
    • If she were to simply cash that check, she’d have to include the full $50,000 as taxable income to her this year, including an additional 10% penalty for the early distribution (maybe that’s why they withheld? We’ll never know).
  • She is not able to come up with an extra $5,000 to complete the full $50,000 indirect rollover into an IRA, so her new IRA will start with a value of $45,000 – down from the $50,000 she had last week.
  • Come tax time, the $5,000 withheld will be included as income on her tax return. Even worse, she will have to pay a 10% early withdrawal penalty on that $5,000!
    • If she is in the 22% tax bracket, that comes up to $1,600 (22% times $5,000 plus 10% times $5,000) in tax and penalties.
  • She will get a refund of $3,400 since the tax and penalty on the $5,000 withheld is only $1,600. But she has now lost over 3% of her IRA value as well as the future tax-deferral on that $5,000.

A unique situation

This is a unique situation – having a distribution happen with no warning or chance to act beforehand (I suspect something was received and discarded on accident, but that is neither here nor there) – but I can only imagine that other recipients of such checks who did not have a financially savvy person to call may have just cashed the check and will find themselves with a big tax surprise in April.

What could’ve been done differently

Had she known this was going to happen, she could have initiated a direct rollover – where the funds move directly from one financial company to another – with no tax implications at all. And no need to worry about getting the funds into a new IRA within 60 days.

The moral of the story

Besides opening your mail and making sure you’re not missing important communications from your financial services providers, the important take-away here is that the simplest way to move retirement money is to avoid being the middle person. If possible, a direct rollover will always be much better than an indirect rollover if your intention is to keep all the funds in the IRA for the future.

This is especially true when rolling funds out of your 401(k) or other employer-sponsored retirement plan, as an indirect rollover does lead to a mandatory 20% tax withholding. When you do a direct rollover, there are no taxes to be withheld, so you don’t have to make up the difference (assuming you have the cash available to do so) or get stuck with unintended income.

The Pros And Cons Of In-Service Withdrawals From Your 401(k)

August 31, 2018

A solid financial plan requires the examination of all available opportunities to use financial resources to meet important life goals. Many 401(k) plans have a unique feature that can either create a world of opportunity for your retirement plans or create a tax and retirement planning nightmare. This 401(k) plan feature is known as an in-service withdrawal.

It is widely understood that distributions from a 401(k) plan that are made before you reach age 59 ½ are taxed as ordinary income. But the real kicker is the fact that minus a few exceptions, they are also subject to an additional 10% early withdrawal penalty.

The in-service withdrawal exception

In-service withdrawals or “in-service distributions” allow you to take distributions or roll your contributions over to an IRA after reaching age 59 1/2 while you are still an employee of the company. (It is important to note that not all 401(k) plans have the option to allow participants to take an in-service distribution while still actively employed. According to the Plan Sponsor Council of America, it has been estimated that up to 77% of 401(k) plans allow in-service withdrawals, so check with your 401(k) provider first.)

Typically, the only way to access elective deferrals to a 401(k) plan while you are still working is through a hardship withdrawal or 401(k) loan. Certain triggering events such as financial hardship must occur related to reasons such as unreimbursed medical expenses, buying a primary residence, paying for college tuition, funeral expenses, and to avoid eviction or foreclosure. Hardship withdrawals are subject to ordinary income taxes PLUS a 10% penalty if you are under age 59 ½. You also must prove that you have no other funds available.

In contrast, in-service withdrawals at age 59 ½ (if offered) that are not due to financial hardship are not subject to the 10% penalty and have no restrictions on how you use these assets.

Here’s how it works:

For example, let’s assume you’re still working for an employer and just reached age 59 ½. If your plan allows for an in-service withdrawal, you may choose to either rollover your 401(k) money to an individual retirement account (IRA) or you can even take a cash distribution. There are no penalties if you’ve reached age 59 ½, but withdrawals from a pre-tax 401(k) are still taxed as ordinary income.

This is where it gets tricky from a tax planning perspective. If your distribution is taxed as ordinary income, it will be added to your earned income for the tax year in which you take money out of the 401(k) plan. The distribution could potentially put you in a higher marginal tax bracket and may completely negate the benefits of making contributions to your retirement plan in the first place.

You can avoid having an in-service withdrawal become a taxable distribution by completing an IRA rollover. In fact, if you take a cash distribution and change your mind, there is a 60-day window to complete a rollover to an IRA. This will continue to allow for tax-deferred growth and could potentially give you more investment options to choose from and more flexibility with how your retirement portfolio is structured. This is why it’s the most common in-service distribution.

Reasons to consider an in-service distribution

The primary reason to consider an in-service withdrawal from your 401(k) is the added control and flexibility that comes with rolling assets into an IRA. If you are unhappy with the investment lineup within your 401(k) plan or have high administrative fees and expenses, it may be a welcome relief to know that you have an exit strategy while still remaining with your employer.

Individual retirement accounts may provide you with more (or different) investment choices than the ones offered in an employer sponsored retirement plan. They may allow for greater overall diversification through investments such as individual stocks, ETFs, individual bonds, no-load mutual funds, CDs, separately managed accounts and a number of other choices.

How to find out if your retirement plan allows in-service distributions

In-service distributions may potentially be available through a variety of qualified retirement plans in addition to 401(k)s. Profit-sharing plans, pension plans, employee stock ownership plans (ESOPs) and 403(b) plans are examples of other qualified retirement plans that allow for withdrawals while still working. Since each qualified retirement plan is unique, there are different withdrawal rules governing each specific type of contributions (salary deferral, employer matching contributions, profit sharing, rollover, etc.).

Check with your plan administrator or review a copy of your employer’s summary plan description (SPD) to find out if your plan offers an in-service withdrawal option. In addition to the age 59 ½ requirement, some plans may have a length of service requirement. You should also make sure that taking an in-service distribution will not hurt your ability to continue contributing to your employer’s qualified retirement plan and will not create any problems with your plan’s vesting schedule.

The potential downsides of an in-service distribution

Having more control and flexibility over how and when to access your retirement savings doesn’t necessarily mean this is the smartest financial decision. There are some compelling arguments against taking in-service withdrawals once you reach age 59 ½. Here are just a few of those downsides to consider:

  • Cash distributions may end up creating a greater tax burden than waiting until full-retirement to take money out of your 401(k) plan. As retirement nears, the urge to eliminate credit card debt or pay off a mortgage can be significant. You may even have a major purchase (e.g., boat, car, second home) that you want to make and your retirement plan would seem like a logical option. Unfortunately, you will likely pay significantly higher taxes if you take an in-service distribution while you are still working. Waiting until retirement to take out 401(k) assets is often a better alternative since your income level and taxes will likely be much lower.

IRA rollovers will allow you to continue to defer taxes until you choose to withdraw the funds in retirement. However, IRA rollovers also have potential drawbacks you must be aware of.

  • You will lose the ability to delay required minimum distributions (RMD) beyond age 70 ½. In reality, this one may not seem as big as a concern because who really wants to work into their 70’s? But with retirement confidence levels low, you may either work beyond the so-called “normal” retirement age out of necessity or because you want to work as long as possible (mind and body willing of course). There are no RMDs from 401(k) plans as long as you are still working (and you don’t own a 5% or bigger stake in the company).
  • You will not be able to use a net unrealized appreciation (NUA) strategy if employer stock is rolled into an IRA. This is important if you have highly appreciated company stock in an employer-sponsored retirement plan. Favorable NUA tax treatment allows you to pay income taxes only on the stock’s cost basis. When you eventually sell shares of stock, you are taxed at long-term capital gains rates, which could be significantly lower. Of course, you must weigh the potential tax savings of using the NUA strategy with the risk of having too much invested in any individual stock holding if you decide to hold on to company shares.
  • You will no longer have access to borrowing options once 401(k) assets are rolled into an IRA. While borrowing money as retirement approaches isn’t on the top of everyone’s list of potential goals, it remains an option within 401(k) plans if provided by your employer. IRAs do not have loan provisions and you would have to take a taxable distribution to gain access to your assets.
  • 401(k)s tend to have broader federal protection from creditors. IRAs have federal protection from bankruptcy protection, but that protection has limitations. General creditor protection is decided at the state level. As a result, 401(k) assets tend to have broader protection from potential lawsuits. If you have a pending lawsuit (or think there may be the possibility of one in your future) you should think twice about rolling assets from a 401(k) plan to an IRA.

It is possible that an IRA rollover may end up costing you more in the long run. Always compare the fees, costs, and services to make sure that a rollover fits your short and long-term financial plans. Also, keep in mind that conflicts of interest may exist if financial advisors stand to benefit from your IRA rollover decision. Financial services companies benefit from money in motion and view the IRA rollover market as a significant business opportunity.

There are plenty of valid reasons to consider an in-service withdrawal from your 401(k) plan. Just be sure that your financial advisor is operating in your best interests and not simply trying to generate assets under management (AUM) fees or earn commissions from the sale of investment or insurance products. Consult a fee-only financial planner or utilize the services of unbiased financial wellness providers to learn more about in-service distribution options.

 

A version of this article was originally published on Forbes.

How To Approach Investing As Retirement Draws Closer

August 15, 2018

One of the things I discuss quite a bit with employees that are approaching retirement is how they should structure their investments as retirement draws closer. Many times, they are considering becoming more aggressive over their last few years in the workforce to try and boost returns and maximize account values. This can be a recipe for delayed retirement if the timing is wrong.

The fundamentals

While the fundamentals of investing – being mindful of how long until you need the money and your risk tolerance – do not change as you approach (or enter) retirement, conventional wisdom says you should really want to take less risk as you approach retirement. The idea being you have less time to recover from market losses than you did earlier in your career.

It’s a (hopefully) long road ahead

But, you don’t want to just plow everything into a stable value fund or cash either. Retirement can last upwards of 30 years or more, so you want some aggressive investments to help that money grow and last. You may be thinking, “OK you’re telling me to be more conservative, but stay aggressive – which one is it?”

Well, like many things in financial planning, it depends. Let’s look at some strategies to help you decide how to best manage your own nest egg as you approach retirement.

Exploring the fundamentals

At any point in your financial life, sticking to the fundamentals is the best way to be a successful investor.

  • When do you need the money? Money you know you will need to spend in the next 5 years should be invested conservatively. Investments like a CD, money market mutual fund, or a stable value fund protect those funds from dramatic market movements.
  • What is your risk tolerance? Knowing how you feel about risk is crucial in setting up your investment allocation. There are investors in their 20s or 30s that are very conservative by nature, just like there are investors in their 70s and 80s that are aggressive. Staying true to your risk tolerance allows you to be comfortable with the risk you are taking, which makes you much more likely to stay with your strategy when markets are down.
  • Don’t react to market moves. This one is easier said than done because it contradicts our human nature. For most of us, the pain of losing value in our accounts is stronger than the joy we feel when our accounts are growing. Selling stock investments at low points locks in losses as we are often selling low after buying high. It’s best to resist watching the market on a day-to-day basis.
  • Rebalance regularly. At least once per year, make sure your allocation reflects your original strategy. If your goal is to have 60% in stocks, 30% in bonds, and 10% in cash, check to make sure that is how your funds are set up. In a year when stocks have done well, you may find yourself with 70% in stocks and 20% in bonds. It can be tempting to keep riding the wave of a bull market, but it’s better in the long run to lock in the gains and stick to your original mix. Rebalance by selling enough of the stock investments (sell high) to get back to your target, then buying enough of the bond investments (buy low) to get back to your target there.

The bucketing strategy

When it comes to making investment changes as you approach retirement, one popular strategy is to think of putting your money in hypothetical buckets.

  1. The first bucket is your short-term funds – money you know you will spend in the next 5 years. This bucket can be thought of almost as a savings account and be very conservatively invested.
  2. The second bucket is your intermediate bucket and should be invested in things that generate income, like bond funds. This is money you’d anticipate withdrawing after 5 years, but before 10 years. This bucket is used to refill your short-term bucket as you spend from it.
  3. The third bucket is your long-term bucket and holds your aggressive investments (think stock funds) and is designed to drive growth. This is the bucket that can help your savings to last those 30+ years you’ll hopefully have in retirement.

Rule of thumb

Another way to look at it is by using a common rule of thumb that says the best balance is investing a percentage in stocks equal to 120 minus your age. So if you are 58, then 62% of your funds would be in stock funds. You may try this rule of thumb, along with the 5-year bucket if you find that simpler.

Final thoughts

As you approach retirement, it is a wonderful time to revisit your retirement accounts and make sure you are in line with your risk tolerance and following good fundamentals. Take some time to review your budget and spending needs over the next couple years, which will help you to clarify how much goes into each bucket. Having your money split into the different buckets can help make sure you have the right balance of safety, income, and growth. This will help your money last as your enjoy your retirement!

How To Find A Lost Retirement Account

August 14, 2018

This is a recent texting exchange I had with my 24-year old daughter who works in the medical field:

 

 

 

 

 

 

 

It got me thinking that if she hadn’t opened her statement or thought it was junk mail, would she ever know she had this plan at work? Since she’s not contributing, there’s a chance she may have never known about it, moved on to another job in the future, and missed out on potential thousands of retirement dollars in the future.

Many of us have changed companies over our careers, and I talk to people on a regular basis who think they might have an old retirement account somewhere, but have no idea how to go about tracking it down. Are you certain that you know where all of your old retirement plans are?

Here’s how to find an orphaned retirement account

First the easy steps:

  • If you remember the name of your 401(k) provider (Vanguard, Fidelity, TIAA, Voya, etc.), first contact them to see if your money is still there.
  • You can also contact the old employer. Look for the company online, and if it still exists, contact the HR department either by phone or email and ask them for your balance and account information.

Now the harder steps:

If the above two steps don’t yield any results, you’ll have to do a little more detective work.

  • You account may have been reported as “abandoned.” To search that, visit the US Department of Labor abandoned retirement plan database. It is searchable, so if you don’t know the Plan Name or exact Company Name, you can search by City and State to narrow the results.
  • Each state has an unclaimed property web site that is searchable as well – to find it, you can either search the name of your state and the term ‘unclaimed property’ or try starting here with a national database. If you have lived in multiple states, make sure you search each state’s site (and include your maiden name if appropriate).

Eureka! You’ve found something

If you are able to uncover old retirement accounts, you’ll have to take some steps to take back control. If it’s been reported as unclaimed property, go through the steps as directed to re-claim it as yours. If the money is still sitting at your old company or old plan, then getting started on re-claiming it may be as simple as updating the address on the account.

Once you’ve regained control of your account, you may want to transfer it to a place where you can keep better track going forward. Options include:

  • Transferring it to a rollover IRA (or existing IRA)
  • Roll it over to your existing retirement plan (if they allow rollovers)

Unless you’re over the age 59 1/2, resist the urge to just take the money and run — there are most likely tax consequences and penalties involved there, and since you didn’t know the money was out there, why not continue to “let it ride” for your future retirement? Happy searching!

How Will Your Social Security Income Be Taxed In Retirement?

August 13, 2018

Many of us dreamily envision the possibility of retiring someday; you know, making work optional, taking a permanent vacation, etc. While we can retire from the world of work, retiring from the world of taxes is typically not an option, as many retirees are surprised to learn.

Tax obligations may not be part of our retirement dreams, but perhaps they should be. The decisions we make about saving and investing for our retirement dreams while we are still working can help prevent a tax nightmare after we retire.

Your retirement income tax bite

As you might imagine, retirement is a popular reason for people to chat with a financial planner, and I have the pleasure of talking almost daily with people from all walks of life about their retirement concerns. Most people understand that pension income and distributions from traditional 401(k) and traditional IRA accounts will be taxed as ordinary income. One thing that surprises me though, is how many people are not aware that a significant portion of their Social Security retirement benefits will most likely be subjected to ordinary income tax as well.

Social Security is not (always) tax-free

If Social Security is your only or primary source of income in retirement, your benefit may not be taxable. However, if you have income from other sources as well (e.g., pension, distributions from a pre-tax IRA or 401(k), part-time work, self-employment, interest, dividends, etc.) that add up to a certain amount, then a portion of your Social Security will also be subject to income tax. Just how much of your Social Security is taxable will be determined by your combined income.

How to calculate whether you hit the income limits

Sometimes referred to as “provisional income,” your combined income figure is calculated as the sum total of adjusted gross income plus nontaxable interest (yes, that’s your municipal bond income) plus ½ of your Social Security income. Your combined income determines how much of your Social Security income is taxable, and the amount subject to income tax could be 0%, 50% or 85% (or even 100% in one special case). (Don’t panic – it’s not a 100% TAX, that’s the percentage of your SS that will be taxable!)

Adjusted gross income (line 37 on Form 1040)
+
Non-taxable interest (line 8b on Form 1040)
+
1/2 of what you received in Social Security (from Form SSA-1099)
_______________________________________________
Income for Social Security taxation purposes

A good rule of thumb is that if your other income is more than $44,000, you’ll be paying taxes on Social Security no matter what. Less than that (or if you’re not married), refer to the chart below.

 

Combined Income Limits for Taxation of Social Security Retirement Benefits

Taxable SS Amount Single, Head of HH, Widowed, Married Filing Separately IF apart entire year Married Filing Jointly
0% Less than $25,000 Less than $32,000
50% Between $25,000 – $34,000 Between $32,000 – $44,000
85% More than $34,000 More than $44,000

Note: If you are married and filing separately but you lived with your spouse even one day out of the year, all of your Social Security retirement benefit will be taxable for that tax year.

 

Roth to the rescue

If you think there isn’t much you can do about your taxes in retirement, you might be surprised to know that you have more control than you think. If you still have a few years to go until retirement, or if you plan to work part-time after you retire, a tax-free Roth IRA can help you keep the tax man at bay.

Here’s why: although the combined income calculation for determining Social Security benefit taxation includes non-taxable interest income (e.g., municipal bond interest), the calculation does not include Roth IRA or Roth 401(k) distributions.

You read that correctly.

Money you take out of a Roth account (assuming it has been in there at least five years) is not subject to income tax, nor does it affect how much of your Social Security is taxable. Accumulating Roth assets during your working years, including converting some traditional IRA/401(k) dollars to Roth accounts, can pay off hugely in retirement by giving you a source of tax-free income that reduces your combined income for Social Security purposes and potentially lessens the tax bite on that benefit.

Remember, you can even convert traditional/pre-tax retirement dollars to Roth IN RETIREMENT, although you’ll have to pay taxes on the amount you convert. However, that’s one way to plan ahead to hopefully avoid taxation of your Social Security in the future. If you want to read about more strategies for reducing your taxes in retirement, my colleague Erik Carter wrote about several strategies in one of his Forbes articles.

Should You Use The Brokerage Window In Your 401(k)?

July 27, 2018

Are you a hands-on investor seeking investments beyond your 401(k) plan’s core list of investment choices? If so, you may have an option available in your retirement plan at work that most retirement savers aren’t aware of – the self-directed brokerage account (SDBA). This “brokerage window” option available in some retirement plans gives participants the ability to invest in mutual funds, exchange-traded funds (ETFs) and in some cases individual stocks and bonds.

Who typically uses a self-directed brokerage account in a 401(k) plan?

According to Aon Hewitt, approximately 40% of employers offer self-directed brokerage account options, but participation rates remain low. Aon Hewitt found that only around 3 to 4 percent of retirement plan participants with access to SDBAs actually use this self-directed option.

The SDBA option has generally been more popular among retirement savers who have larger retirement plan balances or who work with an outside financial advisor. For example, Schwab recently reported that the average account balance of those using this option is just over $260,000. Compare this to Fidelity’s reported average balance of all 401(k) participants, which is just under $100,000.

What does a self-directed brokerage account offer?

The main benefit is that SDBAs give you more flexibility when it comes to the investment options available. Access to a wider range of investment choices than the default ones presented in your plan can be a refreshing alternative if you are generally unhappy with the investment options available in your plan.

For example, if your 401(k) plan does not include access to target date funds or asset allocation funds, you can use the SDBA to add this fund to your retirement portfolio. This can also be appealing if you are simply using the self-directed windows to gain access to asset classes not represented in your core investment lineup such as emerging market stocks, international small cap, and value or growth-oriented funds. SDBAs can even help you diversify with alternative asset classes such as real estate and commodities.

Beware of the paralysis of too many choices

But as behavioral finance studies on the paradox of choice have shown us, too many options can hinder participation rates in 401(k) plans. Choosing the right investments for your goals, risk tolerance, and time horizon also requires discipline. Most investors lack a written game plan or investment policy statement. As a result, many individual investors are prone to the “behavior gap” and underperform the actual funds they own due to mistakes related to emotional decision-making and market timing.  

Self-directed brokerage accounts are designed for advanced investors who know how to research and manage their investments. FINRA warns investors that the additional choices commonly associated with self-directed accounts require additional responsibilities. In order to follow a disciplined investment plan, you can start by focusing on things within your control such as asset allocation, contribution rates, minimizing costs, and asset location (i.e., pre-tax vs. Roth 401(k)).

Pay attention to the fees

Minimizing your overall investment costs is one thing you have some control over as an investor. That’s why it is just as important to understand all fees and expenses associated with a self-directed brokerage account as it is to know your core 401(k) plan expenses.

Some 401(k) plans charge an annual maintenance fee for using the mutual fund or brokerage window. It is also necessary to identify if there are any commissions and transaction costs associated with trades made through SDBA accounts. You can check your plan’s fee disclosure to better understand the actual costs related to your 401(k) plan.

Check mutual fund expenses

In some cases, you may also see an increase in mutual fund expenses when you go outside your core investment options. This is because most funds available in the SDBA are retail share classes which tend to be much more expensive than the institutional funds many large retirement plans provide access. On the other hand, if your 401(k) plan has expensive mutual funds, the self-directed brokerage account is a potential remedy.

How does its performance compare?

Finally, it is important to note that there is a reason self-directed brokerage accounts are underutilized. The average investor is often better served simplifying their investments as much as possible. That is why it is important to establish benchmarks to track your performance.

Self-directed brokerage accounts give you an opportunity to try to outperform or diversify your plan’s core options. But if you choose to take the self-direct route and find that your investment performance consistently lags the core investment portfolio, you may need to take a simpler approach to your retirement savings plan.

 

A version of this post was originally published on Forbes.

What Are Your Health Insurance Options If You Retire Before Medicare?

July 20, 2018

Early retirement is a very common goal, although how exactly do you define “early?” For most people, early means stopping work before the availability of benefits that are used by retirees like Social Security and Medicare. Uncertainty over whether retirement savings can stand up to several years without these programs is often the reason people put off retirement.

If you have dreams of sleeping in or traveling the world before you’re eligible for retiree benefits, all is not lost. As is the case with any goal, you must decide to face it head-on and find ways to make it work within your financial plan. Here are a couple of ways to address meeting your medical care needs if you choose to retire prior to age 65.

Option 1: Obtaining insurance through the federal marketplace

Pros

  • You have the possibility of finding health coverage similar to what you have with your employer – Due to the implementation of the Affordable Care Act, coverage from your employer and coverage through healthcare.gov offer similar coverage benefits, deductibles and premiums.
  • You may be eligible for subsidies depending on your income – The cost of coverage for health insurance through the federal exchange is correlated to how much income you report. In some cases these subsidies  can bring the cost of coverage in line with what you are currently paying through work.

Cons

  • Coverage can be very expensive – Without the subsidies, you are exposed to the full brunt of the cost of healthcare. Depending on where you live and the size of the deductible you choose, costs can approach $1,000 or more per month. While you may want to maintain the deductible you have through your employer, you may need to increase it in order to make premiums affordable.
  • Changes in laws pertaining to the Affordable Care Act can make it difficult to plan – The laws that govern the plans that are available on the exchanges have changed substantially over the past year and there is reason to believe that there are more changes to come. This can make it very difficult to plan the cost for this line item in your budget going forward.

Option 2: Use COBRA coverage

Pros

  • You can maintain your same coverage – The Consolidated Omnibus Reconciliation Act or COBRA is a rule requiring employers to offer you access to coverage after separation of service for a certain amount of time. So rather than searching for a similar plan, you can use the same plan.
  • It may still be at a lower cost than coverage through healthcare.gov – The cost of coverage is essentially what you would normally pay in premium plus what your employer pays. If you work for a large company, the total cost can still end up being cheaper than going it alone in the Exchange because of the cost savings the employer may have negotiated.

Cons

  • Coverage is available for only 18 months in most cases – Because the coverage only lasts 18 months in most cases, COBRA is only a temporary fix for an early retirement. Once the coverage goes away, the exchange may become your primary option.
  • It is still substantially more expensive than what you probably pay today – If your employer covers a large portion of the cost of your insurance benefit, you may experience sticker shock.

Start planning now

As you can tell, both options have some drawbacks but you have no way of knowing how much of a drawback unless you do some research. Here are some things you can do to plan now:

  • Contact HR: If you think COBRA is a likely option, reach out to your benefits department to find out how much it costs today. In the case of insurance on the Federal Exchange price it now. Yes, there is a reasonable likelihood the pricing will change, but it will give you a baseline to plan.
  • Beef up your HSA: If you have an HSA, make sure you’re maxing out your contributions to the account now. You can use the account to pay for COBRA tax-free. HSAs cannot be used to pay health insurance premiums from the exchange, but they can be used to offset out of pocket medical expenses. (and they can also eventually be used to pay for Medicare premiums)
  • Consider investing in vehicles that will not show up as future income: By investing in accounts like Roth 401ks and IRAs, you can lower the amount of taxable income you generate in a year when you withdraw from these accounts. This may help you to qualify for Healthcare Exchange subsidies and will eventually allow you to keep your Medicare premiums down as well.