When it comes to saving for retirement, maybe you've done everything right. You started early, maxed out the 401(k) plan, invested in a diversified portfolio, and avoided costly mistakes, such as cashing out your retirement plan. While that is excellent news, now comes the hard part: making sure you don't outlive your money.
That's a tall order for today's retirees. Taxes, unpredictable investment returns, rising health care costs, and inflation can significantly erode the value of your nest egg as time goes by. Additionally, the biggest challenge is making what you have gained through savings and investments last for a long time. A 65-year-old man has a life expectancy of 19.3 years and it's 21.6 years for a 65-year-old woman. If you're married, there's a 45% chance that one of you will live to age 90 and a nearly 20% chance that you or your spouse will live to age 95.
Fortunately, there are steps you can take to generate extra income and extend the life of your retirement portfolio.
- Put your money in buckets
Experiencing a bear market just as you enter retirement couldn't come at a worst time if you're forced to sell securities after prices have plunged. It is not surprising that many investors today are concerned about how long the bull market can keep running. That's where the "bucket system" can help. You divide your money among different kinds of investments based on when you'll need it. The system splits assets among three buckets: "Now", "Soon", and "Later."
The Now bucket holds what you'll need in the short term. Jason Smith, author of The Bucket Plan: Protecting and Growing Your Assets for a Worry-Free Retirement, recommends setting enough aside so that, when added to Social Security or a pension, it will cover your basic expenses for up to a year. It should also have enough for major expenses that are likely to crop up over the next couple of years, such as needing to pay for a new roof or going for that once-in-a-lifetime trip around the world, while leaving some cash for unexpected emergencies or unforeseen expenses.
Money in the Soon bucket will be your source of income for the next 10 years. As the Now bucket is depleted, you withdraw money from the Soon bucket to replenish it.
The assets in the Later bucket aren't meant to be used for more than a decade into your retirement, so they may be invested more aggressively in stock funds, which will provide greater growth potential. This bucket can also include life insurance or a deferred-income annuity, which pays income later in life. Consider selling securities in the Later bucket to replenish the Soon bucket starting about five years before it runs out of money. If the market is in a downward spiral, you can wait, knowing you still have a few years before the Soon bucket will become empty.
Tip: Money you'll need in the near term should be parked in a savings account.
- Manage spending
To avoid running out of money during retirement, the standard rule has been to withdraw 4% from your nest egg in the first year of retirement and use the inflation rate as a guide to adjust withdrawals in subsequent years. For example, if you have $1 million, you can withdraw $40,000 in year one. If the inflation rate clocks in at 2% in year two, your withdrawal grows by 2% to $40,800.
The 4% rule is based on historical market returns for a portfolio that is evenly split between stocks and bonds. However, as the saying goes, past performance is no guarantee of future returns. Additionally, the rule assumes you will live 30 years in retirement, so you might want to adjust the withdrawal rate up or down based on your life expectancy.
Nevertheless, you should do just fine if you use the rule as a starting point for withdrawals.
Tip: Like any rule of thumb, the 4% rule won't work for everyone or in every situation. You might need to reduce the withdrawal rate if you retire early, have a major expense, or if a market downdraft impacts your retirement assets. Moreover, you might increase it if the investments have appreciated more than expected, or you've spent less than anticipated and have built up a sizable balance.
- Protect against inflation
The inflation rate has averaged 2.2% since 2000. While that seems tame, don't underestimate the power of even modest inflation, which can significantly erode purchasing power over time.
One way to make sure your nest egg keeps up with the cost of living is to continue investing in stocks. That can make for a bumpy ride over the short term, but over the long-haul stocks' steady upward trend makes them a go-to hedge against inflation. As measured by the Standard & Poor's 500 Index, stocks have returned an average annual rate of 10% for nine decades. Over the next decade, investors are more likely to see an average annual rate of 8% or even less—but even if inflation reverts to its long-term historical norm of a little over 3%, that return still provides a healthy cushion during retirement.
Treasury inflation-protected securities (TIPS) are bonds that hedge against rising consumer prices. Your principal will be adjusted for inflation with these bonds. In addition, you're guaranteed a fixed rate of interest every six months; as the principal rises, the amount of interest earned will increase as well.
Ease the tax burden by holding securities in the right accounts. Income from bonds and bond funds are taxed at ordinary income tax rates and are best held in a tax-deferred account, such as an individual retirement account (IRA). Stocks get favorable tax treatment in a taxable account; most dividends from stocks and stock funds, as well as long-term capital gains, are taxed at only a 15% or 20% tax rate. Nonetheless, make sure you keep some stocks in tax-deferred accounts to fight the effects of inflation over the long term.
- Get income from investments
If you need to boost your retirement income to supplement Social Security benefits and other sources of guaranteed income—or to generate cash while waiting for delayed benefits to supercharge your Social Security—dividend-paying stocks in a taxable portfolio should be on your list. They can make up one-fourth to nearly one-half of your stock portfolio.
Several blue-chip stocks have yields of 2.5% to 4%. Look for companies with a record of regularly increasing dividends over time, which can serve as a hedge against inflation. However, beware of chasing the highest yields; outliers that boast yields of 7% or 8% may not generate enough profits to sustain those dividends.
Tip: As alternatives to individual stocks, consider exchange-traded funds and mutual funds that focus on investing in companies that pay dividends. Also, consider bonds as another key source of income.
- Delay Social Security benefits
You might not think of Social Security as an inflation fighter, but for many people, it will be their only stream of income with an automatic cost-of-living adjustment (COLA). While the COLA was only 0.3% in 2017, it was more than 2% in 2018. (When inflation was soaring in 1981, the COLA hit a record high of 14.3%.)
More than 45% of people take Social Security retirement benefits as early as possible, at age 62. If you claim Social Security at this age your benefit will be reduced by as much as 30% compared with delaying until full retirement age (currently age 66 but gradually rising to age 67). In addition, if you're patient and have other sources of income, you get a generous bonus for waiting until age 70 to claim benefits: For every year you wait to take Social Security beyond full retirement age until age 70, your benefit increases by 8%. Even better, future COLAs will be based on that bigger benefit.
Tip: Spouses should coordinate their claiming strategies to maximize the survivor benefit. A married couple is likely to maximize lifetime income from Social Security if the higher earner delays taking Social Security until age 70. Thus, no matter who dies first, the survivor gets the largest possible benefit.
- Minimize taxes
To get the most out of retirement savings, you need to identify tax strategies to protect your assets. There are plenty of legal ways to lower your tax bill, but they require careful planning and a thorough understanding of how different retirement accounts are taxed.
Let's start with your taxable brokerage accounts—money you haven't invested in an IRA or other tax-deferred account. Because you've already paid taxes on that money, you'll be taxed only on interest and dividends as they're earned and capital gains when you sell an asset.
Secondly, your tax-deferred accounts, such as your IRAs and 401(k) plans. Withdrawals from these accounts are taxed at ordinary income rates, ranging from 10% to 39.6%. The accounts grow tax-deferred until you take withdrawals, but you can't wait forever. Once you turn 70½, you'll have to take annual required minimum distributions (RMDs), based on the year-end balance of all your tax-deferred accounts, divided by a life-expectancy factor provided by the IRS that's based on your age. The only exception to this rule applies if you are still working at 70½ and have a 401(k) plan with your current employer; in that case, you don't have to take RMDs from that account. You'll still have to take withdrawals from your other 401(k) plans and traditional IRAs, unless your employer allows you to roll them into your 401(k).
Finally, there are Roth IRAs. The rules for these are refreshingly straightforward: All withdrawals are tax-free, if you've owned the account for at least five years (you can withdraw contributions tax-free at any time). There are no required distributions, so if you don't need the money, you can leave it in the account to grow for your heirs. This flexibility makes the Roth IRA an invaluable apparatus in your retirement toolkit. If you need money for a major expense, you can take a large withdrawal without triggering a tax bill. And if you don't need the money, the account will continue to grow, unencumbered by taxes.
Conventional wisdom holds that you should tap your taxable accounts first, particularly if your income is low enough to qualify for tax-free capital gains. Next, take withdrawals from your tax-deferred accounts, followed by your tax-free Roth IRA accounts so you can take advantage of tax-deferred and tax-free growth.
There are some exceptions to this hierarchy. If you have a large amount of money in traditional IRAs and 401(k) plans, you should work with a financial planner or tax professional to ensure that the amount you withdraw won't propel you into a higher tax bracket or trigger other taxes tied to your adjusted gross income, such as taxes on your Social Security benefits.
Moreover, another strategy to reduce taxes on your IRAs and 401(k) plans is to convert some of that money to a Roth IRA. One downside is that the conversion will be taxed as ordinary income and could bump you into a higher tax bracket. To avoid bracket creep, roll a portion of your IRA into a Roth every year, looking at how the transaction will affect your taxable income.
Tip: If the stock market takes a dive, you may be able to reduce the cost of converting to a Roth IRA.
- Tap permanent life insurance
Most of us buy life insurance to provide financial security for our loved ones after we're gone. However, a permanent life insurance policy could provide a valuable source of income while you're still around to enjoy it.
A permanent life insurance policy has two components: the death benefit, which is the amount that will be paid to your beneficiaries when you die, and the cash value, a tax-advantaged savings account that's funded by a portion of your premiums. After insurance costs and expenses are deducted, insurance companies usually promise a minimal level of interest with whole life and universal life insurance policies. This interest will be credited to your account every year. With variable life insurance policies, you choose the investments and may not get a guarantee.
You can withdraw your basis—the amount in the cash-value account you've paid in premiums—tax-free. That could provide a cash cushion if, for example, the stock market takes a 2008-style downturn, and you want to give your portfolio a chance to recover. (Withdrawals that exceed what's in the cash-value account will be taxed in your top tax bracket.) In addition, the death benefit will be reduced by the total amount you withdraw.
Tip: If your insurance policy pays dividends, you can generate income without giving up the death benefit. Instead of reinvesting the dividends in the policy, which will increase its death benefit and cash value, you can take the dividends in cash. Dividends typically range from 5% to 6.7%, and any dividends you receive up to the policy's cost basis are tax-free. Dividends that exceed that amount are taxable.
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