In the past, experts routinely said you needed to replace 70% to 80% of your pre-retirement income for your golden years. Plus, the experts said, your retirement income need was assumed to increase annually at the rate of inflation for the duration of your retirement. And experts would routinely use 30 years as the standard duration of retirement.
But David Blanchett, the head of retirement research at Morningstar Investment Management, says those rules of thumb/assumptions are shortcuts that when combined can overestimate the true cost of retirement for many investors. Here’s a look at some of the findings from his white paper.
What’s an appropriate replacement rate?
According to Blanchett, a replacement rate between 70% and 80% may be a reasonable starting place for many households but it doesn’t work so well when you model spending over a couple’s life expectancy rather than a fixed 30-year period.
In fact, the data suggest that many retirees may need 20% less in savings than what conventional wisdom would have you believe. That’s the good news.
The bad news: Blanchett found — as have other researchers — that actual replacement rates are likely to vary considerably by retiree household.
In his research, Blanchett found the replacement rate is sensitive to the proportion of pretax expenses (such as contributions to a 401(k) plan or an IRA) to post-tax expenses (such as contributions to a Roth IRA, college tuition for children, mortgage payments, and work-related expenses) and ranges from 54% to 87%.
So, for instance, a household with income of $150,000 where pretax expenses equal 6% of income (the average amount contributed to a 401(k)) and where post-tax expenses equal 12% would need to replace just 65% of their pre-retirement income to maintain their standard of living in retirement. But a household that saved twice as much (pretax expenses equal 12% of income) would need only replace 55% of their pre-retirement income in retirement.
In other words: “There is no ‘one-size-fits-all’ approach to gauging your replacement rate,” Blanchett said.
So, to figure out how much of your pre-retirement income you’ll need to replace in retirement you’ll need to look at all your expenses, and figure out which will decline or disappear when you’re retired, and which might, such as health care, rise. Consider, for instance, that you likely no longer have to pay Social Security and Medicare taxes or save for retirement or have work-related expenses. What’s more, your household may also have a higher standard deduction and receive income (Social Security, for example) that is taxed more favorably than wages, according to Blanchett.
Do retirement income needs rise with inflation?
Another issue to consider is the composition of your expenses in retirement and the rate of inflation associated with those expenses.
According to Blanchett’s paper, expenses for retirees — as measured by the consumer-price index for the elderly (CPI-E) — have increased at a rate greater than general inflation over the past three decades.
For instance, from December 1982 to December 2012 the average annual change in the CPI-E has been has been 3.07% vs. 2.92% for CPI-U, or general inflation. Therefore, Blanchett wrote, the costs of goods for retirees have increased by about 5% more, per year, relative to general inflation.
“If this relationship persists and general inflation (CPI-U) is expected to be 3.0% per year, then retiree inflation would be 3.15% per year,” Blanchett wrote. “This difference would become increasingly important over longer retirement periods, which is likely a concern for retirees given increasing mortality levels.”
Another factor to consider when looking at your expenses in retirement:
The relative amount spent on insurance and pensions decreases significantly at older ages.
The relative amount spent on health care increases significantly at older ages.
Health-care costs increase Plus, it inflates inflate at a rate greater than general inflation. For instance, medical care costs have increased on average 5.42% per year from 1948 to 2012, vs. 3.63% for general inflation. In other words, medical costs have been increasing about 50% more than general inflation, according to Blanchett’s paper.
To be fair, Blanchett noted health-care costs are likely to affect retirees differently. In general, the median percentage of total expenditures spent on medical expenses increases from about 5% of total expenses at age 60 to 15% by age 80. But for low-income households it increases from about 25% at age 60 to about 35% by age 80.
Consumption changes over time
According to Blanchett, research on retirement spending commonly assumes consumption increases annually by inflation (implying a real change of 0%), but he did not witness that relationship in his research.
Instead, he found that retirees tend to spend in a smile pattern; expenses decrease in real terms for retirees throughout retirement and then increase toward the end.
As might be expected, different retiree households have different spending patterns. In general, Blanchett found that low spend/low net worth households and high spend/high net worth households are consuming optimally — their consumption is roughly consistent with their resources.
But high net worth/low spend and low net worth/high spend household are consuming their resources in a suboptimal way. The former group tends to have real increases in spending through retirement, while the latter group tends to see significant decreases.
And the big take-away as it relates to your household trying to get a handle on how much pre-retirement income to replace in retirement is this: Most households will spend less later in retirement but all will likely spend in some sort of a curve that looks like a smile. So factor that rather than straight line spending into your income-replacement equations.
And when in doubt about your spending in retirement consider this: “Households might be better off spending a bit extra when they can enjoy it,” he said.
Another important point: While the idea of a 30-year retirement period is a great way to simplify how long retirement is going to last, the actual period is going to vary by household, Blanchett said. So consider your household’s life expectancy when calculating your income-replacement need.
One last bit of advice
Blanchett also said his research suggests that many households would benefit from claiming Social Security as late as possible. By delaying, you’ll get a higher inflation-adjusted benefit for life.
And this decade is one in which the thought of retirement and other financial issues becomes a little more “real.”
Whether you are about to turn 30, or whether you are heading into your mid-30s, now is a good time to review the following 30 financial rules for your 30s:
1. Create Spending Priorities
By now, you should have a good idea of what you value in life, and what kind of lifestyle you want to lead. This means that it’s time to stop spending on stuff that isn’t important to you. Do you know how much crap I bought in my 20′s that was a complete waste of money? Too much.
Sit down, think about what you want to accomplish with your money, and then create a list of spending priorities that works for you. Then, spend according to those priorities. Your spending will be more in line with your values, and you’ll be happier as a result.
If you have a spouse, this involves them, too. My wife and I are constantly talking about what are the important things we want to spend our money on. In our 30′s the constant topics revolved around upgrades to our home, travel, investing into our businesses, and our kids – three growing boys really add up!
2. Look for Good Value
You work hard for your money. Make sure you are getting the best value. This doesn’t mean you get the cheapest thing — and you don’t need to get the cheapest thing, now that you can afford items of good quality.
My wife is the queen at this. She always finds way to save a quick book.
Make purchases based on true value (financial and emotional), rather than solely on bottom line.
3. Value Your Time
I’m sure you’ve heard the expression “Time is Money“.
Your time is probably more valuable than just about anything else. Value your time. You don’t need to constantly trade your time for money. Look for ways to maximize your time, and to earn more efficiently.
And, if you can afford it, don’t be afraid to pay others to take care of mundane tasks that you don’t want to waste your time on.
4. Evaluate Your Financial Progress Thus Far
How far have you come? Acknowledge your progress. It will provide you with the motivation you need to keep going. Honestly evaluate your missteps and figure out how to fix them.
The good news is that, when you’re in your 30s, you’re old enough to recognize what you should be doing, but still young enough to recover from some of the financial stupidity that may have afflicted you earlier.
5. Buy a House the Right Way
If you waited to buy a house until your 30s, make sure you do it right. Don’t get in over your head. Make a good-sized down payment. A modest home that you can afford will allow you to avoid being house poor and leave your resources available for other things.
We bought our first home when I was 29 and deployed to Iraq. We were able to buy direct from the owner since he was a family friend. This saved us thousands of dollars because of the sale price and avoiding realtor commissions.
If you’re still renting and you’re not sure if you should buy a home, use this calculator to run the numbers.
6. Invest in Reliable Transportation (Beware of New Cars)
Make sure that you have a reliable way to get to where you need to go. If you need to get to work, you need a car that can reliability get you there — or at least live in an area with reliable public transit.
Does that you mean that you need to buy a brand new car? Absolutely not!!
See the video below in response to a reader that tried to convince me that they needed to buy their child a brand new car because they needed something reliable.
For the more adventurous, consider living close enough that you can walk or bike to work.
7. Protect Your Financial Assets
Do you have property insurance? If not, now is the time to get it. By the time you reach your 30s, you have likely accumulated more valuable things. From a nice car to a bigger house, you probably have more to lose in the event of a catastrophe. Even if you rent, you should get renter’s insurance.
Think about the things you have. What would it cost to replace them? Insurance can help you cover that cost without breaking the bank.
8. Buy Health Insurance
Now that you’re getting older, you need to think about health insurance. Even if you live a healthy lifestyle, there are reasons to have health insurance. If you have kids, you definitely need health insurance. If you can afford a high deductible plan, it can make sense (if you have relatively few health care needs and costs) to purchase one.
You can then put money into a Health Savings Account, earning you a tax deduction and allowing the money to grow tax-free as long as you use it for qualified expenses.
9. Provide for Your Family with Life Insurance
If people rely on you for their livelihood, you need life insurance. There are many rules of thumb out there, but the important thing is that your family is provided for until your youngest is an adult.
Figure out how much you need to ensure that your family is taken care of if something happens to you, and purchase a term life insurance policy that fits your needs.
Over 55% of the US population have not drafted a will. At the very least you need a will to make clear the disposition of your assets. And, if you have children, your will provides for their guardianship.
Create a will. Right now.
11. Be Mindful of Your Beneficiaries
If you are accumulating wealth at a rate faster than you anticipated, it’s probably a good time to start estate planning. Structuring your assets so that your heirs benefit is a great way to ensure that you have continuity. Estate planning tactics like power of attorney and health care proxy can ensure that your wishes are carried out if you are alive but incapacitated.
A common estate planning mistake I see is not updating beneficiaries on retirement plans and life insurance policies. I heard a horror story where a husband never changed his new bride to the beneficiary of his life insurance policy at work.
An unfortunate auto accident took his life and his bride was left with nothing. The parents didn’t give their new daughter-in-law anything (for reasons beyond me).
A routine check of the beneficiaries could have prevented this.
12. Prepare for the Unexpected with Supplemental Insurance
In addition to other types of insurance, make sure that you consider the possible need for supplemental insurance. If you are concerned that you will become disabled and unable to make a living, short-term or long-term, you need disability insurance.
Since I’m the primary bread winner we took out a long-term disability policy on myself. If I was no longer to work, we would receive over $4,000 a month.
I’m also looking into dental insurance with an orthodontics rider since my sons will doubtless need braces (mommy and daddy also had braces).
Take stock of your needs and consider supplemental policies.
13. Plan for the Costs of Children
If you have a young family, or if you are planning a family, now is the time for you to get ready for the costs that can come with kids. As your children grow, they get more expensive. We have 3 young boys are they are already eating us out of house and home.
The scary part. It only gets worse!
From providing the essentials for survival to paying for extracurricular activities, set aside a little bit regularly so that you are prepared for the costs associated with raising kids.
14. Start Saving for College
The earlier you start saving for your child’s college education, the better. If you haven’t opened a 529 or some other account that you can use to save for your child, do it now.
You don’t have to completely cover your child’s college costs, but you can help. We intend to help our sons pay for their living expenses and book costs, but we have no intention of paying 100% of their tuition. We would rather encourage them to apply for scholarships, join the military (more me than my wife), or work while they are in school.
Whatever you do, don’t put your retirement at risk, but get started now.
15. Use Credit Cards Wisely
Credit cards can be your friends. If you use them wisely, racking up rewards points on planned purchases and paying off the balance each month, you can derive great benefits from credit cards.
We currently have 4 credit cards (1 personal, and 3 business) that we use and pay off each month. In fact, my wife obsessively sends in payments 2-3 times per month because she doesn’t want to carry a balance even in the smallest amount.
Cash back, free travel, and other perks can help you get ahead financially just by spending on things you normally buy.
16. Pay Down High Interest Debt
Now is a good time to turbo-charge your debt pay down efforts. If you’re making more, and you’ve prioritized so that the unimportant spending is cut from your budget, you should have some extra cash to put toward reducing high interest debt. Getting rid of this debt can free your resources for other things that will help you earn interest, rather than result in you paying interest.
17. Reconsider Pre-Paying Low Interest Debt
I’ll probably get some flack for this one, but maybe now isn’t the time to pre-pay your mortgage or your student loans. It you have a mortgage with a low interest rate, ask yourself if your money could be put to better use in other investments.
The stock market continues to soar, and I’ve made made double digit returns with both Lending Club and Prosper this year which makes you wonder “does it really make sense paying off low interest debt?”.
I don’t think there’s a right or wrong answer. We’ve financed our home twice to a 15 year mortgage which means our house will be paid off before our kids graduate high school – sweet! We still have enough money to save for retirement but we’re not making any extra payments on our mortgage.
If you’re thinking of aggressively paying your home off early, with your mortgage, consider the rate, as well as the tax deduction.
18. Create a Retirement Plan
Many people in their 30s have yet to perform a retirement calculation. Now is the time for you to perform that calculation. Use one of the many online calculators to figure out what you need in retirement, and what you need to do now to meet your goals later.
If you’re making more as a 33-year-old than you were as a 26-year-old, why haven’t you updated your retirement savings contribution?
I run into people all the time that think putting away 5% of your income is enough. Or sometimes they tell me they put in enough to get the 401k match. Ummm….good for you, but you’re not even close.
You’ll want to work to save at least 20% of your income.
Don’t stress and think you have to start there. Boost your retirement savings contribution periodically. Every pay increase should be accompanied by a savings increase.
20. Open a Roth IRA
Don’t rely solely on your company’s retirement plan. If you qualify, open a Roth IRA and make contributions. With a rising federal deficit, and with income tax rates that are relatively low (when you consider history), chances are that higher taxes are coming. A Roth IRA can shelter some of your income from taxes while giving your retirement a boost.
Find the best options to open a Roth IRA. We breakdown all your online options HERE.
21. Increase Your Emergency Fund
Take a look at your emergency fund. Is it big enough to cover your current lifestyle? Chances are that you have more expenses and obligations now than you did in your 20s. The emergency fund you had for that decade just isn’t going to cut it for your 30s.
When my wife and I were married, we had about $500 in our savings account. <gulp>
That wouldn’t even come close to cutting it now. We currently keep around 12 months of emergency funds on hand. We’ve had more than that when we were building our home, but we’ve never went below that.
Increase your rainy day fund because I promise you that one day you’re going to encounter a financial thunderstorm.
Is your portfolio appropriately diversified? Now that you have a little more money to use, it’s a good time to change things up a bit and diversify.
I’ve done this with my investments by getting into stocks, mutual funds, and peer to peer lending
Diversification is important across many fronts.
23. Build More Human Capital
Rather than stagnate in your 30s, continue to develop new skills. Build your human capital so that you can justify promotions and raises. Keep learning and keep your skills sharp. That way you’ll always be valuable to someone, even if you lose your job.
24. Diversify Your Income
Now that you’re in your 30s and things have settled down a bit, it’s a good time to consider income diversity. Don’t rely on your day job for your entire financial well being. That’s just asking for trouble.
I’ve been able to diversify my income by starting this blog and other online ventures to compliment my revenue from my financial planning practice.
Try to cultivate income diversity with side gigs, investments, and other endeavors. That way, your entire family’s financial future isn’t at risk if you’re fired from your job.
25. Look Into Umbrella Insurance
If your assets are growing, you might need umbrella insurance. This extra liability insurance can protect your assets if you are the target of a major lawsuit.
What’s the cost? For $1 million in coverage, the cost should be around $150-$200 (mine was $180) a year. For each additional $1 million in coverage, you should expect to pay an additional $100.
Now that you have the means, start giving to others. Charity is an important part of well-rounded finances. Give what you can to help others. You can even volunteer your time, which is also a valuable commodity.
My wife and I tithe 10% of our income to our church as well as donate to other charities. I will admit that this wasn’t something we did straight out of the gate. It took years to get to the point of feeling financially comfortable to do both.
Look for ways to give back, since you likely receive help early on in your life.
27. Get Financial Planning Help if You Need It
As your finances become more complex, there is a good chance that you will need help working through the ins and outs. Whether you need help with tax planning (I love my accountant), plotting a retirement course, or figuring out what insurance policy is best for you, consider working with a financial planner that has no conflicts of interest.
Sometimes it’s all about having flexibility. Can you move your money around to take care of an emergency? If you had to pick up and move, could you do so and then work out the details later? If you lost your job do you have the flexibility to find something else, or the creativity to get by with your emergency fund?
Develop a flexible approach so you can move with the changes.
29. Live a Little
Remember that your money can be a means to an end. You can live a little, too. Don’t just assume that you have to amass a huge fortune. And don’t wait until you’re too old to enjoy your money.
I’ve have clients that have literally worked their entire lives and now in their 60′s are beat down. I’ve told my wife that while I want to work hard, I want to make sure that we take plenty of time for ourselves. All work and no play is not what living life is all about.
Spend a little on some great experiences and family memories.
30. Never Stop Dreaming
Just because your 30 doesn’t mean that you can’t try new things. Want to travel overseas? Do it.
Want to learn how to play guitar? What’s stopping you.
Always wanted to be your own boss? Who says you can’t?
As kids, we dream about doing awesome things. Don’t let those dreams die. As the message of the video below declares, “Don’t stop dreaming!”
What do you think of these rules? What financial rules do you think should be adopted by those in their 30s?
Black Friday already? Where did the year go? The good news: No matter whether you’re retired or on retirement’s doorstep, there’s plenty you can do before the end of 2013 to avoid giving Uncle Sam more than his fair share of your hard-earned income.
Here’s a laundry list of what experts suggest:
Do a dry run
Lest you do something that you might regret later on, consider taking stock of where you are and where you want to be with your tax return. “The last couple of months of the year is an excellent time to do a dry run on your tax return,” said Andrea Blackwelder, president of Wisdom Wealth Strategies. “By November or December, we have a fairly accurate idea of our income and deductions. However, the timing also provides ample time to take advantage of tax-saving strategies, such as last-minute 401(k) contributions, tax harvesting and charitable contributions.”
For newly minted retirees, Blackwelder said, this tax analysis can be incredibly important. “New retirees often fail to fully understand how to manage taxes in retirement,” she said. “If withholding instructions on Social Security, pensions and IRA withdrawals aren’t accurate or sufficient, investors may pay penalties and interest at tax time.”
By doing a dry run and getting sense of what you might owe Uncle Sam, Blackwelder said retirees can clean up any underpaid taxes by using a critical tax strategy provided by IRAs. For instance, IRA account owners may make a distribution and withhold the entire amount for taxes, she said. “The IRS does not consider the payment late, but rather considers it as taxes paid throughout the year,” said Blackwelder.
Review your income strategy
Retirees should evaluate their income strategy each year, taking account all of the changes that may have occurred throughout the year, said Blackwelder. Changes to consider may include important milestones such as turning 59½ (the age at which you can withdraw your retirement money without having to pay Uncle Sam a 10% penalty for early distributions) or 70½ (the age at which you must start withdrawing money from your IRAs and retirement plans — except Roth IRAs), performance of your portfolio, capital gains, tax bracket and tax law changes, and even gifting strategies.
Donate IRA distribution to charity
Speaking of gifting strategies, retirees over age 70½ with charitable gifts to make before the end of the year should remember that they can donate up to $100,000 directly from their IRA to a charity during 2013, said Michael S. Jackson, a partner with Grant Thornton, who also noted that this “law expires this year, again.”
The benefit: “The distribution is not included in income, which raises adjusted gross income (AGI) and potentially limits other deductions or raises (your) overall tax bracket,” said Jackson. Plus, the amount sent to charity will also count toward you required minimum distribution (RMD) for the year.
Other advisers also recommend donating your RMD to a charity. “Since so much of the current tax calculation is based on AGI, the fact that these distributions don’t count toward one’s AGI makes them potentially much more valuable than the charitable deduction even when using appreciated property, said David Mendels, the director of planning at Creative Financial Concepts.
“It is especially valuable for those generous souls whose charitable contributions are already up against the AGI limits” he said. “Since it is not included in AGI it effectively, gives rise to a charitable deduction where there otherwise would not have been one while still meeting the minimum distribution requirements. In both cases it sidesteps the AGI/MAGI problems.”
You might also consider, especially with the stock market trading at all-time highs, gifting highly appreciated securities to a charitable gift trust, said Catherine Gearig, a financial adviser with LifePlan Financial Advisory Group.
For example, let’s say that you have a taxable account at brokerage firm as well as a donor-advised fund or charitable gift trust. You could “shave off the gains” in those investments that have had “significant growth and send them to the charitable gift account,” said Gearig. “Depending upon how much is gifted, this could serve the same purpose as rebalancing the account. Plus, you can deduct the amount gifted on your tax return.”
FYI: Gifting to individuals is on a calendar-year basis and must be done before the end of the year, said Blackwelder.
Speaking of RMDs
And since we’re on the topic of RMDs, don’t forget to take your RMD. This is especially important for those who turned 70½ in the early part of the year. “A RMD may be required to be taken from qualified retirement plans before the end of the year,” she said. And just in case you need some extra motivation: The penalty for not taking the RMD is substantial—50%.
For the record, RMDs begin in the year you turn 70½. Not age 70 and not age 71 but age 70 ½. So who is age 70 ½ in 2013? If you were born from July 1, 1942 up through June 30, 1943 you will be 70 ½ this year. Read more from Ed Slott’s website, Required Minimum Distributions and Age 70½.
Contribute to an HSA
You might have a planning opportunity if you have a high-deductible health insurance plan that allows contributions to a Health Savings Account, or HSA. “HSAs can do double duty as retirement accounts and they have the tax benefits associated with both traditional IRAs and Roth IRAs,” said Jorie Pitt, an associate financial planner at AHC Advisors. “We often recommend that our clients consider making full contributions to their HSAs each year but avoid using the money to pay for health-care needs. Instead, we encourage them to invest the money inside their HSA for retirement.”
By doing so, you get a tax deduction for your contribution and you get tax-deferred or tax-free growth on the contribution and the investment earnings depending on the future use of the money, said Pitt. “If you use the HSA assets to pay for qualified health-care costs now or in the future the contribution and the earnings are withdrawn tax free,” she said. “If, after the age of 65, you use the HSA assets for non-health care costs then the contribution and the earnings were tax-deferred and the money will be taxed upon withdrawal from the HSA.”
By way of background, HSAs were created in 2003 so that individuals covered by high-deductible health plans could receive tax-preferred treatment of money saved for medical expenses, according to the Treasury Department. Generally, an adult who is covered by a high-deductible health plan (and has no other first-dollar coverage) may establish an HSA, according to the Treasury Department.
For 2013, the HSA contribution limit (for employer and employee) is $3,250 for individuals and $6,450 for families. The HSA catch-up contributions (for those age 55 or older) is $1,000. Learn more about the 2013 HSA contribution limits here. And learn more about HSAs at the Treasury Department’s Resource Center website.
Of course, if you decide to contribute to an HSA, make sure that you have money set aside in non-retirement accounts that you can access in case of emergencies. Otherwise, said Pitt, you might find yourself dipping into your HSA or other retirement accounts and possibly face paying a penalty.
Do you have medical deductions?
Speaking of health-related expenses: Beginning in 2013, Jackson said the AGI threshold for those individuals under age 65 rises to 10% of AGI. But for those 65 and older, the 7.5% of AGI threshold remains in place until 2017.
Don’t forget the Medicare deadline
And since we’re talking all things health care, do remember that the Medicare deadline is Dec. 7. Blackwelder those age 65 and older must sign up or face future penalties and higher costs. Changes to existing plans must also be made before the deadline, she said.
You should contact Medicare.gov about three months before your 65th birthday to sign up for Medicare. You can sign up for Medicare even if you do not plan to retire at age 65.
Contribute to your employer-sponsored retirement plan
If income and savings allow for it, Blackwelder suggests diverting a large percentage or all of December’s paycheck toward your company-sponsored retirement plan. “Workers who receive large bonuses in December, or expect the bonus in January, can benefit by contributing as much as possible to their retirement plan before the end of the year,” she said. “The benefit, of course, is that more is saved for retirement and less is immediately taxed.”
Unless you’re already contributing the maximum allowed, don’t forget to increase for 2014 how much you contribute to your company-sponsored retirement plan. Investors using automatic contributions to IRAs and Roth IRAs should also increase the contribution, said Blackwelder. “Often, around the holidays and the New Year, we make resolutions to manage our finances better and save more in the coming year,” she said. “Take advantage of the positive motivation and make the changes. Chances are, you’ll stick with it if the changes are already made.”
Catch up if you can
If you turned 50 in 2013 or if you’re turning the big five-O in 2014, consider the catch-up contribution limits for IRAs and qualified retirement plans. IRAs offer an additional $1,000 contribution catch-up while 401(k)s, 457s, 403bs and other retirement plans allow for $5,500 in catch-up contributions. “Adjust monthly and payroll deductions to get on track for maxing out,” said Blackwelder.
Contribute to a Roth IRA
If your income allows it, Gearig recommends that you contribute the maximum to a Roth IRA. That would be $5,500, or $6,500 for those 50 and older.
If you’re married filing jointly and your modified AGI (MAGI) is less than $178,000 you can contribute up to the limit. Your contribution maximum is reduced if your MAGI is equal to or more than $178,000 but less than $188,000. And you can’t contribute to a Roth IRA if your MAGI $188,000 or more.
If you make too much money and you don’t have a traditional IRA, consider making a nondeductible IRA contribution, then converting it to a Roth, says Gearig. “It’s a way to get around the income restraints,” she said. “Since the tax basis equals the amount contributed, the conversion should be tax free. If you already have a traditional IRA, it won’t work.”
Roth IRA conversions can be very advantageous for the right taxpayers, notably those who have retired but not yet begun collecting Social Security and/or sizable pensions, according to Pitt. “These taxpayers may have several years of very low taxable income ahead of them,” she said. “In this case, we recommend that (you) consider doing Roth IRA conversions to remove money from (your) tax-deferred IRAs at low tax rates.”
For example, she said a person in the 10% or 15% tax bracket who anticipates being in a higher tax bracket when they begin claiming Social Security may want to consider doing a Roth conversion to the extent that it fills up their current tax bracket. “This can be especially advantageous for taxpayers who still have high deductions,” she said. “In this case, you may even be able to convert to a Roth at no tax liability while you use up room created by your deductions.”
Mendels is also fond of Roth IRA conversions. “The Roth IRA conversion is a perennial favorite of mine,” he said. “While many speak of it as a shelter against tax increases, which it certainly is, it is also a powerful tool even if rates stay the same.”
According to Mendels, many experts point to the tax cost as leading to an immediate decline in one’s “net worth” that can only be made up over time by the resulting tax savings.
That is, of course, true. You have two sides to your personal balance sheet, said Mendels. The Roth IRA conversion reduces the “asset side” because you use this money to pay the taxes due on the Roth IRA conversion but it also reduces the “deferred tax due” on the liability side of your balance sheet. This, said Mendels, “leaves your net worth unaffected and the future tax savings as pure profit.”
Said Mendels: “Only a rather steep decline in tax rates would make it a mistake and, while one can never predict what Congress will do, I don’t know too many people predicting an overall tax cut any time soon.”
And don’t procrastinate when it comes to doing a Roth IRA conversion: It must be done before the end of each calendar year. “However, if you find that the Roth IRA conversion pushed you too far into the next tax bracket you have the option to re-characterize all or a portion of the conversion by the tax filing deadline, including extensions,” Pitt said.
Remember too that once you have done a Roth IRA conversion these funds and earnings on them cannot be accessed for five years from the conversion date without paying a penalty.
According to the IRS, you can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used. Most of the rules for rollovers (Read Rollover From One IRA Into Another) apply to these rollovers.
Speaking of filling up tax brackets, Douglas Gross, a financial adviser with Raymond James Financial, said year’s end is the time to make sure retirees are using up whatever bracket they are now in, especially if pre-RMD and so income is low.
What he does with clients is this: “We figure out their taxable income. Let’s say it is $50,000 and they are married filing jointly. We will then do a Roth conversion of $20,000 to use up the 15% bracket. This is assuming, of course, that once they turn 70½ we know they will always be in the next bracket.”
He too recommends that year-end is the time charitable giving. In his case, he suggests contributing to donor advised fund and offsetting it with a Roth IRA conversion. “It’s tax neutral but it accomplishes two goals: more money in the Roth and more to charity,” said Gross.
Is your mortgage interest deduction worth it?
Determine what the tax benefit is on your mortgage interest compared with what you are earning on your cash, said Jackson. “If retirees are sitting on cash earning 0% interest, it may be prudent to pay down or pay off existing mortgages as long as they have sufficient cash remaining for lifestyle needs,” he said.
Gifts to family members
According to Jackson, you can gift up to $14,000 per year in cash, investments, and/or property without triggering mandatory filing of IRS Gift Tax Form 706 and possible payment of gift taxes to anyone. And married couples can give up to $28,000 to any one person each year.
According to the IRS, the general rule is that any gift is a taxable gift. However, there are many exceptions to this rule, says the IRS. Generally, the following gifts are not taxable gifts: gifts that are not more than the annual exclusion for the calendar year; tuition or medical expenses you pay for someone (the educational and medical exclusions); gifts to your spouse; and gifts to a political organization for its use. Read the IRS’s Gift Tax.
The key benefit in gifting, by the way, is this: Adults can minimize their estate taxes, according to an AXA Equitable primer on the subject.
Also of note. The exclusion amount does not roll from year to year. “It is a use or lose provision,” said Jackson.
Beware the Medicare surtax
Although retirement plan distributions are not subject to the new net investment income tax, Jackson says retirees should know that, since the threshold for this tax is based on a combination of net investment income and AGI, retirement plan distribution can push retirees over those AGI thresholds and subject net investment income to tax.
According to the IRS, the net investment income (NII) tax, which went into effect this year, applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.
Individuals will owe the tax if they have NII and have modified adjusted gross income over the following thresholds:
According to Jackson, gains on the sale of primary residences used as such for two of the past five years can be sheltered ($250,000 for singles, $500,000 for married filing joint). “This leaves more money in the seller’s pocket to put down on the next home,” said Jackson.
Don’t move out of state without crunching the numbers
And last but not least, if you have designs on moving to another state, Jackson suggests that you consider the income tax implications on Social Security benefits, retirement plan distributions, as well as estate and inheritance tax rules. Read The most tax-friendly states for retirees.
If it’s not realistic to expect a traditional retirement — one in which we have enough financial resources to be able to afford to no longer work and instead do whatever we like — what can we do instead? Welcome back to my series on this critical issue that we face, both as individuals and as a society.
As summarized in my last posts, Americans have some significant challenges to overcome if we want to be able to afford and enjoy our retirement years. As a result, I’m focusing on a new vision for my retirement years — one in which I’m happy, healthy, and financially secure but that doesn’t necessarily involve “not working.”
I’ll take inspiration from research that shows that older people are happier than younger people, or when they were younger. For an inspiring video clip on this topic, see this presentation at the TED talks by Dr. Laura Carstensen, Founding Director of the Stanford Center on Longevity. As a result, I’ll focus on finding meaning, purpose, and happiness in life.
I plan to work or volunteer as long as I’m productive and physically able so I can help make a positive difference in the world. I expect that to be an age well past my mid-sixties (the traditional retirement age), and that’s realistic for most people who haven’t developed a serious disability or worked in physically demanding jobs. There are many ways to stay productive and engaged, including part-time work, self-employment, temporary gigs, seasonal work, working at home, and so on. Continuing to work may require making a shift in my attitude: I’m fine with accepting work that pays less or may not have as much authority or prestige as in my career years.
I plan to stay engaged with family, friends, and community; research from the MacArthur Foundation shows that if I do, it will help my physical and mental health. Plus, I’ll have a network of trusted people who can provide physical and emotional support if I need it. So I’ll be careful to nurture my network, including my business contacts.
I’ll buy just enough stuff to meet my needs and be happy instead of wasting my paycheck on things I don’t really need. I’ll constantly look for ways to pool resources and share expenses with family and friends, and I’ll use public transportation whenever possible. This will enable me to save more money for the time when I’m no longer able to work. And at that time, I’ll need less retirement income to cover my living expenses.
I’ll postpone drawing on my financial resources to let them grow as much as possible. This means delaying the start of my Social Security income until age 70 and not tapping into my retirement savings until I fully retire — most likely sometime in my 70s or beyond.
I’ll continue to be serious about taking care of my health by exercising and eating the right amounts and kinds of food. This will help reduce the odds of needing expensive and debilitating medical care in the future. Despite taking these steps, however, I know it’s inevitable that at some point in my life, I’ll need medical care. So I’ll make sure to buy the right kind of medical insurance to cover those needs.
I’ll adopt a new analogy for my health and longevity — my mind and body is like a favorite vintage car. Regular maintenance will make it last longer, but eventually, that treasure will start breaking down, and it won’t be as fast or efficient as the new models. So I’ll need some new parts and occasional overhauls to keep it running. And at some point, I’ll be driving it less — I’ll still take it out for a spin to run basic errands and for fun, but I can’t drive it into the ground if I want it to last.
Most likely our friends and family are in the same boat. In the event of an illness or crisis, we will be the ones to provide emotional, logistical, and even financial support for each other. I’ll participate in the giving part of this relationship, knowing that at some time, I might need to be on the receiving end. And we should all investigate ways to share resources before our backs are against a wall. For example, the “Golden Girls” example of sharing housing during retirement is a great way to reduce living expenses and address loneliness, an important risk to our health and enjoyment of life in our later years. Can we support each other in our quest to stay healthy, maybe by forming walking clubs or sharing tips on nutrition? I’ll bet you can find many ways to help each other.
I’ll plan for the last laps. We all have an eventual conclusion to our life’s adventure; at that time, we might be incapacitated and could need special care to carry out basic living activities. I’ll take responsibility by putting in place contingency plans and financial resources now to mitigate the inevitable burden this might place on my family later.
When you think about it, the traditional retirement may not be the best way to complete our lives. Will we still even call this period of our lives “retirement”? There are many alternative descriptions that are colorful and insightful, such as Life 2.0, rewirement, renewment, reinvention, the third age (or fourth age, depending on how you’re counting), rest-of-life, encore career — you get the picture.
No matter what we call it, let’s face it with courage, creativity, and resilience. Stay tuned for my forthcoming series of posts that provide a week-by-week program for planning to make the best of your retirement years.
The Treasury considers a 401(k)-style plan for people who don’t have one at work
Many experts bemoan the fact that half of working Americans—call it 75 million—don’t have an employer-sponsored retirement plan. And those workers, many of whom are not saving for retirement using an IRA or other type of retirement savings account, are at risk of not being able to sustain their pre-retirement standard of living.
For these workers, lawmakers, policy experts and others have long suggested that automatic IRAs would help solve that problem. But proposed laws to create 401(k)-like accounts for workers who don’t have access to employer-provided qualified pension plans have largely died on the vine. For instance, Rep. Richard Neal, D-Mass., introduced yet another Automatic IRA Act in May of this year, but experts give it little chance of becoming law any time soon. The proposed law would require employers to automatically enroll employees in an IRA unless the employee opts out.
Enter R-Bonds, which so happens to be the default investment in Neal’s automatic IRA proposal. Yes, the Treasury Department, which first began working on the program in 2009, will roll out in January retirement or R-Bonds to encourage savings by Americans not enrolled in a company-sponsored pension, according to a recent Financial Advisor magazine report.
Speaking at the Women’s Institute for a Secure Retirement annual symposium in Washington, D.C. last month, Mark Iwry, a deputy assistant secretary for retirement and health policy at the Treasury Department, said the R-Bonds “would have the tax characteristics of an IRA and be eligible to be rolled over into an IRA once the savings reach a now-unspecified threshold,” according to a recent report in Financial Advisor magazine.
A proposal under consideration at the Treasury Department could create a special kind of savings bond for people who don’t have retirement plans at work.
According to the magazine, Iwry said that “the R-Bonds would be aimed at workers at companies that don’t sponsor retirement programs of any kind, part-time employees not eligible for plans their companies sponsor, and the self-employed or not employed.” With the R-Bonds, an employee could have an automatic payroll deduction to make contributions and the bonds would not be designed to compete with company savings plans. And the best part of all: Iwry said the R-Bond program would not require congressional authorization to begin. Read also Administration explores ‘R bond’ as option for retirement accounts (registration required).
Of course, this plan is by no means a done deal. “Treasury continues to study options to encourage Americans to increase their retirement savings,” a Treasury official says. “No decisions have been made about new policies or programs.”
Still, it’s worth asking: What do experts have to say about R-Bonds? And should you consider using them if and when the Treasury Department rolls them out?
A promising idea
In the main, experts are fond of R-Bonds. “I think this is a pretty good idea,” said Anna Rappaport, the president of a Chicago-based retirement consulting practice.
The R-Bond program is for “new savers with the hope that low income [workers] in particular and those without any way to save at the workplace will take advantage it,” said M. Cindy Hounsell, the president of the Women’s Institute for a Secure Retirement, a nonprofit organization based in Washington, D.C.
And Judy Miller, the executive director of American Society of Pension Professionals and Actuaries (ASPPA), a national organization for career retirement-plan professionals based in Washington, D.C., said the following: “I don’t see this expanding the number of people who have retirement savings, but I do see it as a step toward something like the automatic IRA proposal.”
According to Hounsell, the new R-Bonds–like other government-issued savings bonds–wouldn’t pay very much interest, but they would, at least, be guaranteed by Uncle Sam. Details, however, including whether they will be called “R” or retirement bonds, are still in flux. For one, some at the Treasury Department, including Iwry, want the R-Bonds to be used for long-term savings as they would be in an automatic IRA, while some want a workplace starter savings account but not a retirement account.
In its current construct, Hounsell and others said the R-Bonds might work a bit like the Treasury Department’s I-Bond program, a program Iwry gets credit for launching during the Clinton administration.
I-Bonds are a low-risk, liquid, inflation-adjusted savings product. The bonds have an annual interest rate, currently 1.38%, that reflects the combined effects of a fixed rate and a semiannual inflation rate. At present, you may purchase I-Bonds via TreasuryDirect or with your federal tax refund. Click here to visit the I-Bond website.
Another possible advantage with the R-Bond program: “With R-Bonds there would be less chance of ‘lost participants,’ since presumably the Treasury knows where you are at least once a year when you file a tax return,” said Rappaport.
Creating R-Bonds would also address one of the steps that must be taken for automatic IRAs to become a reality, said Miller. “Having this would [mean] that the default investment is in place,” she said.
R-Bond program faces hurdles
But what might be good for savers who don’t have access to an employer-sponsored retirement might not be so good for providers of IRAs in the financial-services industry. Hounsell, for one, thinks the financial-services community might push back against the idea.
According to Hounsell, savers who invest in R-Bonds would probably have their accounts rolled into a traditional IRA at a traditional financial-service firms once it has $10,000 in it. And small accounts of that size are not so profitable to financial firms. “They have not wanted the smaller accounts,” Hounsell said.
Others agreed. “Financial-service companies probably are not enthusiastic about very small accounts, and the expenses might be a problem,” said Rappaport.
Another expert, meanwhile, raises the possibility that R-Bonds might not be a wise investment for those saving for retirement. “My reaction, not knowing the details, is that they would encourage too much of a conservative and narrow ‘portfolio’ versus, say, just an IRA in ETFs or whatever,” said Steve Cooperstein, an independent actuary and the owner of Steve Cooperstein & Affiliates, based in Pacific Grove, Calif.
There are other questions to be answered about R-Bonds, too.
For instance, Rappaport wants to know what incentive there is for workers to be in the program. “The idea would be much more likely to be successful if linked to some other incentive and I do not know if there is anything on the horizon with regard to this,” she said.
Another question, Rappaport said, is what the rate of return would be on R-Bonds, and what, if any, expense charge they would carry.
Noel Abkemeier, a principal and consulting actuary with Milliman, an independent actuarial and consulting firm based in Seattle, had a laundry list of questions and suggestions. Among them:
What would R-Bonds provide that couldn’t already be done with an IRA? If this is taxed the same way as a traditional IRA, does it limit deductibility of the contribution inversely to income, and with the same limits? Or is it possible to have a Roth IRA version of the bonds?
What is the advantage of qualifying for rollover? That seems to fit somewhere between no-advantage and no-big-deal.
Where are the bonds held? Are they in an electronic notional account at the Treasury Department? Are they in your desk drawer at home? Are they at a brokerage account? If at the Treasury Department, there is the ultimate in portability, although that would not mean much.
If the bonds could be purchased with the filing of your tax return, it might add a little convenience to the transaction.
Are the R-Bonds inflation adjusted? Probably not, but that could be a potential advantage, if offered.
Will contributions be limited so it doesn’t benefit the wealthy disproportionately, as usually happens? This is an issue of both tax brackets and quantity of purchases.
What maturity will these have? Will yields vary depending upon maturity chosen?
Are there any reinvestment guarantees?
Will the bonds mature for a lump-sum payout? Or will they have a coupon payout for a fixed income at some point?
It would be better if they offered “lifetime income bonds,” which effectively would be deferred income annuities. They could have a cash-refund design so the purchasers would be trading lost interest for a lifetime income guarantee, while there was no fear of losing principal. This would send a strong message on priorities by merging the accumulation and decumulation challenges of retirement planning.
What will be the yield on the bonds? Will these have low Treasury yields, which is not the best investment for a complete retirement portfolio? Or will it be higher, which means that taxpayers will be funding government debt at a higher rate than is justified? How would the yield compare with a corporate bond no-load mutual fund?
All good questions, for which good answers might come sometime soon. Or not. After all, we are talking Washington, D.C. here.