6 Ways to Make Your Nest Egg Last Forever
Worried that you have enough? Here are vital actions you should take to guarantee you'll never outlive your savings.
By Kiplinger's Personal Finance Magazine
[2009]
The oldest baby boomers are 60, yet many of them still don't know
whether they are saving enough or how to convert those savings into a
lifetime of retirement income. If you're one of those 41 million
boomers who are now 50 to 60 years old, the next five to 15 years will
be critical. That's when you'll need to top off your retirement
savings, focus your investment strategy and figure out how to maximize
your income after your paychecks stop.
For many people, work remains an important part of
their lives -- financially as well as personally -- even after they
retire. Michele Sabatier's pension from the National School Boards
Association, where she worked for 18 years as a graphic designer and
art director, will buy her the freedom to pursue a new career as a
teacher. After resigning from the association earlier this year,
Sabatier plans to trade a two-year commitment with the Mississippi
Teacher Corps for a free master's degree in education at the University
of Mississippi. When the two years are up, she can apply to teach
anywhere she likes. "I had reached an age where I wanted to do
something different with my life," says Sabatier, 51.
Now that her only child has graduated from college,
she's eager to move from northern Virginia to a less expensive area.
She plans to take her pension as a lump sum -- a wise move because she
is divorced and a monthly benefit would be passed on only to a
surviving spouse. "I can't imagine doing absolutely nothing," Sabatier
says about her ambitious plan for the next phase of her life. "I think
it's interesting how our retirement will be so different from that of
our parents' generation."
If you want your retirement to be ideal as well as
different, these strategies will get you off to a good start:
Get a financial checkup
The five years before you leave your job and the
five years after are the most critical transition periods for investing
and financial planning. As your priority shifts from accumulating money
to shepherding it through retirement, you'll probably benefit from some
financial guidance.
A newly approved pension-reform law will make it
easier for employers and 401(k) providers to offer investment advice to
workers. Some providers, such as Principal Financial Group, already
offer one-on-one counseling to workers who are within five years of
retirement age. If you're behind schedule, you might be urged to boost
your contributions or work longer. Mutual-fund companies encourage new
retirees to roll over 401(k) and other retirement savings into an IRA,
in exchange for advice on investing for growth and income and for
guidance on withdrawing money.
Principal Financial calls the five years before and
after you retire the red zone. It's the time when workers 50 and older
can make catch-up contributions to their 401(k)s and other retirement
plans. They'll also confront crucial decisions about retirement
benefits and investments. For example, if you're lucky enough to have a
traditional pension, you may be able to choose between taking a lump
sum or a monthly check. Deciding when to collect Social Security
benefits can also have an effect on your cash flow.
If you've been an aggressive investor, it's probably
time for a portfolio makeover. Severe market downturns during the first
few years of retirement -- or just before it starts -- can mess up the
rest of your life. Although you should not park all your retirement
money in bonds and bank accounts, you can surely do without the
riskiest kinds of investments.
An illustration from Prudential underscores how
vital it is to avoid large losses during the red-zone years: Even if
your retirement investments average a 7% return for 30 years, the
sequence of year-to-year returns will determine how long your money
lasts. Let's say you retire at 62 with a lump sum of $250,000 and
intend to withdraw 5% of the portfolio's value each year. If you lose a
bundle during your first few years of retirement, you could run out of
money by age 79. But if you enjoy double-digit profits early on and
your losses come later, you'll end up with more than twice as much as
you had when you started -- even after taking annual withdrawals and
allowing for some disastrous drops toward the end of the 30 years.
Set your budget
The possibility of running out of money is the main
reason financial advisers such as Christine Fahlund, of T. Rowe Price,
urge you to go slow, limiting your first year's withdrawals to 4% of
your total retirement funds. Then you can raise the draw by 3% a year
to cover inflation. If you start at $500,000, you can safely withdraw
$20,000, or 4%, during the first year. Then you boost the second year's
take to $20,600, the third year's to $21,200, and so on.
While that sounds conservative -- and it is --
there's a reason. The strategy is intended to help you survive should a
bear market strike as you begin your retirement. On the other hand, if
your investments perform well initially, you can reassess the situation
after a few years and pay yourself more.
Unfortunately, few prospective and current retirees
are aware of these guidelines. A recent survey by New York Life found
that only one in 10 people could identify 4% as an appropriate initial
withdrawal rate. Nearly half thought it should be more.
David Colescott is living proof that the 4% rule
works. After retiring at age 65 in 1999, when the stock market was
soaring, the Pinehurst, N.C., man enrolled in T. Rowe Price's
Retirement Income Manager program. That was early in 2000, just before
the three-year bear market began. Even though his portfolio took a hit
during those down years, he's been able to recover and give himself a
raise every year since. He has no concerns about outliving his money.
Colescott, who is a former Marine and international
communications consultant, calculates that even if his investments
don't earn another dime -- which is unlikely because he has 60% in
stock funds and 40% in bond funds -- he'll still be able to withdraw
money at his current rate for another 15 years. Colescott's advice: Be
cautious with your withdrawal strategy but not too timid with your
investments, because you'll need some growth to sustain you through a
retirement that could last for decades.
Do a dry run
As with most things, practice makes perfect. That's
why Ed Fulbright, a CPA and financial adviser in Durham, N.C., advises
near-retirees to test-drive a retirement budget. "If you can live on
your projected retirement cash flow for two to three years without
increasing your debt, then you know that you can make it in
retirement," Fulbright says.
That's also a backdoor strategy to finding something
extra to put away. If you believe you can live comfortably in
retirement on 85% of what you're making -- a fair rule of thumb -- then
save and invest at least 15% of your gross income.
Paul and Madonna Engle of Marietta, Ga., decided to experiment with a
retirement budget before they quit their jobs. "We kept track of our
expenses for two years and figured we needed about $4,000 a month after
taxes," Paul says. The couple, both 57, contributed the maximum amount
to their 401(k) plans plus the additional catch-up contributions. In
2006, you can contribute up to $15,000 to a 401(k) or similar
retirement plan. If you are 50 or older, you can kick in an extra
$5,000.
After living on their practice-retirement budget for
two years, the Engles decided they were ready for the real thing. In
2005, Paul stepped down after 29 years with IBM, and Madonna gave up
her job with a small accounting firm after the 2006 tax season. Paul's
pension and their income from four rental properties will provide all
the income they need -- even before they start claiming Social Security
benefits. At this rate, they may never have to raid their retirement
savings -- except for splurges like an upcoming trip to the Galapagos
Islands.
Choose your date
The government pegs the "normal" Social Security
retirement age at 65 to 67, but yours is really up to you -- and it's a
big decision. Ron and Monica Reimer could begin collecting Social
Security benefits next year when they both turn 62, but their checks
would be reduced by 25% for the rest of their lives. Or they can wait
until their normal retirement age of 66 and get full benefits. Your
best starting date depends on several factors, including: Do you plan
to work beyond 62? Will you need money immediately? Are you concerned
about providing the largest monthly benefit for a surviving spouse?
If your vision of retirement includes work, as it
does for more than three-fourths of baby boomers interviewed in a
recent Merrill Lynch study, then claiming Social Security at 62 is a
mistake. Should you continue working, there's an "earnings cap" penalty
on Social Security benefits paid prior to your normal retirement age.
Earn more than the cap -- $12,480 for 2006 -- and you forfeit $1 in
benefits for every $2 you make over the limit. Once you reach your
normal retirement age, the earnings cap disappears.
For the Reimers, who live in Georgetown, Texas, the
decision is not clear-cut. Since neither spouse is employed, the
earnings cap doesn't matter. With Ron's pension from DuPont and their
stash of other retirement savings, they don't need the Social Security
money. Still, they want to know the best time to start collecting
benefits.
Thomas Dalton, a professor of accounting and
taxation at the University of San Diego, says a single, nonworking
62-year-old would be better off taking Social Security as soon as
possible because doing so reduces the need to tap tax-deferred
retirement funds. "The advantage of leaving retirement funds in a
tax-deferred account earning 8% far outweighs the loss in Social
Security benefits from early retirement," Dalton wrote in the June 2006
issue of The CPA Journal. Even at 5%, the early retiree would still
come out ahead until age 89. Waiting until normal retirement age to
collect benefits would pay off only if a retiree lives past 89.
The situation is different for married couples, says Henry Hebeler,
author of "J.K. Lasser's Your Winning Retirement Plan." Hebeler agrees
that taking reduced Social Security benefits at 62 might be the right
thing to do if you've been forced out of your job and need money or if
you're in poor health and doubt that you'll live to 66 or 67. But
delaying is wisest for most married couples, he says. A surviving
spouse is entitled to 100% of the primary wage earner's benefits. So if
Ron wants to leave the most income possible for Monica, he should wait
until his normal retirement age or later to tap Social Security
benefits. That way, Monica would be entitled to the maximum survivor
benefit -- including annual cost- of-living adjustments -- for life.
Also, because Monica earned a small Social Security
benefit based on her earnings history, she can claim her own retirement
benefits earlier without jeopardizing her future survivor benefits.
Although her retirement checks would be 25% smaller at 62, she would
still be entitled to the full survivor benefit -- worth 100% of Ron's
monthly retirement payments -- as long as she is at least 66 when she
begins to collect it.
Consider an annuity
Concerned that you'll outlive your money? One
solution is to use a portion of your savings -- usually no more than
half your nest egg -- to buy an immediate annuity that will guarantee
you income for the rest of your life. A traditional annuity has several
flaws. You relinquish a large chunk of your assets, and if you die
prematurely, the insurance company keeps the money unless you pay extra
to pass on the benefit to a surviving spouse or continue payments to a
named beneficiary for a set number of years. Plus, inflation eats up
the buying power of your fixed payouts.
The insurance industry is selling new varieties of
immediate annuities that offer you more choices and more control. For
example, New York Life sells an immediate annuity with a "changing
needs" option that lets you raise or lower payouts to accommodate your
situation. If you owe five years of payments on your mortgage, for
example, you can take more income now and reduce the amount after the
debt is paid. Or, if you fear your savings will run dry in 20 years,
you can choose a smaller payout up front and arrange to boost your
income later.
A new deferred annuity from Prudential lets you gamble for growth by
investing in a variety of accounts that resemble mutual funds but
guarantee you a minimum return of at least 5% a year, regardless of
market performance. If the investments outperform the guaranteed
return, you can base your annual withdrawal on the higher balance.
Those added guarantees come at a price, however. For
example, if a 65-year-old married couple invested $100,000 in a
traditional fixed immediate annuity, they would receive payouts of
about $7,000 a year as long as either of them lived.
If the same couple bought a deferred annuity with a minimum-earnings
guarantee, they would receive only about $5,000 a year if they began
payouts immediately. But the longer they waited to use the annuity
balance for income, the more guaranteed principal they'd build up,
resulting in larger monthly checks for life. And once the surrender
period disappeared, they could cancel their deferred-annuity contract
and collect their remaining balance, if there was any left over.
The minimum-earnings guarantee and assured income
for life made sense to Bill and Amanda Cichanski. Bill, 62, is a design
engineer in Tacoma, Wash., who is scaling back his hours as he makes
the transition to retirement. He and Amanda, a legal nurse consultant,
have been planning an exit strategy that will allow them to travel and
pursue outdoor sports, such as hiking and fly-fishing. Bill recently
put $300,000 into one of the new-style Prudential annuities. He plans
to rely on other retirement savings first, letting his annuity balance
grow. "It allows me more control than an immediate annuity, and
whatever's not used can go to Amanda," he says.
Roll it over
When it's time to switch jobs or retire, you have
three options for your retirement savings. If you have at least $5,000,
you can leave it in the account with your former employer. Or,
regardless of the amount, you can roll it into an IRA -- or into your
new employer's plan, if it accepts rollovers. In general, an IRA offers
you more investment options than most employers' 401(k)s, so a rollover
is usually wise. But if your 401(k) includes company stock, don't move
it without evaluating all your options. There are special rules
involving company stock that could result in significant tax savings.
Let's say you have $500,000 worth of company stock
in your 401(k) that you bought on your own or received as your
employer's match, and your total purchasing cost, or basis, is
$100,000. If you roll over the stock into an IRA, you would pay
ordinary income taxes on all withdrawals. So would your beneficiaries,
if you die with money in your account.
Instead, consider taking advantage of special rules
for what's called net unrealized appreciation. When you take a lump-sum
distribution from a 401(k), you can move the stock to a taxable account
and roll the rest of the assets to an IRA. You'll pay ordinary income
taxes on your $100,000 basis, which in the 28% tax bracket is $28,000.
But the remaining $400,000 of appreciated earnings will be taxed only
when sold and will qualify for the 15% long-term capital-gains tax
rate. If you leave the stock to your heirs, they will inherit the
stepped-up basis, which is the value of the stock at the time of your
death. If they sell it immediately, they could end up paying little or
no taxes on many years of growth.
By Mary Beth Franklin, Kiplinger's
Contact our office if you have any questions about your nest egg.
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