| Retirement |
1. Introduction
For years, The Motley Fool has been telling its readers that if they were young and had a lifetime of investing ahead of them to go ahead and put retirement savings into the stock market.
But, hey, wait a second -- not everybody tuning in to the Fool comes from a generation that ranks sky-surfing ahead of grandchildren-spoiling as a favorite pastime. What about all the other Fools out there who have to actually live off of their savings and investments? Should they just be tossing every dollar into the market? Is the long-term upward direction of the stock market reason enough to never invest in bonds? Never keep any money in a money market fund? Are annuities really always bad?
We've heard our more mature Fools asking these questions for a while now, so we've sicked retirement specialist David Braze (TMF Pixy) on the problem -- and he's come up with the Foolish answers as to how you may want to start, maintain, and live off a Foolish retirement portfolio. Like most areas of personal finance, the waters have long been muddied by Wise proclamations about asset allocation and risk exposure -- so we think you'll find some surprises as we finally address....How to Foolishly Stay Retired.
2. Selecting a Company Pension Payment Plan
Retirement. A time to get out on the golf course more often, travel, spend additional time with your family, pamper your grandchildren, generally reflect upon how hard you've worked (and how kids these days don't know how easy they've got it), and, if one were to believe certain television commercials, take up rollerblading and skydiving to prove that you're "getting more out of life."
Your ability to fully indulge yourself in whichever of these activities actually appeals to you (if any) will depend to a great extent on how well you arrange the finances that you'll have for your retirement, and for many Fools, that starts with looking at your company pension -- or in more highfalutin language, a "defined benefit plan."
A defined benefit plan provides a specific and guaranteed retirement income, typically based on the number of years of employment, an average of the final few years of salary (as the final years will in most cases be the highest annual salaries of an employee's career), and a percentage multiplier. (For details, see the discussion in our Foolish Retirement Plan Primer.) This benefit is normally paid out as a monthly pension for life with an additional percentage payable to a surviving spouse following the death of the pensioner.
Below are some typical annuity options from which a pensioner may choose. An annuity is nothing more than a payment made over time, and that time may be for life or for a specified period of years. Also, bear in mind that only one option may be elected, and once it's chosen, that election can't be altered, changed, folded, spindled, or mutilated for any reason. Finally, some definitions may be in order:
a. "Joint and 50%" means you will collect a payment for life. On your death, your spouse will receive half of that amount for the remainder of his/her life.
b. "Joint and 66 2/3%" means you will collect a payment for life. On your death, your spouse will receive two-thirds of that amount for the remainder of his/her life.
c. "Joint and 100%" means you will collect a payment for life. On your death, your spouse will receive the same amount for the remainder of his/her life.
d. "10-Year Certain & Life" means you will collect a payment for life. If you die within 10 years of retirement, your designated beneficiary will collect the same amount until reaching the 10th anniversary of your retirement. At that time, all payments cease. If you die after you have been retired for 10 years or more, all payments cease on the day of your death.
e. "Life Only" means that you will collect a payment for your life. At your death, all payments cease.
f. "Lump sum" means you take the present cash value of the future stream of payments of the basic annuity benefit prescribed by the plan (usually a Joint & 50% annuity). On payment of the lump sum, all benefits have been disbursed by the plan to you, and no further benefits are due.
The dollar amounts in the chart below are just hypothetical, given to demonstrate the different percentages available for each choice.
These choices may look enormously different to you -- but as far as your company is concerned, they'll all end up costing about the same. That is, the company has had actuaries look at thousands upon millions of life expectancy tables, tally up how many people at the company are likely to be smokers, teetotalers, hang-gliders, or couch potatoes, and figure out about how long its employees and their spouses are likely to live.
No matter which option is chosen, the company figures its expected cost should average out to be exactly the same. Of course, you're an individual and not a composite average of thousands of individuals. (Hopefully. You can tell if you're a composite by counting your children. If you have 2.7 of them, you're a composite. Call Ripley's Believe it or Not, or write us a Fribble about the experience.) For individuals, the options can provide very different payouts over the course of a lifetime.
You may choose any of the three joint annuities without having your spouse sign off on the choice. But if you elect the 10-year certain annuity, the life-only annuity, or the lump-sum payment, then you must obtain your spouse's permission to do so. Ain't that a kick in the pants? You do the work, but your spouse says how you'll take the reward. By law, your spouse must sign a statement acknowledging that he or she would not be entitled to any further benefit at the time of your death, and have that signature notarized.
Without that notarized statement, the plan may only pay one of the three joint annuity benefits. (So, if you're trying to slip one by your spouse by whispering sweet nothings in his ear and having him sign the lump-sum payment option while he's distracted, just realize you'll have to pull the same trick with a notary as well.) Notice that in the three joint annuities, as the benefit to the surviving spouse increases, the benefit payable during your life decreases.
With any of the annuities, your annual income is known, and that income will continue for your lifetime and possibly your spouse's as well. With a lump-sum payment, your annual income will depend on how you invest that sum and on how much you withdraw each year. It may or may not last for the rest of your and your spouse's lives, but invested Foolishly it can provide inflation protection for your income.
One drawback to the annuity payments is that they may not be transferred to an Individual Retirement Account (IRA), and must be declared as income and taxed as such in the year received. In most plans, the annuity and the surviving spouse benefit will not increase during retirement. They will be the same 20 years from now as they are today. If inflation averages 4% per year in that period, that means the annuities will then be worth about 45.6% of what they are today in terms of purchasing power. (Now you see why it's good that Federal Reserve Chairman Greenspan is always on the lookout for inflation.) By taking an annuity you gain the security of guaranteed income, but because of inflation you also gain the guarantee of a gradual reduction in your purchasing power.
While it does not provide the same security of guaranteed income every year, a lump-sum payment does provide a few advantages and additional options that annuities do not. You may take the money from a lump-sum payment and deposit it in your bank. You may transfer it to an IRA. (A traditional IRA, that is. You may not transfer a lump-sum payment to a Roth IRA.) Or you may take part and transfer the rest to an IRA. Any money you do not transfer to an IRA is taxed as ordinary income as you receive it. Any money transferred to an IRA will not be taxed until withdrawn from that IRA.
The Most Foolish Choice?
Arguably, a lump-sum payment is the most Foolish of the payout options available. A Fool who is comfortable with handling her own investments can take the lump sum and likely do better on her own than with an annuity. Taking the numbers above, it would only require seeing about a 7.6% annual return on the $210,082.79 to get a better annual payout than the annuity options available. Investing in an equal mix of bonds and stocks will, over most 15- or 20-year time periods, provide returns that would beat 7%.
If you do take the lump-sum payment, in most cases it's usually best on the pocketbook to keep only what's currently needed for income and transfer the remaining monies directly to an IRA. That lessens the current year's tax bite. But we don't want to oversimplify here. You must look at your entire financial situation to evaluate the tax impact of keeping the money and paying taxes today versus deferring those taxes to future years through withdrawals from an IRA. (This is a topic that requires discussion with your tax advisor, who is in the best position to analyze the alternatives. That analysis may cost you a few hundred dollars, but it could also save you far more in income and/or estate taxes as well. Consider the fees paid to the tax advisor money well spent because he may very well save you from a costly error.)
Company pension plan distribution options may confuse you at first. But if you take the time to learn what your plan allows and ask questions of your plan administrator or post questions on our Retirement Investing message board, you should soon have all the information you need to make a fully informed decision.
That's it for the company pension plan. Onward we go to the 401(k), or Defined Contribution Plan. Isn't this fun?
3. Defined Contribution Plans
There's a pretty good chance that if you've been gainfully employed for any period of time and are close to retirement age, you have something called a "defined contribution plan." Defined contribution plans travel under many confusing aliases, including money purchase plans, profit sharing plans, and employee stock ownership plans. Adding to the confusion, one or more of these types of plans are often combined. For most Fools, though, a defined contribution plan is most likely to be simply known as a 401(k).
For the purposes of what follows, and to keep things simple, let's assume that you're retiring (Woo-hoo!), have a 401(k) plan that you've been contributing to (Woo-hoo! Woo-hoo!), and that your employer hasn't explained much about the methods of taking your money with you when you leave (yikes!). This, actually, is a pretty common scenario for the average Fool.
Upon retirement, your defined contribution plan will typically permit you to take a lump-sum payment. In many plans, after you have reached normal retirement age (as defined by the plan), a lump-sum payment will be the only choice you have. You just have to take the whole chunk of cash with you when you leave.
Many other plans, though, will allow you to take annual installments paid typically over a period of not less than 2 nor more than 15 years. A few plans will even allow you to convert your plan proceeds to an annuity payable over your life or the joint lives of you and your spouse. (See Selecting a Company Pension Payment Plan for more details.)
While having a choice between a lump sum, annual installments, or annuity payouts is nice, be aware that it is a one-time irrevocable decision with significant tax consequences. It behooves you, therefore, to devote a little more time to understanding your options than the amount of time you spend planning your blowout party on your final day at the office. Actually, if you spend time figuring out your choices, you may save enough money over the long term to justify making your good-bye extravaganza that much bigger.
The Lump-Sum Payment
If your defined contribution plan allows you to choose a lump-sum payment, you have these choices:
-- You may take all the money immediately -- and pay ordinary income taxes immediately.
-- You may transfer the money directly to an Individual Retirement Account (IRA) to continue the tax deferral until you begin withdrawals. (Warning! The note that follows may confuse you if you don't read it twice: Any after-tax employee contributions you made to a 401(k) or other defined contribution plan are not taxable and may not be transferred to an IRA. Such monies will normally be provided to you in a separate check, which you may cash and use as desired.)
-- You may take part of the benefit immediiately (paying income taxes on that part) and transfer the rest to an IRA.
Usually, the best choice for a lump-sum distribution is to simply transfer your money to an Individual Retirement Account. For more information on how to do so, click onto our article Getting the Loot to an IRA.
By transferring your 401(k) money to an IRA, the tax-deferred status of that sum continues and your current tax burden is kept to a minimum. However, we'll now repeat these Foolish words of wisdom from our article on Selecting a Company Pension Payment Plan in case you're one of the few people out there who hasn't read it yet:
"You must look at your entire financial situation to evaluate the tax impact of keeping the money and paying taxes today versus deferring those taxes to future years through withdrawals from an IRA. This is a topic that requires discussion with your tax advisor, who is in the best position to analyze the alternatives based on your tax situation. That analysis may cost you a few hundred dollars, but it could also save you far more in income and/or estate taxes. Consider the fees paid to the tax advisor money well spent because they may very well save you from a costly error."
We Fools are, for the most part, do-it-yourselfers. However, for a choice as important as how to take the rest of your life's income, we're pretty sure that this 1,000-word article isn't going to provide all the answers. We think you'd be well-advised to sit down with a tax advisor who can go over your individual financial situation. While we'd love to be able to give short, quippy answers to all of life's financial questions right here, we realize our limits in this regard. Please swing by our Retirement Investing message board with any questions you have, though, so that you can make a meeting with a tax advisor shorter and smoother.
Annuities
If you have and use the option to take your defined contribution money in the form of an annuity, all payments will be taxed as ordinary income when received. Those payments are ineligible for transfer to an IRA.
The Installment Payment
A final option is the installment payment, which works differently from the annuity or the lump sum. With this option, you will receive the market value of a certain number of shares (sometimes called units) you hold in your investment accounts each year.
For example, let's say you opt to take five installments from your 401(k) plan. On the day you retire, you will receive a check for the market value of one-fifth of the shares you hold on that day. You now have four installments remaining to be paid.
One year later, you will receive a check for the market value of one-fourth of the shares remaining in your plan accounts. The size of the checks you receive is solely contingent on the share value of your investment accounts on the day the payments are made. You may or may not be able to change your investment accounts during the installment payment period. That's up to the plan.
Income tax treatment of these payments will depend on the period of time over which you choose to receive installments. If the payments will last 10 years or more, then each one will be taxed at ordinary income rates in the year received. However, installments paid over a period of less than 10 years may be transferred to an IRA to continue the tax deferral. For more information on getting your money to an IRA, read the Getting the Loot to an IRA article.
And there you have the scoop on defined contribution plans. Now it's time for Taking Stock.
4. Taking Stock
When company stock is received as part of a lump-sum distribution from a defined contribution plan, your plan's provisions may allow you to handle that distribution in one of four ways:
a. Transfer the shares to an Individual Retirement Account (IRA).
Form of Annuity
Your Monthly Benefit
Surviving Spouse Monthly Benefit
Joint and 50%
$1,225
$613
Joint and 66 2/3 %
$1,177
$784
Joint and 100%
$1,066
$1,066
10 Year Certain & Life
$1,176
Life Only
$1,296
Lump Sum
$210,283
b. Sell the shares and transfer the cash from that sale to an IRA.
c. Keep the stock and pay ordinary income taxes on the cost basis of the shares. Gains on a subsequent saleare eligible for capital gains treatment.
d. Keep the stock and pay ordinary income taxes on the market value of the shares at the time of distribution.
(Note: In all cases, fractional shares will be redeemed by the plan for cash.)
Transferring Shares to an IRA
Transferring shares to an IRA is advantageous in that the distribution avoids immediate taxation, and the tax deferral continues until the funds are ultimately withdrawn from your IRA. When the distribution from the IRA consists of actual shares of stock instead of cash, the shares will be valued at market as of the day of withdrawal, and that amount must be declared as income for tax purposes. The market value of those shares then becomes the new basis, and the holding period for calculating capital gains on a future sale of those shares begins on the day after the day of distribution from the IRA.
Selling the Shares and Transferring the Cash to an IRA
On withdrawal from the IRA, the sum taken will be taxed at the ordinary income tax rates in effect in the year of distribution.
Keeping the Stock and Paying Ordinary Income Tax on the Cost Basis of the Shares
You will pay ordinary income taxes on the cost basis of the shares taken in the year of distribution. Additionally, those younger than age 55 at the time of separation must pay an early withdrawal penalty of 10% on the cost basis as well. Your plan administrator will tell you what the cost basis is. Your holding period in those shares begins on the day after the day the plan trustee delivers the shares to the transfer agent on your behalf. Any unrealized appreciation (i.e., the difference between market value on the day of distribution and your cost basis) is not recognized until a later sale; however, any gain attributable to the excluded appreciation as of the distribution date from the plan will be treated as a long-term capital gain regardless of your holding period. Any gain exceeding that as of the day of distribution will be considered a long- or short-term capital gain based on your holding period after the shares were distributed.
Keeping the Stock and Paying Ordinary Income Taxes on the Market Value of the Shares at the Time of Distribution
In the fourth choice, you will pay ordinary income taxes on the market value of the shares as of the day of distribution from the plan. Your holding period in those shares begins on the day after the day the plan trustee delivers the shares to the transfer agent on your behalf. Any gain on a subsequent sale will be considered a long- or short-term capital gain based on your holding period after the shares were distributed.
Making a Decision
Which is the best choice for you? Ah, now, there's the rub. Like so many things connected with taking distributions from a retirement plan... it depends. The factors involved include your desire to retain the stock (Do you have some emotional attachment to it? Do you just want to be rid of any association with that employer?), your income tax situation, and your estate-planning desires.
Let's consider a hypothetical person who we'll call Vespasian. Vespasian is in the 28% federal income tax bracket and expects to stay there in retirement. Vespasian likes his company, believes its prospects are good, and wants to retain the shares he owns. At the same time, he wants to minimize any taxation issues for his heirs after he dies. Vespasian has 1,000 shares of company stock in his plan with a cost basis of $10 per share. The stock's market value at Vespasian's retirement is $50 per share. He expects those shares to increase in value at a rate of 9% per year. He is considering a transfer of these shares to either an IRA or a non-IRA account.
If Vespasian puts the shares in his IRA, he has no immediate tax impact to worry about. But he could still sell the stock immediately, withdraw the $50,000 in sales proceeds from his IRA, and pay federal income taxes of $14,000, thus netting a total of $36,000. (Note: He could also get the same result by using the fourth option. Any subsequent gains at the time of a future sale would then be eligible for capital gains treatment.)
Most likely, though, Vespasian will let the shares sit in his IRA. At a 9% expected growth rate, his shares would be worth $76,931 in five years. If he cashed in those shares at that time or if he died, then he or his heirs (ignoring the spouse's ability to take over his IRA) would face a federal income tax bill of $21,541. That means he or his heirs would net $55,390 after paying the federal income tax due on the sale.
For comparison, if Vespasian takes the shares today, he would pay $2,800 in ordinary federal income taxes on his $10,000 cost basis. He could then immediately sell those shares for $50,000 and pay long-term capital gains taxes of $8,000 to net $39,200 (after we also consider his original tax bill). That's some $3,200 more than the IRA would produce following the same procedure. But, again, it's more likely Vespasian would wait before cashing in those shares. In five years, the shares would sell for $76,931 just as they would in the IRA. His gain, though, would be taxed at a capital gains rate of 20%, which means his tax bill would be $13,386, and he would net $60,745 after we also deducted the original tax bill he paid on those shares at retirement.
If we consider the lost "opportunity cost" as 9% on that original tax payment of $2,800, then we should deduct another $1,508 in foregone earnings on that $2,800 as well. That would make Vespasian's actual net $59,237, a sum that's still $3,847 greater than that produced by the IRA option. And if Vespasian died five years from now, prior to selling those shares? His heirs would take the stock with a basis equal to its market value at the time of Vespasian's death less the unrealized appreciation in the shares when Vespasian received them ($40,000). Their basis would be $36,931 ($76,931 less $40,000).
If they sold everything immediately, they would owe Uncle Sammy a long-term capital gains tax on the unrealized appreciation of $40,000, for a maximum long-term capital gains tax of $8,000. They would owe nothing on the gain from the date of Vespasian's retirement to the date of his death. Vespasian's heirs would thus net $68,931, some $13,500 more than they would have if the shares were in Vespasian's IRA. If they continue to hold those shares, all gains above their basis will be taxed at long-term capital gains rates in the year of sale regardless of how long they hold them.
In Vespasian's case, taking the stock and paying federal income taxes on the cost basis seems the Foolish way to go. By doing so he lessens the potential tax burden for both himself and his heirs. Faced with a similar distribution choice at retirement, that approach may be appropriate for you, too. You'll have to run the numbers to be sure, but at least you're aware of the option.
OK, now you have a general idea of how to take retirement plan and stock distributions. What's next? Getting the Loot to an IRA, that's what.
5. Getting the Loot to IRA
If you've read our articles on receiving money from defined benefit plans, defined contribution plans, or profit sharing plans, then you're probably giving a bit of thought as to how to move that money into an Individual Retirement Account (IRA). This article will hopefully help you avoid the mistakes that can occur if you do not exercise a little care when making this transfer.
First, your company's plan may have restrictions as to when money may be distributed. As an example, many defined contribution plans restrict withdrawals to certain times of the year or month. To learn about any applicable plan restrictions, go bother the Human Resources folks in your office. They should be able to tell you what to expect, and if they can't, try to figure out from them just what else it is that they get paid to do.
Second, to get this money to an IRA with no possibility of a tax problem, you should arrange for a direct transfer of all distributions to that vehicle. This is known as a custodian-to-custodian transfer. Both your defined contribution plan custodians and future IRA custodians will know how to do this and can guide you through the process. You definitely do not want to receive a check made out in your name for the plan's proceeds.
This then qualifies as one of the very, very few times in life when the proper response to receiving a couple-hundred-thousand-dollar check in your name is not "Woo-hoo!" It's understandable that a lot of people make mistakes with this step. But you need to know that plans must, by law, withhold 20% for possible income taxes on any amount distributed whenever they cut a check payable to you, even if you cross your heart and promise to deposit the money right away in your IRA.
If you get a check from your plan payable to you, then in order to complete a 100% rollover of the retirement money, you must come up with the missing 20% from other resources, probably by removing money from your bank account. You would then add that 20% to the 80% you got from the plan, and deposit those proceeds into the IRA within 60 days. If you fail to add those extra funds, then at the end of your tax year the Internal Revenue Service will call the missing 20% a distribution -- even though you never intended to receive any distribution. Yikes! What's more, you will pay a 10% penalty if you're younger than 59 1/2.
You would then have to declare the withheld 20% as income for the year despite the fact that Uncle Sammy has been holding it all year for you. In effect, you've really made an advance payment on your income tax bill. While it probably will be refunded (at least in part) based on your overall tax situation for the year, you really don't want the government playing with your money for half a year or so. Arranging for a direct transfer solves that potential problem: Nothing is withheld by your employer for taxes, and 100% gets into your IRA lickety-split.
As a side issue to the direct transfer, be aware that some plans will insist on mailing you a check for plan proceeds instead of sending one to your selected IRA provider. If your plan is one that does -- please, please don't panic. I know we've just described receiving a check made out to you as an Excedrin-level headache, but take a few deep breaths, and remain focused -- for all is not lost. Just make sure the check isn't made out to you. You don't want a check that shows the payee as "Bea Fool." Instead, make sure that it is issued to show the payee as "ABC Brokerage Services, F.B.O. Bea Fool" or some other way that's acceptable to your IRA provider. Ask your IRA provider how the check should be issued to be sure, and then provide that information to your plan benefit administrators.
The key point is you do not want the check made out in a way that would allow you to cash it. If the check is written in any way such that you could immediately take it to the local "Chex 'R Us Check Cashing and Nose Piercing" outlet and get your loot, the IRS will send a couple of guys in suits to your house and tell you that you have had "constructive receipt" of the money. This would put you right back into the 20% withholding problem discussed previously. As long as the selected IRA provider is the clear payee, the check may be physically handed or mailed to you with no problems as a result. All you have to do is send it on to your IRA folks. Not having it mailed directly might be a little annoying, but it's a lot less annoying than having to cut a check to the IRS later in the year.
Think About Keeping Your Rollover IRA Separate From Other IRA Accounts
One last item: If there is even a remote possibility that at some point in the future you may wish to transfer this money to a new employer's qualified retirement plan, you should not mix these funds with any other IRA you may have. Also, you should not add anything else to the rollover IRA you establish for these funds. That way the proceeds and all earnings retain their eligibility for a later transfer to a new employer's retirement plan.
Put the funds being rolled over from an ex-employer into an existing IRA or add any other funds to this sum, and the IRS will say the money is now "tainted." Apparently any money you add to your rollover IRA or already in an existing IRA will cause 401(k) rollover money to smoke or drink or start chasing boys or something. Don't worry, we don't understand where the IRS is coming from on this "tainted" thing either. But the upshot is that your money will be ineligible for a rollover to a future employer's plan.
To Fools, this is not a terribly important point. We believe we can invest these funds to earn more than in an employer's plan anyway -- the best possible choice that an employer would likely provide in its retirement plan would be an index fund, and you, dear Fool, are perfectly capable of acquiring one of those on your own.
Still, at least now you know the rules for keeping your rollover money "pure."
At long last the money is in an IRA. We turn now to the next problem, Investing Your Nest Egg Foolishly.
6. Investing Your Nest Eggs
There it was, the notice confirming that the $224,517 from his 401(k) plan and the $210,083 from his company pension had reached his IRA.
$434,600.
He suppressed a giggle. He thought about taking the money, converting it into one-dollar bills, and rolling around in it. This seemed interesting, but not terribly original. He thought about taking the money, converting it into nickels, dimes, and quarters, and rolling on top of it.
He quickly discarded that idea.
"This," thought Vespasian, "takes a little more thinking. There must be something better -- and I don't know that rolling around, on, under, or through the money is going to actually make it grow. Not that I've ever really thought about it."
What irony! His security blanket in retirement had just become his greatest worry. Vespasian knew all that cash could provide him the necessary income to enjoy the rest of his life, but it had to last, too. Short of returning to work, that pot of money was all he had to live on besides Social Security. Therefore, taking undue investment risks just didn't seem appropriate. Vespasian knew he didn't have the same luxury of time to recover from an economic downturn as he did in his salad years. "I've gotta do something with this stash besides giggle about it," he mused.
"But where should I invest it so it's safe?
"And how much can I take each year without ever running out?"
Welcome to the wonderful world of retirement, Fool. These are the two eternal questions posed and faced by all retirees. For time immemorial, the simple answer was to invest retirement proceeds in utilities, preferred stock, REITs, bonds, and other dividend-producing, interest-paying securities. You took the interest and dividends as income for the year and let the principal ride. The emphasis here was on income, not growing the base of the investment. Investing for growth meant taking more risk, and risk was to be avoided at all costs -- or at least so said the Wise retirement advisors who held sway in Americans' psyches.
Times have changed (they always do), and the approach that once seemed so attractive and so sensible no longer holds sway. Companies no longer promising or even attempting to provide any dividend growth, deregulation of the utilities, increasingly volatile bond markets, low interest rates, inflation, and increasing life spans have all reared their ugly heads at one time or another to undermine the security of a "low-risk, income-only" investment strategy for retirees. OK, an increasing life span isn't exactly an "ugly head" -- but it poses a few complications as well as providing additional years to celebrate life's many joys. At any rate, many financial experts believe the "low-risk, income-only" strategy may pose the ultimate threat to retirees -- running out of money before you run out of time to spend it. In essence, some retirees are taking the greatest risk of all -- not taking enough risk with their retirement money.
Life expectancies have increased dramatically over the years. A 62-year-old retiree today can expect to live into her 80s and even her 90s. That means required income must continue for 20 to 35 years, and much longer for those who retire at earlier ages. While an "income-only" portfolio may produce desired income in the early retired years, it could fall woefully short in later years.
As an example, a low-risk, all-bond portfolio with an average return of 6% might throw off enough income for a retiree today. Nevertheless, at a modest inflation rate of 3% per year, every $1,000 produced by that portfolio will only be worth $554 in 20 years. Worse, the principal available then for reinvestment will be the same as it is today because it didn't grow through the years. As purchasing power declines, a retiree using such a strategy almost certainly will have to dip into principal to sustain her lifestyle, and the use of that principal will definitely shorten the life of her portfolio. Conversely, an all-stock portfolio may produce growth from which one may take income. Yet stocks can plunge in value overnight, and they can stay down for five years or longer. To a retiree, that, too, can be a devastating result.
So what's the answer? There ain't a perfect one, Fool, except to live each day as if it were your last. Just chill out and enjoy the fruits of your life's labors. When the money gives out -- just move in with the kids. After all, they mooched off you for years, didn't they? Turnabout just seems like fair play -- most of recorded history shows that the main reason to have lots of children is so they can take care of you in your old age. Who are you, Mr. Bigshot, to turn your back on millennia of accepted practice?
But, then again -- kids today. They might not even know about all those millennia of recorded practice. Just in case you might be tempted to mark the "Move In With The Kids" folder with a big red "Plan B" stamp, there is a solution that might work better. It's called asset allocation.
Asset allocation means part of our investment portfolio should go to each of the three primary investment markets: Stocks, bonds, and cash. In theory, these markets do not move together. As one is at a high, another is at a low, and the third is somewhere in between the other two. By having a portion of our money in all three areas, we minimize our downside risk while achieving necessary portfolio growth. We and we alone decide how much of our total portfolio we want in each area, and then we allocate that percentage to each. Periodically, typically once each year, we see what happened. Because markets are doing their crazy "up and down" thing, we will find that our original allocation has changed. At that point we rebalance our investments to restore our desired percentages.
That means we sell our winners to replenish our losers. In other words, we buy low and sell high. Now isn't that a Foolish thought, and yet so Wise, too? (Who said there weren't any areas of mutual agreement?) The trick is to decide how much to place in each sector, and that's something every Fool has to decide for herself. No one else can really do it for you. There just isn't a "right" answer or "one size fits all" solution to this conundrum.
Typical "convention wisdom" held that the way to allocate money was to subtract your age from 100, and devote that portion to stocks. Therefore, a 50-year-old would have 50% of her portfolio devoted to stocks. A 70-year-old should only have 30% devoted to stocks. Then, as we know, people started living longer, and the number to subtract from became 110. Perhaps there is some vague broad-stroke sense to that, but in reality, as retirees we must determine the allocation that allows us as individuals to sleep well at night while still generating the income and portfolio growth required for the rest of our lives.
A Foolish retirement allocation is really determined no differently than it is for any other investor at any other age. We seek the mix that fits our risk tolerance for losing money yet still achieves our objectives. In this case, we want growth and income. To achieve both, we look at total portfolio return and adjust for risk by controlling the ratio of stocks within that portfolio. A major factor in that equation is the desired withdrawal rate from that portfolio, a topic covered next in How Much Are Ya Gonna Take?
7. How Much to Take?
There you sit with a finite pile of savings from which you will need to take all or most of the money to support your retirement spending. How much of that stash can you safely take each year to ensure it lasts your lifetime? Will you take the same amount annually? Will you adjust the withdrawal each year to offset purchasing power lost due to inflation? Will you dip into the principal during your lifetime or will you leave it to the kids? Will you just buy all the cool toys and vacations you've always really wanted, and let your slightly older self deal with the fallout a few years later? And have you really sat down and talked with your future self about this plan of yours?
These can be tricky questions (especially the one about sitting down and talking with your future self -- there are psychiatrists that can help you out with this problem if you've really been doing it). But there's lots of help out there. Various calculators are available online and in commercial financial planning software to help retirees cope with these issues. We've even got one or two on this site, and we're constantly on the lookout to steal the best features from everyone else's calculators to improve our own. Write us if you see anything you really think we should copy.
Anyway, most retirement calculators ask you to provide:
You provide that data, and with quick mathematical certainty the calculator will tell you either the starting value of the retirement nest egg required to support the desired income or the income that can be supported by your starting portfolio.
While these computations are useful -- and some of the online toys out there can easily be played with for hours before you grow tired of seeing how much money you'll have if you live to be 137 and the government increases Social Security payouts (ha!) -- they do have some drawbacks. Perhaps the worst defect is that they rely on average rates of return and inflation. Over the long term, an average rate will work. That's especially true when you're still saving for retirement. Unfortunately, year-to-year results won't be the same as the average, and to a retiree who is taking instead of saving money, those yearly variations can be devastating.
Ibbotson Associates tells us that for the years 1926 through 2000 the average annual S&P 500 total return was 11.1%, the annual average total return for long-term corporate bonds was 5.7%, and inflation averaged 3.1% per year. That's not too shabby. That means a portfolio constructed of a 75% holding in the S&P 500 and a 25% holding of long-term corporate bonds would have produced an annual total return of 9.75% on average. As a retiree, I could look at that result and reasonably conclude I could take 7% of my portfolio yearly and not be fearful of running out of money. But -- ain't there always one of those? -- what if you were unfortunate enough to retire on January 1, 1964?
According to Ibbotson, for the 15-year period ending on December 31, 1978, the S&P 500 total return averaged 5.4% per year, long-term corporate bonds averaged 4.0%, and inflation averaged 5.4%. Starting on January 1, 1964, with a 75% S&P 500 and 25% long-term corporate bond portfolio mix, you would have averaged a total return of only 5.1% per year through the end of 1978. That's less than the average inflation rate in that period. Consider the first year's 7% withdrawal rate you want in income that year. Consider increasing that income annually by the inflation rate. Then ask yourself if you could have survived those 15 years intact. Not a chance, Fool. You'd be eating government surplus cheese by now.
Obviously, when you start withdrawals is just as important as how much you take. Start in a period when the market is in a multiyear slump, and you could run out of money. Start at the onset of a sustained bull market like that of the past 15 years, and your children may very well inherit a substantial sum of cash. Therefore, the answer is very simple. Time your retirement withdrawals so they begin at the start of a long bull market.
All you have to do is get into a time machine and go back to about 1982 and retire then. That way you can take 7% to 10% each year and not go broke. Unfortunately, whether due to a massive governmental conspiracy, incompetence at NASA, or the simple realities of quantum physics, working time machines are in short supply. Similarly, few of us have Magic 8-balls that work reliably enough to see the start of prolonged market surges. Given, then, that our ability to predict the future is limited, what's the maximum amount we can really take to ensure we don't run out of cash?
One study compiled by three Trinity University professors -- Philip Cooley, Carl Hubbard, and Daniel Walz -- examined this issue by looking at historical annual returns for stocks and bonds from 1926 through 1995. Their results were published in the February 1998 issue of the AAII Journal in an article entitled "Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable." Using historical data published by Ibbotson Associates, the study looks at the impact of withdrawal rates from 3% to 12% on 5 portfolios ranging from 100% stocks to 100% bonds over all rolling withdrawal periods of 15, 20, 25, and 30 years from 1926 through 1995.
A successful portfolio was one that ended a particular withdrawal period with a positive value. The probability of success was measured based on the ratio of positive-value ending portfolios for a specific withdrawal period to the number of possible rolling periods for that category in the years studied. As an example, there were 56 possible 15-year withdrawal periods between 1926 and 1995. If in 31 of those periods a portfolio had a positive value after a final withdrawal of 12%, then a portfolio using that withdrawal rate for 15 years had a success rate of 55% (31 divided by 56, rounded to the nearest whole percentage). The study looked at both a fixed annual withdrawal based on the rate applied to the initial portfolio and at an inflation-adjusted annual withdrawal of that initial amount.
Not surprisingly, the study revealed withdrawal periods longer than 15 years dramatically reduced the probability of success at withdrawal rates exceeding 5%. The authors reached five general conclusions:
Additional commentary may be found in "The Trinity Study" by Scott Burns and the Retire Early website's article "What's the 'Safe' Withdrawal Rate in Retirement?" The Retire Early website recently conducted a similar study using an alternative database spanning the years 1871 through 1998. Found in "The Retire Early Study on Safe Withdrawal Rates," it generally confirms the Trinity Study results.
All of these references agree that a "safe" withdrawal rate ranges between 4% to 6% of a retiree's starting portfolio. Withdrawal rates above 5% increase the probability that a retiree will go broke in her lifetime. They also agree that the presence of bonds in the portfolio provides a measure of stability absent in an all-stock portfolio. And all agree that inflation-adjusted withdrawals fare best at lower to midlevel withdrawal rates.
And now we look at how to get to the money early..
8. Getting the Money Early
Most people think that they can't touch the money in their IRAs until they reach the age of 59 1/2. While it's generally true that you're not going to want to before that age, you should know you can tap into your retirement cash before then with no penalty owed to Uncle Sam. And you don't even have to be retired to get your hands on it. What makes this possible is a little known section (ssshhhh) of the Internal Revenue Code (IRC). Section 72(t)(2)(iv), IRC -- there'll be a quiz on that later, so remember it -- stipulates that funds may be withdrawn penalty-free from an IRA or qualified retirement plan at any age prior to age 59 1/2. There is, of course, a catch. Actually, there are more catches than Jerry Rice has in the average season.
To qualify for this treatment, the withdrawal must be part of a series of "substantially equal periodic payments" determined by the participant's life expectancy or the joint life expectancy of the participant and a designated beneficiary (spouse, usually). There are three approved and accepted methods for receiving these payments, all of which result in a different sum paid to you. In each, you must pay ordinary income taxes on the withdrawal, but you will not have to pay the 10% "excise tax" due to a premature distribution.
If you have multiple IRAs, you may choose which IRA to use for withdrawals. Additionally, you may make simultaneous withdrawals from two or more IRAs, and use a different withdrawal method for each. When you get right down to it, there's almost no end to how complicated you can make these things -- but we'll try to keep them as simple as we can.
Be forewarned. There is a common belief that the various methods of determining the acceptable annual payouts were created by failed math Ph.D. candidates as some sort of bizarre revenge on society. We're not entirely going to rule out that hypothesis, but, to set the record straight, if there is any evidence to support this theory, it is marked "Top Secret." The IRS swears that it is just trying its best.
Be that as it may, let's look at the three methods through which you may take penalty-free withdrawals from your IRA.
Life Expectancy Method. The life expectancy for the participant or the joint life expectancies of the participant and a beneficiary are determined using the IRS life expectancy tables found in IRS Publication 590, Individual Retirement Arrangements. (Download this publication at http://www.irs.gov/.)
The account balance as of the beginning of the year is divided by the life expectancy factor found in the applicable table. If your account balance is $100,000 and the table states that you are expected to live 20 years, you can take $5,000. In the second and succeeding years, the required withdrawal amount is recalculated in one of two ways. In the first, the life expectancy factor used in the first year is reduced by one (i.e., you are now expected to live 19 years), and that recalculated factor is used as the new divisor of the remaining money in the account. After 20 years, you will have withdrawn all the money.
Alternatively, you can look up the new life expectancy based on attained age. (Perhaps the IRS now thinks you will live even longer, and surprisingly, actuaries tell us that's true.) Then use that new factor as the divisor.
For every successive year, you must continue to use the recalculation method selected in year two of the withdrawal.
Should you use either of the life expectancy methods? Do you understand them? Know this much -- the life expectancy method results in the smallest withdrawal amount of the three methods permitted by the IRS to avoid the excise tax, so that may decide the issue for you.
Amortization Method. In this method, life expectancy is again determined using the tables in IRS Publication 590. Additionally, an assumed earnings rate may be used to determine the annual withdrawal amount that will deplete the entire account over that life expectancy. The rate must be a "reasonable interest rate" decided on before the withdrawals begin, and generally it must be within 120% of the applicable federal long-term rate. There is no precise definition of this rate that has been established by the IRS, so it must be selected with care. Once determined, the withdrawal amount remains fixed from year to year; however, that amount will be larger than the one determined using the life expectancy method. Consult with a qualified tax advisor.
Annuity Method. This method results in a fixed withdrawal amount like the amortization method, and it is computed similarly. The difference is in the fact that IRS life expectancy tables are not used. Instead, those in general use by the life insurance industry are acceptable. An annuity factor derived by using the UP-1984 Mortality Table is the general standard for this method. The resulting calculation results in the highest withdrawal amount of the three approved withdrawal methods.
72(t) Pros and Cons. Mostly Cons.
There are a number of drawbacks to using the Section 72(t) method of withdrawals. First, regardless of the method used, the process must continue for a minimum of five years or until age 59 1/2, whichever occurs later in time. Start at age 58, and you must continue until age 63. Start at age 50, and you must continue until age 59 1/2. If withdrawals are made from multiple IRAs, the five-year period runs separately for each IRA based on the date withdrawals started. This, obviously, can result in a lot of paperwork.
Second, if you make a simple math error in computing the exact amount of the withdrawal, if you stop the withdrawals too early, or if you change the calculation method, then all withdrawals up to that point are subject to the 10% premature distribution excise tax. And if that isn't enough, the IRS will also assess an additional penalty for failure to pay that amount in prior tax years.
Third, the life expectancy method too often fails to provide the needed income to the recipient anyway. To increase the amount, the person must use one of the other two methods and/or withdrawals from multiple IRAs. The "reasonable interest rate" that must be used in these methods, while resulting in a higher withdrawal amount, can be challenged by the IRS. Thus, it's a rate that must be selected with extreme care. Additionally, the calculations involved in the amortization and annuity methods may be beyond the capability of most folks. In short, the potential for error and subsequent IRS penalties with these two methods is large.
To be safe, those who wish to use Section 72(t) withdrawals should engage a professional skilled in the computations of all three methods. In addition, that professional should provide the account owner a letter specifying in detail the calculation method used. The letter should also specifically express an opinion that the calculations comply fully with the requirements specified in the IRC and by the IRS. That way, there's someone for you to point your finger at if everything blows up and the IRS comes a-callin'. Things are just much safer that way.
If you don't really need to think about taking the money early, learn what happens when you must take the money.
9. 70 1/2: You gotta take it
We've looked at how you may take qualified retirement plan or traditional IRA tax-deferred money before age 59 1/2 without penalty. You can do it -- but it's complicated.
Between the ages of 59 1/2 and 70 1/2 (the so-called "easy math" years of your retirement), you may take as much or as little as you wish from your tax-deferred accounts. You'll pay taxes on the withdrawals (unless it's a Roth IRA), but no penalties are involved.
Reach age 70 1/2 (there's that important half year again), and our administrative friends in Washington say the free ride of tax-deferred accumulation is OVER. No more hoarding -- the government has been exceedingly patient, but there are limits. It wants you (actually it needs you) to start paying some taxes, so you've got to start taking the money out of that IRA. You must take a "minimum required distribution" (MRD).
What Happens When You Turn 70 1/2
At 70 1/2, previously untaxed money amassed in retirement plans and traditional IRAs will start to be taxed. Only money in a Roth IRA can continue to avoid taxation. If you're still working, then anything in your qualified retirement plan at that job can stay there until you retire. But if you're retired, any money in that plan must come out. And regardless of your work status, at 70 1/2 you must take an MRD from your traditional IRAs.
The Internal Revenue Code requires that MRDs begin no later than April 1 of the year following the year you reach age 70 1/2. Remember that much. The next few sentences will be put in brackets to emphasize that they aren't the main point -- they're kind of the footnote to what was just said.
[If you turn 70 1/2 on January 1, 1999 -- or any day in 1999 -- that means you must begin your MRD no later than April 1, 2000. While the first MRD will be for tax year 1999, actually taking it in 2000 means you won't report that withdrawal income until you file your income tax return for 2000. BUT (warning -- the inevitable catch is coming) your second annual minimum withdrawal must be for and occur in the year 2000 as well. That means you must make the second distribution no later than December 31, 2000, which results in another taxable IRA event in that year. As usual and as always, you'll have to look at your tax situation to see if you want those payments lumped into the same tax year.]
Whatever you decide, make sure you take the MRD by the deadlines prescribed. If you fail to do so, the IRS will be very happy. Why? Because it will assess a penalty of 50%(!!!) on the monies you should have taken but did not. Fools are good citizens. Doggone it, Fools are great citizens -- and comply with their civic duties willingly. We're sure you do, too, dear Fool. But paying a 50% penalty seems to be carrying the concept of good citizenship toward the socialist side of the spectrum a tad too far. Therefore, Fools will avoid paying that penalty at all costs.
You may take more than the MRD, but you must take at least that amount or pay the 50% penalty on anything you should have withdrawn. Any excess you take above the MRD, though, does not count toward the next year's MRD.
How MRDs Are Calculated
Under old IRS regulations, the MRD is calculated using a life expectancy factor that's based on your age, the age of your IRA or plan beneficiary, and the total balance of your IRA or retirement plan as of December 31 of the previous year. The procedures for finding that factor and for calculating the amount of the MRD are prescribed in IRS Publication 590, Individual Retirement Arrangements.
Under newly proposed regulations, as of January 1, 2001, those taking MRDs from IRAs may opt to use a new uniform life expectancy table that assumes the IRA or plan owner has a beneficiary who is exactly ten years younger than the account owner. Each year the account owner would find a life expectancy factor in that table that corresponds to the attained age of the owner in that year. That factor would then be divided into the account balance as of December 31 of the prior year to determine the new year's MRD. For most people, use of the new regulations will result in an extended tax-deferred life for and lower taxes on the account. Use of the new methodology is optional in 2001, but is anticipated to become mandatory in 2002 for those who must begin MRD in that year.
When You Have Multiple IRAs
Currently, you are responsible for computing the MRD for each of your IRA. Under the new rules, starting in 2002 each IRA custodian will compute the MRD for that IRA. The MRD amount will be reported to you and the IRS. Whether you compute the MRD this year or your IRA custodian does next year, when you own multiple IRA you have a choice of which IRA you use to meet the total amount of MRDs you must take. Just total all the MRDs computed for each IRA. That total may then be taken from any one or any combination of IRAs. This proviso may be useful if you have one IRA earning a 6% return and another earning 18%. The Foolish choice would be to deplete the lower-returning IRA first, and to allow the better one to continue its tax-deferred compounding.
The issue of MRDs and the selection of beneficiaries has a great bearing on the taxation of estates and the net proceeds that will be available to heirs at death. Therefore, make sure you've given plenty of thought to how to Leave It Behind.
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