Your retirement date is rapidly approaching. You’re in good financial health and you feel well-positioned for a secure retirement. But you’re still worried you might be overlooking something.
You’ve heard a lot of information about retirement planning basics: Contribute regularly to tax-advantaged accounts like your 401(k) or IRA, choose the right mix of assets for your age and risk tolerance, and rebalance regularly. You’ve followed this advice for decades, and you feel confident about the results.
But you still can’t help but wonder if you’re missing something crucial.
Are there better asset allocation tactics you should be using? How should you re-weight your portfolio as you get closer to retirement day? What withdrawal strategy should you adopt?
To set your mind at ease, let’s explore five of the most commonly overlooked retirement steps.
1. Not Balancing Assets for Tax Benefits
Most people know they should diversify between equities (like stocks), fixed-income (like bonds) and other types of investments (like commodities or cash equivalents). But many people don't think about placing each type of asset in a location that best fits its tax consequences.
Here’s an example: Imagine that your portfolio is split 50/30/20 between stocks, bonds and cash. You hold multiple retirement accounts, including a company 401k, Roth IRA, an old SEP-IRA from when you used to be a small business owner, and a 403b that your spouse holds. You also have two taxable brokerage accounts.
Should each of these accounts mirror that exact 50/30/20 split? Not necessarily.
You should locate assets in particular accounts based on trading frequency and tax considerations. Fixed-income assets and high-dividend assets like REITs, for example, have the potential to generate a large tax bill, especially if you’re a frequent trader. As a result, these investments should ideally be located in tax-exempt accounts, such as your Roth IRA or Roth 401k.
By contrast, assets that you don’t trade often may fare better in tax-deferred or taxable accounts.
Why? Ordinary dividends and short-term capital gains are taxed at the higher ordinary income tax rate, while qualified dividends and long-term capital gains are taxed at the lower capital gains rate. As a result, you’ll want to locate frequently-traded assets (which are likely to qualify for ordinary income tax treatment) in tax-exempt accounts whenever possible.
This means that not all of your accounts will perfectly mirror your overall allocation. Don’t worry; this is totally fine, as long as your overall portfolio is balanced.
2. Overlooking Cash Equivalents
Many people think of their retirement portfolio as a place where they hold market investments.
But cash equivalents like CDs and Treasury Inflation Protected Securities (or TIPS) have a large role to play, especially as you reach your 50's and 60's.The closer you get to retirement day, the more you’ll want to start shifting your portfolio into lower-risk assets such as bonds and cash equivalents.
The keyword in that last sentence is “equivalents.” Many investors simply shift into cash, thinking that this is the safest route. But holding too much cash (beyond your emergency fund) carries its own risks.
Instead of allocating into cash, try investing in equivalents such as TIPS, which are designed to match either inflation or deflation (protecting you in either event) at maturity.
You can also try “laddering” CDs, which means that you buy into a series of CDs with different expiry dates, such as six months, one year, two years, three years, and five years. When the shortest-term CD expires, you roll it into the longest-duration. This preserves some of your liquidity while also allowing you to earn a tad bit of interest (though admittedly CDs aren’t paying much these days).
3. Forgetting about Income Taxes When Moving
Are you planning on retiring in a state with high income taxes, like New York or California, or in a state with no income tax, like Florida or Tennessee?
Your decision on where to retire should, of course, be based on your lifestyle desires—such as weather, amenities and family—but you should also tax-plan accordingly. The date that you move, for example, might influence your decision about when to take a distribution from your retirement accounts.
For instance, let’s say you live in Florida right now, but you’re moving to California next year. You need to withdraw $40,000 from your portfolio annually to cover living expenses.
In theory, you could withdraw $40,000 this year and another $40,000 next year. But you know that you’ll be liable for paying state income taxes next year, after you move.
So instead, you decide to take a two-year withdrawal from your 401K this year, while you’re not paying state income tax, so you can have that money to support you through the first year after you move.
You shouldn’t withdraw too much money (remember what we said about the risk of holding too much cash?), but you should think of tax consequences while you’re planning your withdrawal strategy. Sometimes the difference between taking a withdrawal on December 31 vs. January 1 can make a huge impact.
4. Taking Distributions in the Wrong Order
You have a bevy of accounts: 401K, Roth IRA, Traditional IRA, HSA, pension, even a SEP-IRA from those 4 years you were self-employed back in the 90's. Which accounts should you take distributions from first? Which ones should you let grow?
As background: Your “traditional” accounts are tax-deferred, which means you still pay taxes on the gains, so you’ll want to spend that money first. Your “Roth” accounts are tax-exempt, meaning you never pay taxes on the gains, no matter how big they get — so you might be better off leaving that money in your account to grow.
Furthermore, you’ll need to take a Required Minimum Distribution, or RMD, from your tax-deferred accounts such as your Traditional IRA. By contrast, you don’t need to take an RMD from your Roth IRA. This is yet another argument in favor of drawing down your tax-deferred accounts first.
One thing that’s worth noting: Unless an account is specifically called a “Roth,” it’s taxed as a “traditional” account. That’s why a traditional 401K is just called a 401K, while a Roth 401K is called a Roth 401K. Like all matters in life, if something is “traditional,” it goes without saying.
5. Collecting Social Security Too Early
Should you begin taking Social Security benefits at age 62, wait until you're 65 or 66, or further delay to age 70?
Answer: If you’re in good health, you’re aiming to enjoy a long lifespan, and you can survive without collecting payments, wait until you’re 70.
Why? Your benefits increase each year until you turn 70, as you probably already know. (There’s no benefit to waiting past that age.) How much of a difference does this make?
Let’s assume that you were born in 1955, and your “full retirement age” – the age at which you can collect full benefits – is 66 and 2 months. (“Full age” varies based on the year in which you were born.)
You collect benefits based on a final income of $80,000, your income has increased by 3 percent annually throughout your career, and Social Security benefits also rise by 3 percent per year.
If you collect Social Security at age 66 and 2 months, your monthly payment will be $2,561 before taxes. But if you wait until age 70, your payout nearly doubles to $3,854 per month.
Moral of the story? Delaying Social Security gives you a “guaranteed return” on your investment – so postpone these checks for as long as possible.
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