So the big day is finally here. At long last, you're saying adios to your job and settling down to a well-deserved retirement. This is a huge transition, and getting off on the right foot will help to ensure that you enjoy every moment of it. When you clock out for the last time, take these six steps to help ensure a happy and financially secure retirement.
Add up your assets
If you haven't already done so, it's time to take stock of your assets. These assets will likely be your primary source of income for the rest of your life, so it's important to understand exactly what you have and how much income you can expect it to generate now and in the future. First, open up your most recent Social Security statement (or pop over to the Social Security website and look it up online) to find out how much your Social Security benefits will be each month.
Next, take a peek at your investments, starting with everything in retirement savings accounts -- 401(k)s, IRAs, and so on. Write down the total value of the investments in these accounts and the amount you have allocated between stocks, bonds, and other investments (e.g., REITs). If you have both tax-deferred and Roth accounts, jot those amounts down separately; you'll want to treat these accounts differently when you start taking distributions, because withdrawals from traditional retirement accounts will be taxable, while withdrawals from Roth accounts will not be.
Finally, list any other investments or cash assets you have, such as bank checking and savings accounts.
Shift some money into bonds -- but don't overdo it
Many retirees have had it drummed into their heads that stocks are far riskier than bonds (which is true), so the first thing they do when they retire is get rid of all their stocks and put that money into bonds. The problem with this strategy is that bonds are guaranteed to return less than inflation over the long term. For example, say you put all your money into 30-year bonds that will produce $50,000 per year in interest payments. Twenty years from now, your bonds will still be paying you $50,000 per year, but because of inflation, that $50,000 will buy you a lot less than it did back when you first purchased the bonds.
The solution to the inflation problem is to keep a reasonable percentage of your investments in stocks. Yes, they're riskier, but they will also produce considerably higher returns over the long term than bonds will. And those returns will help keep the overall value of your investments high enough to meet or beat inflation.
A fairly safe way to plan your asset allocation is to subtract your age from 110 and keep that percentage of your portfolio in stocks, with the remainder in bonds. This formula may sound familiar to you, as it's the same formula many people use to determine their asset allocation while they're still working and saving. If you've been using this formula yourself, you probably don't have much of a shift to make in your assets. If not, you may have some changing to do.
Pick some high-dividend stocks
Stocks are riskier than bonds, all right, but not all stocks are equally risky. And it just so happens that many of the stocks that pay high dividends (something to be desired when you're looking for steady income) belong to large, well-established companies with long records of stable performance. In other words, these are companies that are unlikely to suffer massive share-price losses or otherwise run into trouble that would endanger the value of their stock. Putting your stock investments into these blue-chip companies not only gets you high dividends (and therefore income), but it also reduces your risk. You can try picking out your own high-dividend value stocks, or you can simply choose an index fund that specializes in those types of stocks.
Remember that a big dividend yield is not always a sign of a healthy company. Read up on dividend investing and learn how to spot reliable dividend payers before throwing your money down.
Calculate your distributions
There's a lot of contradictory advice about how much money it's safe to take out of your retirement savings accounts each year without running the risk of depleting them. While it would be nice if there were one simple number that would always be right, in reality there are too many factors that can influence how much you can safely withdraw, like your age, the performance of your portfolio, current and predicted economic pressures, and your health.
The popular 4% rule worked for a while, but it has come under attack as being too risky for some retirees, especially given that Americans are living longer and therefore need their savings to stretch further. If you retire in your 60s and you want to minimize your risk of running out of money, stick to distributions of 3% to 3-1/2% for at least the first few years of your retirement. As you get older, you can increase this percentage to keep up with inflation. And if your portfolio has a good year with substantial returns, you can take out a little more that year.
Do the math on RMDs
The IRS requires you to withdraw a certain amount from your tax-deferred retirement savings accounts each year once you reach age 70-1/2. These required minimum distributions (RMDs) can create a problem if they work out to be higher than the distribution percentage you had decided on.
This is where it helps a lot to have a Roth account in addition to your traditional retirement savings accounts, as Roth accounts don't have RMDs, and thus they can pick up the slack if you're forced to overdraw your traditional retirement accounts. Even if you have a few years to go before you need to draw your first RMD, go ahead and look up the amount you'll be required to take during that first year. If it's higher than you're comfortable taking from your accounts, you can reduce the risk of overdrawing your capital by taking slightly lower distributions during the years before you turn 70-1/2. That allows your accounts to hang on to a bit more capital in preparation for the big distribution to come. RMDs get smaller as you age, so the first one is most likely to be a problem; if you can manage that one, the rest should be easy.
Develop a distribution strategy
Once you've figured out roughly how much you're going withdraw from your retirement accounts during the first year, the last step is to decide where that money will come from. Assuming you have a standard brokerage account, a traditional retirement savings account, and a Roth account, you'll want to turn to the standard brokerage account first. That allows the investments in the retirement accounts to continue growing tax-free. The next step is to tap the tax-deferred retirement accounts, partly because you'll have to take the RMD anyway and partly because distributions from these accounts are taxable, while distributions from Roth accounts are not. Ideally, you'll take as much from the tax-deferred accounts as you can afford to, given that you'll have to pay taxes on that money, and then take whatever you need from the Roth account.
Using this strategy, you'll eventually be left with nothing but your Roth account -- which is perfect, because you don't have to take RMDs or pay taxes on distributions from these accounts. You can enjoy the sweet freedom of tax-free income, doled out on your own schedule instead of the government's.
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