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Part 1: Impacts on your retirement funds
It’s pretty standard advice: save as much money as you can early in life so you can have a comfortable retirement later. Saving and investing is the first part of the effort; then you have to spend it wisely in your retirement years so you have enough to last as long as you do.
The saving and investing period of your life is called the accumulation phase. When you quit working and decide to access your funds, you’re in the distribution (or decumulation) phase. As you map out this distribution of funds, you’ll need to think about several constants, like taxes and age requirements.
Setting up success
As you age closer to retiring, your investment portfolio should gradually change to become more conservative, meaning you convert risky equities to safer investments. Your financial advisor will have an eye on this.
If you have a target year 401(k), it will make these changes accordingly. For example, if your portfolio is Target Year 2030, your percentage of high-risk, (potentially) high-return investments will be sold and replaced with low-risk, low-return options.
A comprehensive plan not only addresses portfolio risk management, but also incorporates strategies to lower your tax liability and maximize your income. The following information does not cover everything you need to consider, by a long shot. But, it’s a good starting point for thinking about retirement plans.
Account for outside impacts
Market Volatility: As a retiree, you are not usually in the position to ride the market ups and downs. You do not have the years left to wait for your investments to return gains after a market downturn. You are not in the position to earn more to replace lost funds. As you age, taking fewer risks with your money is better.
Inflation: The money you have today will be worth less in the future. Sad, but true. Inflation will require you to spend a larger amount of your money later in retirement than in the early years of retirement. Your distribution plan must reflect this.
Tax liability: The popular investment plans like 401(k) and Individual Retirement Accounts (IRAs) use pre-tax money. The taxes on the money will have to be paid when you take it from the account. Tax laws are always changing and there are multiple ways to take the money to lower the amount of tax you pay.
Some say paying taxes later in life is beneficial because your tax bracket – and, thus, your tax percentage – will probably be lower. Others advise that you convert some of the money to a Roth account early and pay the taxes because taxes may rise in the future. Your professional financial advisor will make the calculations and advise you appropriately. The bottom line is the dollar amount in your retirement accounts is not the amount of money you will have to spend.
Capital gains taxes: For investments held more than one year, you’ll pay taxes on the earnings between the purchase price and the sales price of real estate or investments. The taxes are currently between 0% and 20%, depending on your tax bracket.
A different standard applies to real estate capital gains if you’re selling your principal residence. Here’s how it works: $250,000 of an individual’s capital gains on the sale of a home are excluded from taxable income ($500,000 for those married filing jointly).
This applies so long as the seller has owned and lived in the home for two years or more. In most cases, the costs of significant repairs and improvements to the home can be added to its cost, thus reducing the amount of taxable capital gain.
Owners of an investment property will usually take tax breaks for the depreciation of the property over the years. When calculating capital gains taxes, those deductions for depreciation essentially reduce the amount you’re considered to have paid for the property in the first place. That in turn can increase your taxable capital gain if you sell the property, because the gap between the property’s value after deductions and its sale price will be greater.
Required Minimum Distributions: Plan ahead for your Required Minimum Distributions (RMDs). Any money in a 401(k) or traditional IRA will be subject to RMDs, which means that you must begin taking the money out by age 73. You cannot take it out before age 59 ½ without penalties.
The SECURE 2.0 Act increases the beginning date of RMDs to age 73 in 2023 and to age 75 in 2033. This change does not apply to individuals who were age 72 or older on 31 December 2022.
Partial annuity rules: Under the new rule, the value of the annuity contract is treated as part of the account balance and payments from the annuity contract are applied toward the total amount required to be distributed. This change became effective on 29 December 2022.
The age and tax restrictions of RMDs can help you decide when to use the money from those accounts.
Social Security: Deciding on the age to begin taking your Social Security benefits is a keystone of your retirement distribution plan. You can collect benefits starting at age 62, but the monthly payments will be less than if you wait until you are at full retirement age – age 66 or 67, depending on when you were born.
If you wait until you are 70, your monthly Social Security benefit will grow by 8% a year until then. Any cost-of-living adjustments will be included, too, so you don’t lose those by waiting. Think of that time as bonus earning years – and remember that you’d be hard pressed to find guaranteed 8% growth for zero risk during that period of your life anywhere else. Reviewing your health, savings, and expenses will help you decide which age will work best for you to take these benefits.
Healthcare costs: Most people pay nothing at age 65 for Part A – hospital insurance -because they paid Medicare taxes while working. If you don’t get premium-free Part A, you pay up to $506 each month.
“Free” Medicare means that the monthly premiums are free, but that you’ll still pay for part of your hospital stay. These are hefty bills: $1,600 per year, plus $400 per day for days 61-90; $800 per day until day 100, when you have to take on the entire cost. Then, add the costs of medical visits, tests, and prescriptions (Part A is only for hospital stays) or skilled nursing home care, and your savings could be gone. If you have a chronic disease, a Health Savings Account (HSA) could be a reasonable consideration.
If you’re ready for more information, read: PART 2: Strategies for accessing your money in retirement.
The views expressed in this article are not to be construed as personal advice. You should contact a qualified and ideally regulated adviser in order to obtain up-to-date personal advice with regard to your own personal circumstances. If you do not then you are acting under your own authority and deemed “execution only”. The author does not accept any liability for people acting without personalised advice, who base a decision on views expressed in this generic article. Where this article is dated then it is based on legislation as of the date. Legislation changes but articles are rarely updated, although sometimes a new article is written; so, please check for later articles or changes in legislation on official government websites, as this article should not be relied on in isolation.
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