Dear Liz: Our advisor recommended that we convert our rollover IRA to an annuity. We are having difficulty researching this. Any suggestions?
Answer: Unless your advisor is a complete numskull, he probably didn’t mean you should cash out your IRA to invest in an annuity. That would incur a big, unnecessary tax bill.
The idea he’s trying to promote is to sell the investments within your IRA, which wouldn’t trigger taxes, and invest the proceeds in an annuity.
The devil is in the details — specifically, what type of annuity he’s suggesting. If he wants you to buy a variable deferred annuity, you should probably find another advisor or at least get a second opinion. The primary benefit of a variable annuity is tax deferral, which you’ve already got with your IRA. The insurance companies that provide variable annuities, which are basically mutual fund-type investments inside an insurance wrapper, tout other benefits, including locking in a certain payout. Those benefits come at the cost of higher expenses, which is why you want a neutral party — someone who doesn’t earn a commission on the sale — to review it.
If he’s suggesting you buy a fixed annuity, which typically provides you a payout for life, you still should get that second opinion. A fixed annuity creates a kind of pension for you, with checks that last as long as you do. There are downsides to consider, though. Typically, once you invest the money, you can’t get it back. Also, today’s low interest rates mean you’re not going to get as much money in those monthly checks as you would if rates were higher. Some financial planners suggest their clients put off investing in fixed annuities until that happens, or at least spread out their purchases over time in hopes of locking in more favorable rates.
You can hire a fee-only financial planner who works by the hour to review your options. You can get referrals to such planners from Garrett Planning Network, http://www.garrettplanningnetwork.com.
Question: In a recent column you repeat advice I have often read that withdrawing about 3% of my investment capital will reduce the chances of my running out of money in retirement. But that doesn’t make sense to me. I have been retired for over 19 years and I have sufficient data now to extrapolate that I could live for 100 more years with so meager a drawdown because, through good and bad times, my earnings after inflation and taxes always exceed 3%. If I am missing something, I must be extraordinarily lucky because it hasn’t hurt me yet, and at age 77 I think it unlikely to do so in my remaining years. Can you explain this discrepancy between my experience and the consequences of your advice?
Answer: Sure. You got extraordinarily lucky.
You retired during a massive bull market, which is the best possible scenario for someone who hopes to live off investments. You were drawing from an expanding pool of money. Your stocks probably were growing at an astonishing clip of 20% or more a year for several years. Although later market downturns probably affected your portfolio, those initial years of good returns kept you comfortably ahead of the game.
Contrast that with someone who retires into a bear market. She’s drawing from a shrinking pool of money as her investments swoon. The money she takes out can’t participate in the inevitable rebound, so she loses out on those gains as well. All that dramatically increases the risks that she’ll run out of money before she runs out of breath.
It’s the first five years of retirement that are crucial, according to analyses by mutual fund company T. Rowe Price, which has done extensive research on sustainable withdrawal rates. Bad markets and losses in the first five years after withdrawals begin significantly increase the chances that a person will run out of money during a 30-year retirement.
Some advisors contend that a 3% initial withdrawal rate, adjusted each subsequent year for inflation, is too conservative. If you retire into a long-lasting bull market, it may well be. But none of us knows what the future holds, which is why so many advisors stick with the 3%-to-4% rule.
Dear Liz: After working all out for 28 years in a small business, I have put away $2.6 million in stocks, bonds and some cash. (I am a reasonably smart investor.) I’m 58 and want to be done at 60. I’m not tired of my business, just tired of working. How much do you think I could draw out and not get myself into trouble? I’m in great health, so I could last 30 more years. Our house is paid off, and my wife gets about $40,000 a year from a nice pension. Any ideas?
Answer: Financial planners typically recommend an initial withdrawal rate of 3% to 4% of your portfolio. With $2.6 million, your first year’s withdrawal would be $78,000 to $104,000. The idea is that you could adjust the withdrawal upward by the inflation rate each year and still be reasonably confident you won’t run out of money after 30 years.
Some studies indicate you can start with a higher withdrawal rate, as long as you’re willing to cut back in bad markets.
There is still some risk of going broke, though, even with a 3% withdrawal rate. Particularly poor stock market returns at the beginning of your retirement, for example, could increase the chances your nest egg will give out before you do.
This is an issue you really should discuss with a fee-only financial planner who can review your investments and your spending to make personalized recommendations. (You can get referrals from the National Assn. of Personal Financial Advisors or the Garrett Planning Network.) If you’ve chosen especially risky stocks or have too much of your portfolio in bonds, for example, your retirement plan could fail even if you choose a conservative initial withdrawal rate.
You’ll also want to talk about how you’re going to get health insurance, and how much it’s likely to cost. If you’ve been arranging coverage through your business, you might face some sticker shock when you have to buy a policy on your own. But it’s essential to have this coverage, since you won’t qualify for Medicare until you’re 65.
If you’re not tired of your business, you might consider phasing in retirement, if that’s possible in your situation. That would mean starting to take some long breaks to travel or pursue the interests you plan to indulge in retirement. Delaying retirement even a few years can dramatically increase the chances your nest egg will last.
Dear Liz: I am 56 and will be receiving $175,000 from the sale of a home I inherited. I do not know what to do with this money. I have been underemployed or unemployed for six years, have no retirement savings and am terrified this money will get chipped away for day-to-day expenses so that I’ll have nothing to show for it. Should I invest? If so, what is relatively safe? Should I try to buy another house as an investment?
Answer: You’re right to worry about wasting this windfall, because that’s what often happens. A few thousand dollars here, a few thousand dollars there, and suddenly what once seemed like a vast amount of money is gone.
First, you need to talk to a tax pro to make sure there won’t be a tax bill from your home sale. Then you need to use a small portion of your inheritance to hire a fee-only financial planner who can review your situation and suggest some options. You can get referrals for fee-only planners who charge by the hour from the Garrett Planning Network at http://www.garrettplanningnetwork.com.
You’re closing in quickly on retirement age, and you should know that typically Social Security doesn’t pay much. The average check is around $1,000 a month. This windfall can’t make up for all the years you didn’t save, but it could help you live a little better in retirement if properly invested.
You should read a good book on investing, such as Kathy Kristof’s “Investing 101,” so you can better understand the relationship between risk and reward. It’s understandable that you want to keep your money safe, but investments that promise no loss of principal don’t yield very much. In other words, keeping your money safe means it won’t be able to grow, which in turn means your buying power will be eroded over time.
Dear Liz: I’m 64 and retired on a Social Security income of $10,000. My wife is also 64 and is still working, earning $91,000 a year. She contributes $13,000 to a 401(k). Can both of us also contribute the maximum $6,000 to our IRAs?
Answer: Since your wife has earned income, you both can contribute to IRAs, and you would be able to deduct your contribution. She, however, probably would be able to deduct only part of hers.
Because she’s covered by a retirement plan at work, her ability to deduct an IRA contribution for 2011 phases out at a modified adjusted gross income of between $90,000 and $110,000, said Mark Luscombe, principal analyst for tax research firm CCH, a Wolters Kluwer business. The portion of your Social Security benefits that are taxable would be added to her earned income to determine how much of her contribution is deductible.
“The working spouse would appear, therefore, based on the facts available, to only qualify for a partial deduction of her IRA contribution,” Luscombe said.
You’re luckier. As a non-working spouse, the phase-out range for deducting an IRA contribution is higher: In 2011, it applied to modified adjusted gross income between $169,000 and $179,000. “The non-working spouse would therefore, under these facts, qualify for a full deduction for a $6,000 contribution to an IRA,” Luscombe said.
Dear Liz: I have a 401(k) loan that I used to purchase a car. I plan on aggressively paying off the balance in 2 years or less. Should I continue making contributions to my 401(k) or should I stop and use the money I was contributing to pay the loan off faster?
Answer: Continue contributing to your 401(k), no matter what. You may save a few bucks in interest in the short run if you stop contributing to pay down the loan, but you’ll lose out on the much bigger compounded gains your contributions could have made over the coming decades.
Dear Liz: I am a 20-year-old college student with a stable, part-time job. I haven’t contributed to a 401(k) with this company because I don’t plan to be working for it for two years, which is how long I’d have to wait for my contributions and earnings to be 100% mine. I’d like to open a Roth IRA, but I’m not sure I’m eligible. I’m listed as a dependent and our household adjusted gross income is between $145,000 and $155,000. Can I open a Roth?
Answer: The short answer is yes, although you may want to reconsider contributing to your workplace 401(k) as well.
As long as you have earned income that’s less than the Roth limits, you can contribute to a Roth account, said Mark Luscombe, principal analyst for tax research firm CCH Inc. Your status as a dependent and your parents’ household income aren’t factors.
This fact allows many wealthier parents who make too much for their own Roth IRAs — the limits are $179,000 for a married couple filing jointly and $122,000 for singles — to give money to their lower-earning children to fund the kids’ Roth accounts.
“The dependent would need to have earned income for the year at least equal to or greater than the amount of the Roth IRA contribution,” Luscombe said. But “the Roth IRA contribution would not have to come from that earned income.” The money could come from the parents’ gift.
All that said, you should reconsider your aversion to your company’s 401(k), especially since you may be misunderstanding how it works. You typically would be able to leave with your own contributions, and the earnings on those contributions, at any time. What you may not be able to take with you is your employer’s full match, since it may take several years for you to be fully vested. Still, you may be able to leave with part of the match, which would make it free money that you shouldn’t turn down.