Should life insurance be renewed in retirement?

Dear Liz: My life insurance policy of $500,000 will end in four years, when I’m 63. My wife’s policy ends at age 62. Our kids are 28 and 25 and successfully launched with careers. I also have a $180,000 life insurance policy through my job that expires when I plan to retire, also at age 63. My wife and I have long-term-care insurance policies. We have $170,000 in an active investment account plus $1.4 million in our 401(k)s. Our kids also have trust funds that they will get when they turn 30 of about $80,000 each. Should I buy more life insurance for 10 to 15 years? Our estate, which is in a living trust, will pass to the kids. Our house is worth about $1 million.

Answer: The first question you must ask when it comes to life insurance is whether you need it. If you have people who are financially dependent on you, you typically do. If your wife has sufficient retirement income should you die, and vice versa, then you probably don’t.

So-called permanent or cash-value life insurance is often sold as a way to pay estate taxes, but again, it doesn’t look as if you’ll need that coverage. Congress increased the estate tax exemption limit for 2012 to $5.12 million, and that amount is tied to inflation going forward.

Still, this is a good question to pose to a fee-only financial planner, and you should be seeing one for a consultation before you retire in any case. Retirement involves too many complicated, irreversible decisions to proceed without help.

About to retire? Get some help

Dear Liz: I am approaching being able to retire in three years at 56, but I’m really concerned with the current market conditions. I have around $320,000 in 401(k) and 457 accounts now, all of it invested in stocks. Should I scale this back to more moderate allocations? My pension will pay me around $5,200 a month, so I do not anticipate needing to withdraw from my investments before age 59.

Answer: Even if you’ve been a die-hard do-it-yourself investor until now, it’s time to get help. Retirement decisions can be incredibly complicated, and you may not have time to recover from mistakes.

A fee-only financial planner would ask, among other things, what your current living costs are and what additional expenses you expect, such as buying another car, taking trips and so on. Those details can help determine whether your savings are adequate. The planner also would ask you how you plan to pay for healthcare in retirement, since Medicare doesn’t kick in until age 65, and an individual policy at your age could eat into that pension check. Even with Medicare, Fidelity Investments estimates, a 65-year-old couple retiring this year would need $240,000 to cover medical expenses throughout retirement — not counting any money they might need to pay for nursing home or other custodial care.

What a planner probably wouldn’t do is approve having 100% of your investments in stock at any age, even with a nice pension. You may have time to ride out another market downturn, but watching half of your life savings disappear might increase the chances you’d sell out in a panic. Having a more moderate allocation that includes bonds and cash could help cushion those market swings and keep you invested.

You can get referrals to fee-only planners who charge by the hour at the Garrett Planning Network, http://www.garrettplanningnetwork.com. If you’re looking for fee-only planners who charge a retainer or a percentage of assets, you’ll find those at the National Assn. of Personal Financial Advisors, http://www.napfa.org. NAPFA has tools for consumers at http://www.napfa.org/consumer/Resources.asp and the Financial Planning Assn. has tips on choosing a financial planner at http://www.fpanet.org/FindaPlanner/ChoosingaPlanner/.

Advice not to fund 401(k) is a red flag

Dear Liz: You recently suggested an insurance salesman be reported to state regulators because he suggested a reader stop funding a 401(k) and instead fund an insurance contract with after-tax dollars. You were way out of line. It’s very likely tax rates will be going up, so it may make sense to trade a tax benefit now for a better one in the future.

Answer: You might have a valid point if the reader were wealthy enough to be funding a life insurance policy or annuity in addition to his 401(k) contributions. Wealthier people are already facing higher tax rates, and they are more likely to be in the same bracket, or perhaps even a higher one, when they retire.

The fact that the insurance salesman suggested the reader redirect his retirement contributions to the insurance contract indicates the reader didn’t have the cash flow to do both. So it’s still quite likely that the reader will drop into a lower tax bracket in retirement, in which case he’s given up a valuable tax break now for a less valuable one in the future.

A red flag should go up anytime an insurance salesperson recommends you stop funding a tax-deductible retirement plan or that you tap home equity to buy whatever he or she is selling. That indicates the product was designed for someone wealthier than you. At the very least, you should run the purchase past a fee-only financial planner — someone who doesn’t earn commissions on product sales — to make sure you’re getting the whole story.

Insurance better than 401(k)?

Dear Liz: Recently, someone from an insurance company proposed that I stop investing through my 401(k) at work and instead invest in his insurance company contract with after-tax dollars. He claims the funds would be guaranteed so that I would never lose principal, although there would be a cap on how much I could make in any given year. His claim is that it is better to forgo the tax deduction I would get from my 401(k) contributions so that I can take the money out of this contract tax-free in 20 or 30 years. I think I am too old for this program (I am 61 now) but I thought it might be appropriate for my daughter when she enters the workforce in a few years.

Answer: You may have been pitched an equity-indexed annuity. These are extremely complex investments that should not be purchased from someone who misrepresents how they work and who encourages you to forgo better methods of saving for retirement.

Withdrawals from annuities are not tax-free. You would not have to pay income tax on the portion of the withdrawal that represents your initial contributions, but any gain would be taxable at regular income tax rates.

Furthermore, most people fall into a lower tax bracket in retirement. That makes the tax break offered by 401(k) contributions especially valuable, because you’re getting the deduction when your tax rate is higher and paying the tax when your rate is lower.

The Financial Industry Regulatory Authority, which regulates securities firms, has warned that most investors consider equity-indexed annuities and other annuity products “only after they make the maximum contribution to their 401(k) and other before-tax retirement plans.”

Even then, you probably have better ways to save. Contributions to a Roth IRA would not be tax-deductible, but withdrawals in retirement would be tax-free. If you’re able to save still more, you could contribute to a regular, taxable brokerage account and hold your investments at least one year to qualify for long-term capital gains rates, which are lower than regular income tax rates.

The other possibility is that the insurance salesman was pitching a life insurance policy that would allow you to take out a tax-free loan. Although life insurance is sometimes pitched as a retirement savings vehicle, it’s an expensive way to go. In general, you should buy life insurance only if you need life insurance. To help ensure a policy is suitable for your situation, you should take it to a fee-only financial planner—one who does not make commissions from selling investments–for review.

In any case, you don’t want to do business with someone suggests you stop funding your workplace retirement plan, and you certainly don’t want to refer him to family members. What you should do instead is pick up the phone and report him to your state insurance department.

How to keep mortgage debt from wrecking your retirement

Dear Liz: I have a first mortgage with a current balance of $32,000 at 5.625% interest. This will be paid off in about 24 months, based on regular payments plus $200 a month extra I am paying on principal. I have a home equity line of credit with a balance of $200,000 at 3% interest on which I am paying interest only ($490) monthly with an occasional principal payment when I can afford it. Between the two mortgages I am making payments of about $1,950 per month.

I am about to retire and want to reduce my payments to a more manageable amount. I do not intend to move in the near future. Income is $145,000 annually now but will be reduced to about $76,000 annually upon retirement. Should I just hold on, pay off the first mortgage and then begin making interest plus principal payments on the credit line? Or should I refinance both mortgages now into a 30-year fixed mortgage?

Answer: Ideally, you would retire your mortgage debt before you retire from your job. That’s not possible in your case, so you should focus on making sure this debt doesn’t wreck your retirement.

A spike in interest rates could play havoc with your budget. Mortgage interest rates have been extremely low for some time, but that won’t continue indefinitely. Inflation may pick up as the economy improves, which means that 3% variable rate on your home equity line of credit could march considerably higher.

Consider locking in today’s low mortgage rates with a 30-year, fixed-rate mortgage. You could get an even lower rate on a 15-year mortgage, but the payment would be significantly higher — about $1,600 a month on a $232,000 mortgage, compared with about $1,000 a month for the 30-year loan. You may prefer the flexibility of the 30-year loan, which would still allow you to make extra principal payments to pay off the loan faster without locking you into a higher monthly payment.

Can’t afford to save for retirement?

Dear Liz: Is it reasonable for a 50-year-old single man helping with support of a teenage child and earning a steady $35,000 a year to save for his retirement? Rent alone takes $800 a month; food, car and health costs leave little discretionary money.

Answer: Can you reasonably expect to live on Social Security alone? If making ends meet now is a strain, imagine trying to get by on about $1,230 a month (which was the average Social Security check in 2012). Your check could be higher or lower; you can get an estimate at http://www.ssa.gov/estimator.

If you can’t scrape by with whatever Social Security offers, then you need to find a way to save. You should be able to increase your savings once your child support ends, but you should get started now.

Don’t tap retirement funds to pay kids’ student loans

Dear Liz: I’m in my 50s. My kids have college loan debts that might total more than $200,000. I allowed them to take out loans because I expected to inherit $300,000 to help them pay off the debt. Now that inheritance will not happen.

I have $250,000 saved for retirement. When I’m 58 1/2 years old, I would like to pull that money out and pay some or all of these debts. Or use home equity. I’ve recently been downsized in employment, but I am looking to increase my income so I can help with their debt. Advice?

Answer: If your goal is to impoverish yourself so your kids will have to take care of you in your old age, by all means proceed with your plan. Otherwise, you need to rethink this.

You’ve been laid off in the middle of what should be your peak earning years. Older workers often have a tougher time than younger ones finding replacement jobs, even in a better economy than this one. You may not be able to replace your former income, which means you may not be able to add much to the amount you’ve already saved. You should be conserving your resources, including your home equity, and not squandering it repaying debts that aren’t yours.

And “squandering” is the right word. You may be able to avoid paying federal and state tax penalties on withdrawals under certain conditions; distributions made after age 59 1/2 avoid the penalties, as do those made if you’re “separated from service” if the job termination occurred in or after the year you turn 55. But you’ll still owe income taxes on the withdrawal, and those can be considerable.

Your children are the ones who will benefit from their educations. Those educations should allow them to earn incomes to repay these loans. The amount of debt they’ve accrued might be excessive — you didn’t specify how many kids, or whether this debt is being incurred pursuing undergraduate or graduate degrees. Ultimately, though, they will be in a better position to pay the debt than you are.

If you promised them help you can’t deliver, sit down with them now to break the bad news and strategize on how they can finish their educations without incurring substantially more debt.

Your story also should serve as a cautionary tale for anyone counting on an inheritance to pay future bills. Until the money is in your bank account, it’s not yours and shouldn’t be part of your financial planning.

Don’t use your 401(k) to pay debt

Dear Liz: I will be 61 in December. I have $15,000 in credit card debt at 9.9% and $41,000 in a certificate of deposit earning 3% per year. I have $590,000 in my 401(k) account. I want to pay off the credit card balance to redirect my income to paying off my $26,000 mortgage by the end of 2013. Which near-term option for paying off the credit card is better: close the CD and buy a new, lower-paying CD with the balance after paying the card off, or take a 401(k) distribution, leaving the $41,000 emergency fund untouched?

Answer: Since you’re older than 591/2, you would not have to pay penalties on any withdrawal from your 401(k). But a withdrawal would still be a bad idea for a number of reasons.

The most obvious is that you would have to pay taxes on any amount you take out. Typically 20% is withheld from any distribution, but your bill could well be higher depending on your federal and state tax brackets. In the 25% federal and 8% state brackets, you’d owe $3,750 in federal and $1,200 in state taxes on a $15,000 withdrawal. So even without penalties, you’d lose one-third of a withdrawal to taxes.

The money you take out also wouldn’t be able to earn any future tax-deferred returns for you. At 60, you have a life expectancy of a couple more decades. The money you plan to withdraw potentially could grow to more than $70,000, assuming 8% average annual returns, if you leave it alone.

So using 401(k) money to pay debt is almost as dumb for you as it would be for a younger person who would pay penalties and incur an even bigger potential loss of future tax-deferred money.

Use the CD money instead, and change your spending habits so you don’t incur any future credit card debt.

How Social Security calculates your check

Dear Liz: I have been told over the years that your Social Security monthly benefit amount is computed using years closest to retirement. I have now been told benefits are calculated from your highest earning year in your working life. Which is true? I am 61 and unable to work more than part time for physical reasons, so now my income has gone down while I’m still contributing to Social Security from my earnings. Are my lower yearly earnings for the next couple of years going to lower my overall benefit when I do start drawing my benefit?

Answer: Your Social Security benefit is not based on either your earnings close to retirement or your highest-earning year. Your checks will be based on your 35 highest-earning years. That long period helps keep you from being too badly penalized if your earnings drop toward the end of your working career. You can find out more at http://www.ssa.gov/pubs/10070.html. You can estimate your future benefits with this calculator: http://www.ssa.gov/estimator.