By Christine Fahlund on March 13, 2012
How do you prepare for a comfortable retirement? For too many people, the answers can seem overly complex. The following four steps can help to strengthen your long-term financial position and help you reach your retirement goals.
Of all the major changes in life, retirement may pose the greatest long-term challenge. For those in their 50s or 60s and on the cusp of retirement, the prospect of leaving the workforce and a regular paycheck might be a pressing emotional concern, posing a difficult question: Am I ready? The planning tools and steps required to help you succeed are, for the most part, straightforward.
At the core of a strong retirement plan that could last into your 90s is a spending and saving strategy that will help you live within your means today and at the same time prepare you adequately for retirement. Think of your strategy as a map. Knowing where you are now and where you want to go will help you understand your future income needs and how to get there.
Project your expenses. Begin by writing down an inventory of current expenses, both essential and discretionary. Then add a "projected" column to get a sense for what you may spend in retirement. Consider changes in your spending patterns that may occur. For example, you won't be commuting to work each day, and you may have paid off your mortgage. Ask yourself if you plan to stay in your current home and how you plan to spend your time. Dream about the life you want to lead. It will help you see the steps you need to take now to move toward your goals.
Save for the income you'll need. Our research shows that you can build a sound retirement income plan if you follow some standard guidelines. The T. Rowe Price rule of thumb is to plan on replacing 75% of your preretirement income. Approximately 50% of that income may come from investments, 20% or more from Social Security benefits, and the rest from other sources, such as a pension or part-time work. Most people need to save 15% of their annual income, including any employer contributions, to achieve those percentages. On the other hand, your savings percentage may need to be higher if you're getting a late start or expect to receive numerous promotions throughout your career. Creating a spending and saving plan can give you peace of mind that you are on a well-considered path to achieving your goals.
Diversify your investments. You should hold a wide range of stock and bond sub-asset classes, including exposure to domestic and international equities and select investments in small, mid-size, and large firms. Likewise, spread your bond holdings among domestic and international bonds that vary by maturity and credit quality. This broad diversification can help insulate your portfolio from sharp declines in any one segment of the market and participate in other segments when they are doing well. And diversification can help you balance the risk and return of your portfolio. Of course, diversification cannot assure a profit or protect against loss in a declining market. Globalization has made investing more complex. In turn, it's become more important than ever to diversify your portfolio in order to prepare for a wide variety of potential events—including changes to the tax code, political unrest around the world, and rising inflation.
Diversify your tax exposure. With a Roth IRA and/or Roth Contribution to a 401(k). The majority of your retirement savings likely is held in a tax-deferred, employer-sponsored plan. You may have an opportunity to convert some of these assets to a Roth IRA and/or contribute to a Roth IRA or to the Roth source in a 401(k) to provide you with sources of income down the road that will be income tax-free (certain exceptions apply). Under current tax law, Roth IRAs and Roth source in 401(k)s may give you the greatest long-range flexibility and control over how and when your income is taxed in retirement. What is especially nice is Roth IRAs also provide similar advantages for your heirs.
- Tax-free withdrawals. Roth Contributions to Roth IRAs and 401(k)s are made with after-tax dollars, meaning that subsequent withdrawals of those contributions will be income tax-free. In addition, withdrawals of the earnings on those contributions will also be free of income tax as long as you have held the account for five years and are age 59 1/2 or older.* Roth IRAs can be an ideal source of contingency money later in retirement. If you suddenly have large medical bills, for example, you can generally tap into the account without increasing your tax liability.
- No required minimum distributions (RMDs). As the owner of the Roth IRA account, you will not have to take required distributions. (Any non-spouse beneficiaries, however, will be required to take RMDs once they inherit your Roth IRA.) 401(k)s, on the other hand, do have RMDs regardless of where the money is held. To avoid this requirement, many investors choose to roll over their 401(k) assets to a Roth IRA account prior to their reaching age 70 1/2.
- Future generations. Roth IRAs can be passed along to your heirs with many of their tax advantages intact. These inherited Roth IRA accounts are often called "stretch" IRAs, to refer to the fact that the tax-deferral of most of the assets in the account can be stretched out over many years, depending on the life expectancy of the beneficiary of the account. Imagine your children and grandchildren being able to enjoy decades of potential portfolio growth as well as income tax-free withdrawals. Their inherited Roth IRA account will have RMDs based on each account's value and the age of the inheritor, but in many cases, these are relatively modest amounts—especially if the recipient is young. Although the beneficiary may always take more than the RMD amount, "stretch" IRAs have the potential to last until the beneficiary attains age 80 or more.
*As long as the combined amount of time the original account and the inherited account have been open is at least 5 years, your heirs may take tax-free withdrawals of earnings from the account (contributions may be withdrawn tax-free at any time).
If you have a Traditional IRA, consider converting part of the account to a Roth IRA either prior to retiring or when you have retired and may be in a lower tax bracket. Since you will have to pay income taxes on some or all of the conversion amounts when you file your income tax return for that year (an exception applies if you converted assets in 2010), doing several partial conversions over a number of years may make the process more manageable financially.
Having assets in a Roth IRA will provide you with more freedom to control your withdrawals later in life because you will not be subject to required minimum distributions. Instead, you may choose to locate some or all of your most aggressive growth funds in your Roth IRA account, while you focus primarily on diversifying the balance of your portfolio and drawing down your taxable and tax-deferred accounts.
Like every feature of your retirement strategy, the goal of your estate plan should be to provide you with maximum flexibility and control over the future distribution of your assets and distributions to your heirs. Consult with your estate planning attorney and review the elements of your current plan, including titles on your investment accounts, beneficiary designations, and distribution provisions in your will and/or revocable living trust (if applicable). Your plan should:
- Include an up-to-date will and/or living trust;
- Authorize both financial and medical powers of attorney to appropriate people in the event you're unable to make decisions for yourself;
- Minimize estate taxes if your estate exceeds either the federal or your state's exemption amount (or amounts, if you are married); and
- Coordinate beneficiary designations on retirement plans and insurance policies with your overall estate plan and choose which assets to hold in joint tenancy with right of survivorship, since these designations and titles take precedence over the dispositive provisions included in your will or living trust.
Think carefully about your options when designating minor children as beneficiaries. Most state laws require money left to children to be held by a custodian only until the child reaches the age of majority, typically age 18 or 21.
No retirement plan is complete without insurance to protect against catastrophic events and liability. Some of the largest threats to your assets in retirement likely are expenses related to health care, long-term care, and accidents. The right insurance policies, with appropriate coverage, can keep certain events from jeopardizing your long-term financial security.
How much coverage is enough? The answer depends on your individual situation. Start by looking for coverage against expenses that could potentially wipe out your savings, and search out policies with premiums you can afford.
- Health. As you approach age 65, review the Medicare application process and take note of the deadlines. If you expect to remain employed after you attain age 65, check with your employer to determine whether you (and your spouse, if applicable) can delay applying for Medicare benefits until you terminate your employment. Medicare covers only about 50% of medical costs in retirement, so once you retire you will need to explore your options for purchasing a supplemental insurance policy to cover the rest, including coverage for prescription drugs. Check with your current employer to see if there will be any options to continue coverage under the company's health care plan once you retire and at what cost.
- Long-term care. Long-term care insurance is important for many people, but especially so if there is a history of long-term, care-intensive conditions such as dementia in your family or if you have no children who could assist you with daily activities. Paying out of pocket for institutional care, for example, is likely to place a significant strain on your family's assets. It's important to investigate your options early and consider enrolling in a plan while you are in your 50s or early 60s, when premiums are lower and you are still insurable.
- Liability coverage. Make sure you have purchased enough liability coverage to protect your assets. When you retire, if you have not already done so, you should consider purchasing an umbrella insurance policy. It serves to augment your auto and homeowner's insurance liability coverage and to provide you with a very large amount of overarching financial protection in the event you are ever sued. You may be surprised at the reasonable prices of many of these policies, which can go a long way toward providing you with peace of mind as you age.
- Life insurance. Ask yourself whether your family would have enough income to meet its various goals, such as college and retirement, if you pass away sooner than expected. A financial advisor can help you determine the coverage they're likely to need. If you are close to retirement, with grown, self-reliant children, you may not need life insurance coverage at all. In fact, you may choose to redirect the amount you would have spent on life insurance premiums to pay for coverage such as long-term care insurance, instead.
Revisit your plan regularly. Retirement planning is a dynamic and continual process that should enable you to achieve your ambitions. Your vision for what is important in retirement will evolve as your children and grandchildren become adults, your career progresses, and you are introduced to new ideas and experiences. Begin the planning process as early as you can, and as you approach the year you hope to retire, consider embarking on a retirement transition strategy—when you continue working but at the same time try out the life you envision for yourself. Doing this will help you adjust emotionally to future changes, as well as sharpen your vision for what you want to do next.
T. Rowe Price (including T. Rowe Price Group, Inc., and its affiliates) and its associates do not provide legal or tax advice. Any tax-related discussion contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i.) avoiding any tax penalties or (ii.) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this article.