Running out of money is one of the biggest fears for retirees and people planning to retire. With the general population living longer and medical expenses rising each year, living within your retirement income is a major concern. According to the Centers for Disease Control, the life expectancy rates for both men and women have increased steadily since 1980.
By creating a financial plan for retirement and sticking to a disciplined withdrawal strategy, you are more likely to make your hard-earned dollars last throughout your lifetime. As you plan, keep the following considerations in mind.
Estimate how much money you'll need in retirement
As a general rule, figure you'll need about 80 percent of your current income to maintain your lifestyle when you retire. So if you earn $100,000 now, you'll need $80,000 in annual retirement income. The total sum that you will need depends on what age you retire, your life expectancy, the age that you start collecting Social Security, and the rate of investment returns. Our Retirement Income Calculator can help you estimate how much you can afford to spend each year, based on how long you want your savings to last. However, how many years you live in retirement is also a major, and unknown, factor to take into consideration.
Be disciplined about withdrawals
When you retire, you have to be careful that you don't withdraw too much money from your investment accounts. A 2011 report from the Government Accountability Office (GAO) recommends annual withdrawals of three to six percent of the value of your investments in the first year of retirement, with adjustments for inflation in later years, so that you don’t deplete your savings too quickly.
If you own a tax-deferred retirement account like a 401(k) or IRA, the tax rules allow you to withdraw money when you turn 59 ½ years of age. Generally speaking, if you take money out before that, you'll be hit with an early withdrawal penalty of 10 percent.
In addition, in tax-deferred retirement accounts (excluding Roth-IRAs), you are subject to Required Minimum Distributions (RMD). RMD means that you must withdraw a certain amount of money, depending on your age and value of your investments, from your IRA or 401(k) no later than December 31st each year (your first RMD can be delayed until April 1st of the year following the year you turn 70 ½ years of age). If you don't take the RMD on time, you'll face a tax hit of 50 percent of the amount you're required to withdraw. While this is based on current laws, it is always wise to consult a tax advisor as tax laws are subject to change with little or no notice.
Keep a stash of cash for emergencies
Financial advisors recommend setting aside some money for unexpected events such as medical emergencies or a car or home repair. Put this emergency cash in a savings or money market account so that it's easy to access when you need it. When meeting with an investment advisor, make sure to discuss a reasonable cash amount to keep accessible and what account type would work best for you.
Delay receiving Social Security payments
Although you're allowed to start collecting Social Security at age 62, many suggest that you should most likely wait to collect the benefit until retirement age (age 66 for those born between 1943 to 1954 and age 67 for those born 1960 or later) because your payment will be higher. Exceptions to this include needing the money for living expenses or a shortened life expectancy. The GAO report says people born in 1943 who took benefits on or before age 63 passed up 25 to 33 percent increases in monthly inflation-adjusted benefits that they would have gotten if they had waited until their full retirement age. Therefore, in many cases, it can pay to wait as long as you can to collect Social Security.
Contribute the maximum amount into tax-deferred retirement accounts
If your employer offers a 401(k) plan, put as much as you can afford from your paycheck into that retirement plan. For instance, even if the company matches your contribution up to three percent of your salary, try to put in even more—say, six or seven percent. When you get a raise, try to put half of it away for retirement. If you have an IRA, the maximum that you can contribute, based on 2012 limits, is $5,000, or $6,000 if you're age 50 or older. If you start contributing to a retirement account in your early 20s and keep setting aside up to 10 percent of your paycheck (and stay invested), you should be in good shape to have enough money for retirement.
Risks of being too conservative
Keeping too much of your money in a money market account or CD won't get you anywhere. And with interest rates so low, bonds may not be returning enough income for retirees. The problem is, when interest rates rise, the value of existing bonds fall. That has forced many people to chase investments with higher yields. But don't be tempted by longer-term bonds, which could lose more value when rates go up. For the conservative part of your portfolio, consider no-load bond funds with shorter duration that are well diversified. Investment advisors can help you assess your risk tolerance and help manage your investments in a way that best fits your needs.
Use Dollar Cost Averaging
Dollar cost averaging is a simple practice that involves putting a certain amount of money each month into your investment and retirement accounts. When you set up a 401(k) at work that automatically puts money into the account from your paycheck, you're using dollar cost averaging. For example, with as little as $50 from each paycheck ($100 a month or $1,200 a year), you have contributed $48,000 after 40 years. Assuming a 7 percent annualized rate of return, you would have more than $260,000. Combine that with a company match of $50 per month (making your total contribution $150 per month) and your account would be worth $390,000 (before taxes). Investing regularly, and taking advantage of your company’s 401(k) match along with the power of compounding interest, can help you on the road to building your retirement nest egg.
Dollar cost averaging takes the emotion out of investing because no matter what direction the market is going, you'll continue to buy shares of the investments you've chosen. It can allow you to purchase mutual funds with a lower initial investment, sometimes with no initial investment, as long as it is established with a minimum monthly investment as low as $50 per month (depending on individual fund family). Therefore, you don't need a large sum of money to start investing.
Try to limit taxes
As mentioned above, you can avoid tax penalties that can accompany non-Roth-IRA accounts if you don't withdraw money from your retirement accounts too early (before age 59 ½) or too late (after 70 ½ years of age). It’s possible you may also be subject to taxes on Social Security benefits if you receive wages from a job or self-employment, interest, dividends or other taxable income that pushes you into a higher income bracket. Make sure to familiarize yourself with both penalties and benefits. The tax rules can change, so it's best to seek professional advice about taxes or check the IRS website.
What to do next
- Create your investment plan with the above factors in mind.
- Be disciplined about how much you contribute and withdraw from your plan.
- Stay aware of potential tax benefits and penalties.
- Meet regularly with an investment advisor to review you plan.