Early IRA withdrawals - 72(t) Distributions

Well, I am not in a place where I'm able to take early distributions yet, but I came across a nifty way to take distributions without the 10% penalty before age 59 1/2 if you are so inclined.

Note: PLEASE do not do this simply to get at some money early!! But, if you are in a sweet spot and have a couple million in an IRA and still have a few years until 59.5, read on!

72(t) Distributions

First, please note that you still get taxed at your marginal rate on the amount of the distribution. You are only saving yourself the 10% early withdrawal penalty!
Second, you have three methods of determining how much you withdraw -- you cannot just take any old amount.
Third, once you start taking these withdrawals, you have to continue for either five years or until you reach age 59 1/2 -- whichever in LONGER.

The three methods are:
1) Balance divided by your life expectancy.
2) Balance divided by an annuity factor.
3) Balance amortized across your life expectancy with an pre-specified growth rate.

Method 1 results in the smallest annual payment. 2 and 3 seem to usually come pretty close to the same amount, and they can be more than half again the amount from #1.

As always, consult a tax adviser and consider reading the tax code yourself (you were trying to go to sleep,right?). There is a calculator here (http://www.dinkytown.net/java/Retire72T.html) that allows you to see how much you could take now. Have fun!

Regards,
Trond

Retiring on 70% of your income

One person commented on my most recent 401(k) post (thanks, Ming!).
Although the main point of that entry was a way to jazz up the returns within your defined contribution plan (allocate most of your contributions towards stock mutual funds, and transfer more in during down stock market periods), I mentioned that most people underestimate the amount of money they will need in retirement: those assuming they could retire on 70% to 80% of their pre-retirement income could be in for a nasty shock. Ming took exception to this.

(I love comments, by the way, positive or negative – please keep them coming!)

His arguments make sense, by the way, for him. One's income and lifesytyle are so personal that you can't pigeonhole everything into nice, neat packages and say, “Voila, here's your plan!” Everyone's idea of what the ideal retirement situation will be different, and there is no “right” or “wrong.” Depending on expectations and what makes you comfortable, you might need thousands a month more, or less, than someone else in your golden years. The two things I would consider sad, though. are to have the amount in your retirement fund limit what you want to do, or to run out before you die.

Comment:
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I'd have to say to a certain extent I disagree.
When you retire, you'll typically need less than what you need now. Especially if you've purchased a home. I honestly don't expect to continue giving my mortgage company any more money after I've paid off my mortgage. Honestly, my mortgage is about 30% of my current living expense, so I don't believe my standard of living would be lower when I retire at only 70% of my current income. And I can see the justification for people believing that they can live off 70% of their current income too.
Personally, I don't know if I'd stay in California eiher. I could easily move to another state where there is little or no property tax (ie. TX) or where there is no sales tax (ie. OR). I could even move up to Alaska (AK) where the US govt would give me a stipend to live there and make my home up there. Though I don't know if I could handle so many months with no sun light.
Now in terms of medical expenses, we'll just put a couple of democrats like Hiliary or Obama in office and all our medical expenses will be covered... or we could simply move to Canada.
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So – the major points are 1) owning one's home will decrease your expenses 2) moving to lower income/tax advantaged locations 3) universal healthcare.

Let's deal with #3 first – and although I recognize the humor, let's treat this seriously. I don't have exact numbers in front of me but Medicare cost about 1/3 of a TRILLION dollars in 2006. I would submit that expanding Medicare to everyone, and having it cover “everything” will cost $4+ trillion dollars. With the US Gross Domestic Product at around $13T, I just don't see this happening. Even expanding it slightly will increase taxes for most of us.
(For a good read on both Social Security and Medicare funding, read http://www.arlingtoninstitute.org/wbp/economic-collapse/438#)

Regarding #1, of course you won't be paying off the mortgage forever. Here a couple thoughts, however.
Once the mortgage payment is gone, so is that sweet interest deduction. Do me a favor and recalculate what your taxes would have been this last year without that! And I keep harping on it – but taxes in general will be going up in the future!
Okay, so you're still looking at much more disposable income once the mortgage is gone. Recall my other point; once you are not spending 8+ hours a day at a job, you will want to DO something with that time. Recreational activities will become a larger percentage of your expenses – maybe not 30% but a good chunk of it. Will you enjoy dining out more? Travel? That hobby you always wanted to try your hand at?
Finally, as you get older, and assuming you stay in your house, will you need to spend some money to remodel your house to make it more comfortable and safer?

On #2, there are two points worth mentioning.
The first relates back to your mortgage – now you're selling your house here. When you buy your retirement home, is it a small condo in North Dakota? Or somewhere really nice, with lots of amenities and by the coast in a place where you still pay a “sunshine tax”? If you opt for luxury, you may end up, if not with a new mortgage, then perhaps with not quite the nest egg you thought you had in home equity.
The second is that there really is no such thing as a free lunch. If you move to a state with no income tax, then property taxes or rent is going to kill you. If there is no sales tax, then odds are that you'll see a hefty income tax.

Yes, if you are spending a good percentage now on your mortgage, then you may not need to replace all your income when you retire. But let's shift our focus to instead talk about that retirement and the "bucket" concept.

Ideally you will have multiple “buckets” to dip money out of at retirement. Having different income streams allows you some flexibility in managing income, taxes, and even inheritance issues.

• First, looking at social security, benefits are taxable at 50, 85, or 100% of your payments, depending on your filing status and other taxable income. Given the size of the deficit and the disregard we've paid the trust fund, I think you have to plan on having payments highly means-tested and overall benefits reduced within the next twenty years or so.
• Most people will have some sort of funds within either traditional IRAs or 401(k)s. This too will be counted as taxable income – and again I think you have to at least plan for higher tax rates in the future. However, this portion of your funds is at least to a large degree under your control (most people do not fully fund their 401(k) or IRA at the legal limits). This portion may be one of the largest percentages of your assets at retirement.
• Roth IRA / 401(k)s – the golden goose. PLEASE fund this at the maximum allowed. I truly expect Congress to stop allowing these at some point when they realize they've given away the farm – I only hope they grandfather in existing balances.
• Pensions or other defined benefit plans seem to be going by the wayside. Too many seem to be slashing expected benefits, or coverages for me to be confident in them for the long term.
• Finally, if you have a large amount stashed away on non-retirements funds, congratulations! Being able to cash in a $20,000 CD every year to aid in your expenses, or sell some stocks from your brokerage account to help a child's down payment on their first home is wonderful. Again, I unfortunately just don't see most people having this option, as saving and investing INSTEAD of consuming doesn't seem to come naturally to most of us.

Some of these are beyond our control, such as Social Security. Some, such as brokerage accounts or CDs, are up to you to take the first step. The old saw "He didn't plan to fail -- he just failed to plan" comes to mind. Take the time now to review your budget and decide where you can free up money to invest in your future -- because it will only be as good as YOU make it.

Regards,
Trond

401(k) investing for dummies

People talk about the stock market being risky. I see risk as running out of money halfway through your retirement!

If you withdraw $50,000 per year starting at 65, at only 3% inflation you would need to withdraw $75,600 at age 80 to maintain your standard of living. At 90 you are looking at taking out $101,600! Are you going to have enough to comfortably live in retirement? Or are you going to spend your golden years working part time under the Golden Arches to supplement your income?

An argument I've heard is that you need much less income to live on once you retire -- 70% to 80% of what you earned will be enough.
I say, ummm, no.
You will likely not have a company health plan to subsidize your costs. Taxes will almost certainly be higher in the future (remember that lovely economic stimulus check you received a month ago? Guess how long we'll be paying off those billions of dollars?).
And guess what? You're retired – no job to suck up 8 hours a day. What will you DO in those hours and days and weeks? Travel? Hello expenses! Golf lessons? I hope you are friends with the local pro. Nearly anything you do will involve higher leisure expenses

To combat all this, how would you like to add a couple percentage points of annual return to your 401(k) investments? Read on!

Let's get a few facts straight about 401(k)s, mutual funds, and market tendencies before getting to the meat of the post.

401(k):

• In your 401(k), you have a select group of mutual funds that you can contribute to.
• You may also have the option to buy your company's stock. (This post will deal with only the mutual fund option)
• You can change how you want future contributions allocated across the various funds (you may have conditions on this; once a month, once per year, etc.)
• You can also transfer existing money between funds. There may be conditions on this option too – recently many funds have started charging fees if you transfer money out within a month or two of having moved the money into the fund.

Mutual Funds:

• Mutual funds are basically group investments. A group of investors pool their money and it is professionally managed. The positives for the group is that they do not have to micro-manage their investments, costs are shared amongst everyone, and the professional money manager has greater information (usually!) and resources available to find potential investments. The negatives are that most funds tend to NOT do quite as well as whatever base or index it is measured against, and that fees can sometimes be quite high.
• Funds have rules about not putting all their eggs in one basket – they have to be diversified.
• Most mutual funds available through 401(k)s are grouped by whether they are stock funds, bond funds, or cash (money market) funds.
• Money market funds (also known as cash or GIC funds) keep all money liquid and available, and only earn whatever the prevailing interest rate is.
• Bond funds are divided into the duration of the bonds bought and by the relative safety of the bonds. Typical durations are short, medium, and long term, while safety ranges from government insured to corporate paper to municipal (or general obligation), to high yield (or junk) bonds.
• Stock funds are divided into large, middle, or small cap depending on the size of the companies they invest in. They can be domestic, regional, or worldwide. They are also typically segregated by the style they exhibit – value (under priced to what they should be worth), growth (strong earners), or mixed.
• Some funds are specialty – they deal with an index, real estate, technology, health care, or dividend stocks exclusively.

Tendencies:

• Stocks tends to be cyclic, like waves. However, the general tendency is for each succeeding crest to be higher than the prior wave.
• Over time, the stock market tends to return the highest returns. Bonds are next, and then money markets.
• These higher returns are over the long term – usually periods of 10 years or more.
• Inflation averages around 3% -- and this government-stated rate is less than the real rate experienced by people living normal lives. Housing and college costs, for example, were taken out of the calculation back in the 1980s! I would submit the real rate people face is closer to 4%, when the recent increases in energy and health care are factored in.
• If bonds return around 6% on average, after inflation you only see a 2 or 3% real return!
  With increasing life expectancies and better health care, a worker retiring at age 65 in good health needs to plan to have retirement income for at least 30 years!

Since over time, stocks give you the highest returns, and you need to have your money working for longer than ever, I don't see why most people should not be nearly 100% in stocks.

The standard argument for diversifying over different classes is that as one type under performs, other types over perform, and thus the risk is reduced. I think I covered my point of view on risk at the beginning of this article!
The other argument I've heard as to the benefits of diversification is the psychological one. People are not good investors – they see their holdings going down in value and they sell. In essence, they have bought high and sold low. Then when the market starts booming, Johnny-come-lately plows his money back into the latest technology fund to start the cycle all over again. My response to this argument is 1) the person reading this is hopefully not the average person, and 2) a little willpower and a plan helps to inure oneself against temporary losses.

So, point number one to add sizzle to your annual returns is to be invested almost totally in stock mutual funds. Remember – this is advice only for 401(k)s, where you have only mutual funds available to you, and you are by definition “in it” for the long term. My target is 90% for everyone that is more than 10 year away from retirement, and 80% for those within that 10 year span.
Which funds? We'll address that in a future post – but in general a breakdown of 30% foreign stocks, 30% “total stock market” indexes, and 20 – 30% mid-cap or value funds is sufficient. If you have a choice between similar funds, make sure you invest in the one with lower annual fees!
The remainder (10 – 20%) of your contributions should be into medium term, medium risk bond funds. You want something that will beat inflation but not (again, over time) run too much risk of negative returns.

Now for the second ingredient for red-hot returns: remember how the stock market goes up and down over time? We are going to modify the old bromide “buy low and sell high” to simply, “buy stock funds low.”
As a general rule, look at the charts of the S&P and the NASDAQ 4 times a year, in Feb, May, Aug, and Nov. If either index is down 10% from where it was one year prior, then put in an order in your 401(k) to transfer 10% to 20% from the bond fund into the stock funds. (If you have less than 10 years until retirement, move 10%, otherwise move 20%.)

And that is it! You are taking advantage of the cycles and also taking emotions out of the process. When the stock market is doing well, you're hoarding some money in reserve – and when it tanks, you're buying low. Call me in 30 years and thank me.

Regards,
Trond

Up, up, and away!

My nephew just got his pilot license and was hired at a major airline. Congratulations!!
(got engaged too... congrats to you both!)

I, of course, am going to turn this into a lesson. :-)

You have joined a profession that, from my limited Googling, appears to have a decent starting salary and that can easily turn into an extremely well-paying career, six to ten years down the road. I'll whip out the old cliche though -- it ain't how much you make, it's how much you keep.

Most companies are turning away from pension-type plans, and opting into defined contributions plans -- or 401(k)s. If yours offers one, please, *please*, just fill out the paperwork to start contributing 10% as soon as they let you!

Now, 10% is a pretty large chunk of change for someone to voluntarily give up. You have probably already estimated your paycheck and have spent it all mentally already. Don't!!

First, the good news. 401(k) contributions don't count towards earned income, and so you'll pay less taxes than you otherwise would. If you make $30,000 and contribute $3,000, then you only get taxed on $27,000 of income (heh -- read an earlier post and you'll see I'd love for you to also contribute $5,000 to a Roth IRA).

Next, the really good news. Employers typically will also contribute some money for you too, based on what you put in. Let's say it is 50% of your contributions, up to your 10%. So -- you put in 10%, they put in 5%, so you've added $3,000 to your retirement, they've added $1,500, and you've lowered your taxes.

Finally, the best news. As your investments grow, they do not get taxed while in this account. That is called tax deferred compounding, and it's a beautiful thing. Sure, in 30 years if you retire and take some out, that gets taxed -- but 100% of it gets to compound in the meantime, year after year.

Downside? You might only go to Starbucks once a week instead of every day. Upside? How does retiring at age 50 - 55 grab you? If you contribute 10% from day one, you'll be in a position to retire early!

Next week: what funds to invest in for a rookie. :-)

Regards,
Trond