Is Your IRA Ready For Retirement?
You’re Ready for Retirement. Is Your IRA Ready?
You’ve made the decision to retire, but as you shift from relying on income from work to income from your assets, you’ll need to make some changes to your IRA.
There’s a lot to think about, and some important steps to take. We’ve broken down the basics into two categories.
Setting Your IRA Up for Retirement Income
Asset allocation. The mix of stocks, bonds, cash and alternatives should reflect your temperament and capacity for risk. The purpose of investing in different asset classes is to own things that do not go up and down together. When stocks are down we hope bonds are up. As you get closer to retirement you might want to dial back the allocation to stocks. Be careful not to dial it back too far, you still want growth.
Asset Location- IRAs come in two flavors, traditional and Roth. Traditional is the one where you get a tax deduction today but pay taxes later when you take the money out. Traditional is also the one where you must take distributions when you turn 72 years old. Roth is the one where you do not get a tax deduction when you put the money in, but you never have to pay income taxes on that money, or on any growth on that money. Roth is also the one where you do not have to make distributions. The money can continue to grow tax free until you die – and then you can pass it on without the restrictions on traditional IRAs.
Distribution strategy- Let's assume you retire with three “buckets” of money, Traditional IRA, Roth IRA and After tax. How you take money out of these three buckets is almost as important as how much you put in these three buckets. Common sense says to spend after tax money first and let tax free and tax deferred money continue to grow. A closer look reveals that waiting to take tax deferred money might push you into higher and higher tax brackets causing you to pay more taxes in retirement, not less. In fact, careful studies have shown that taking combinations of all three buckets, paying attention to tax brackets each year, is the best strategy. You can also increase your total net worth by using IRA to Roth IRA conversions in the early years of retirement to prevent enormous required distributions later that result in higher taxes.
Retirement Isn’t “Set It and Forget It.”
Regardless of which buckets your money is in, all of the buckets require some maintenance. Basic retirement savings hygiene includes rebalancing, reallocation and benchmarking.
Rebalancing Keeps Your Plan in Place
As investment values go up and down your asset allocation can become unbalanced. Let's look at a hypothetical portfolio of $100,000. Let's assume your target asset allocation is 60% stocks, 35% bonds and alternatives and 5% cash. Let's further assume that stocks have a great quarter and they are up 20%, bonds and alts are down 2% and cash is flat. This means that your $100,000 portfolio is now worth $111,300. The stock portion is now almost 65% and the bonds/alternatives are 30%. If you want to stay strictly in balance you should sell $5,220 worth of stock and use it to buy bonds. Easy,right? Not so fast, what would be going through your head at this point? Would you really be eager to sell your stocks? What if they keep going up? What if bonds keep going down? There are plenty of experts that advocate for letting the winners run a little bit. They might be right or they might be wrong. Once you start to second guess you are in the world of market timing. There is a ton of research out there that says market timing does not work. You need to have the discipline to stick to your plan.
Re-allocation
At least once a year it is recommended that you reassess your overall allocation. Each year you get closer to your goal, perhaps your situation has changed, you make more or less income, expenses rise or fall, maybe a family member needs care. All these things can affect your appetite for risk.
There are three components to assessing your overall risk tolerance.
1. FirstCapacity for risk. Capacity can be thought of as your ability to take a risk based on your time horizon, which is how long it will be you need the money, and whether what you need it for is life sustaining or just for fun. How much money do you actually have is the baseline of this.
2. Next you want to consider your tolerance for risk. How comfortable or uncomfortable are you when the market is whipsawing up and down?
3. Finally you should consider your emotional response to risk. At a deeper level do you become fearful in the face of uncertainty?
Benchmarking
Another important piece of annual maintenance is figuring out where you stand relative to indexes or other benchmarks. Benchmarking lets you compare performance and fees. If you are investing in actively managed funds and ETFs that are trying to beat the indexes, you will want to know if they're doing what you are paying them to do- beating the index.
The data shows that most active managers are unable to consistently outperform the indexes. Even when using index funds, you want to make sure that the fund is accurately tracking the desired index.
Fees are another area that you want to include in your benchmark analysis. There are usually two layers of fees that you should be concerned about. The first is the fund level expenses. These are the daily costs of administrative and trading activities. The other fee is for the investment advisor. Most investment advisors charge a percentage of the assets they manage. Make sure you know how and how much your advisor gets paid.
The Bottom Line
Retirement planning sounds complicated, and it is. Ensuring that your assets will not only last as long as your retirement – that they’ll provide you with the retirement you want – is a process. Thinking about the steps independently, and then building a sustainable plan that combines each piece is the core of financially sound retirement.
