Start Planning Early

Renowned investor Warren Buffet reportedly once said, “Someone’s sitting in the shade today because someone planted a tree a long time ago.”

Indeed, one of the keys to overcoming retirement concerns, and to creating a successful retirement, financial security, and peace of mind, is having a plan.  And it’s never too early to start thinking about what you’d like your retirement to look like.

A robust financial plan will include retirement planning as a key element.  As part of the process, you’ll want to think about where you’d like to live once you stop working, and how you’d like to fill your days.  Perhaps you’ll never fully retire, but just gradually reduce the amount you “work”.  Maybe you’d like to volunteer, or spend time traveling the country or the world.  If you have a family, you’ll almost certainly want visit your children and grandchildren.

In the planning process, you and your advisor will attach price tags to many of these goals that you’ve created. How much income you’ll need for your living expenses, how much you’d like to spend on travel, and how much you’d like to give to family and/or charities and other worthy causes.

Another well-known expression is, “Save early, save often”. By getting an early start on saving for retirement – and for your other financial goals – you give yourself the best chance of success. That’s due to what’s known as the “magic” of compounding.  Compounding is what makes even a small sum of money to grow into a large amount, if given enough time.  How does it work?

Well, your savings account earns a return.  Over time, your account will generate earnings on your old and new contributions, as well as on past earnings you’ve accumulated (“earnings on earnings”).   As your savings grow, you generate earnings on a bigger and bigger pool of money. It’s like a financial snowball effect.

For reasons that we’ll discuss below, you’ll want to accumulate savings in different types of accounts: taxable, tax-deferred, and tax-free. Taxable accounts include checking and savings accounts, and traditional brokerage accounts. Tax-deferred accounts include employer-sponsored retirement plans like 401(k)s, 403(b)s and profit sharing plans, and traditional Individual Retirement Accounts (IRAs). Tax-free accounts include the Roth versions of 401(k)s and IRAs.

Get the Right Investment Mix

One of the biggest retirement concerns for investors is deciding what to invest in. That’s where “asset allocation” comes in to play.

Asset allocation is one of the most basic and important concepts in investing. It refers to the strategy of dividing your investments among different categories of investments, or “asset classes” – such as stocks, bonds, real estate, cash, and cash alternatives.

Your asset allocation is what will determine how risky your portfolio is. If you increase the percentage that you’re investing in risky asset classes – like stocks – your returns will fluctuate more. That sounds bad, so why would you do that? Well, because with investing, risk and return are related. Simply put, if you’d like your portfolio to generate more return, you have to increase your exposure to risky asset classes.

Within each of the asset classes you include in your portfolio, you should own as many securities as you can. Why? Because this “diversification” will eliminate the risk that one underperforming investment can permanently damage your portfolio.  The best way to get adequately diversified in an asset class is to use a mutual fund or exchange-traded fund, rather than individual securities.

But what’s the right asset allocation? Well, that will depend on how much return you need from your portfolio. At Springwater, one of our guiding principles is that we prefer to have our clients take as little investment risk as possible, while still ensuring that their plans “work”. For some, that might mean only 25-30% allocated to stocks, while for others it might mean 65-70%.

So, the starting point for a discussion about what your investment mix should be is what level of return is needed for your plan to succeed.

Understand Total Return Investing

Once you’ve determined what the appropriate investment mix is for your portfolio, you’ll need to implement it.  An important concept to understand when doing so is “total return investing”.

When preparing for retirement, some investors worry that they’ll need to use some of the principal for income.  What they don’t realize is that generating enough income solely from interest and dividends requires a very large portfolio, and isn’t a realistic approach for most investors. The current low interest rate environment makes this even less practical.

A total return approach to investing is one that recognizes that investors should focus on generating the highest possible after-tax return, for a given level of portfolio risk. They should be indifferent as to the source of the income – it could be interest, dividends, or capital gain from price appreciation.

As an example, which portfolio would you rather own:

Portfolio A, which is invested 60% in a few stocks that each pay a regular 5% dividend, but don’t appreciate in value much, or Portfolio B, which is invested 60% in a selection of mutual funds that pay a 2-3% dividend, and appreciate by 10% per year?

Hopefully you answered, “Portfolio B”. While its dividend income stream is much smaller, you could sell a bit of your fund holdings each year, pay a little capital gains tax, and have a better after-tax return from a more well-diversified (and likely less risky) portfolio.

Use Tax-Efficient Withdrawal Strategies

The sequence in which you withdraw money from your investment and retirement accounts can have a major effect on how much you’ll keep and the taxes you’ll pay.

Retirees often simply take money from an account that’s most convenient, or sell investments based on speculation about the direction of the market or the prospects for a particular company. But understanding the tax consequences of distributions from different types of accounts can be very beneficial.

You probably already know that you’ll pay income tax on distributions from your traditional IRA and 401(k) retirement account. So, if you’re retired in your 60s, the first account to access for income would typically be your taxable brokerage account. The reason is that money taken from a brokerage account isn’t subject to income tax, because you originally funded the account with after-tax dollars. While you might have to pay some capital gains tax when you sell an investment in a brokerage account, it will almost certainly be less than ordinary income tax rates.

Once you turn age 72, though, the best order for withdrawals will change slightly.  That’s because at that age the IRS will require you to start taking so-called required minimum distributions from your IRAs and retirement plan accounts.  The dollar amount of those distributions is based on your age and the value of the accounts. Taking your RMDs on time should be your top priority, because there are harsh penalties for not doing so.

Roth IRAs, which are funded by after-tax contributions, should generally be saved for last. Since Roth account withdrawals are free of both income and capital gains taxes, it makes sense to allow these accounts to continue to grow as long as possible.

Each year, your CPA and financial advisor can help you determine how to generate the income you’ll need in the most-tax efficient manner. This is what’s known as income distribution planning.

Consider Working with An Advisor

If you’re not already working with an advisor, you should ask yourself if it would be helpful to do so once you retire. Here are a few questions you can ask yourself, to help you decide:

Do you have an aptitude for investment management?

The responsibility for managing your nest egg is a significant one, and you shouldn’t delegate it to someone without a successful track record – even if that person is yourself. While investment management isn’t literally rocket science, it isn’t something that everyone can do, either. You would need to educate yourself about the science of investing, and keep abreast of changes in the field of financial economics and investment theory.

Do you have an affinity for managing your investments?

You may find that you have the aptitude for managing your own investments, but simply don’t enjoy it. If you find yourself dreading the time you’ll need to commit to properly and prudently managing your portfolio, the results will eventually reflect that.

Do you have the time for it?

Managing your own portfolio isn’t a full-time job, but it’s much more than a hobby that will only take you a few minutes now and then. If you’ve worked for decades in anticipation of retirement, you may not want to dedicate the time needed to do justice to the management of your portfolio once you stop working.

Do you know how you’ll respond during a major market downturn?

One of the biggest benefits of working with an advisor is that they can act as a dispassionate filter between your emotional reactions and your portfolio. You should honestly assess your response to the March 2020 stock market correction, the 2007-09 Great Recession and, depending on your age, possibly also the 2000-02 dot com crash. If you let your emotions influence your investment decision-making, it’s probably better to hire an investment adviser.

If you can’t definitively answer yes to all four of these questions, you’ll be best-served by hiring a financial advisor to help you manage your portfolio once you retire, and likely also before then.

You can find a qualified, experienced financial advisor online, and the best places to start your search are the websites for the National Association of Personal Financial Advisors, the Financial Planning Association, and the CFP Board.

In summary, if one of your retirement concerns is the prudent management of your investment and retirement accounts once you retire, you should build a plan, get the right investment mix, understand total return investing, familiarize yourself with tax-efficient distribution planning, and, last but not least, consider working with an advisor.