For a lot of us, by the time we retire, our 401(k) or other plan is our biggest asset - or for some people, second only to the equity in their home. But how much do most of us know about what to do with it? Here are a few basics:
While you are still working
- It’s smart for most people to contribute to such plans, especially if it’s an employer-sponsored plan with an employer matching contribution. Even without an employer contribution, these plans reduce your taxes in the short run, build up savings you are likely to need in retirement, and (because of the tax deferral) allow your funds to grow faster than they generally would in regular, taxable investments. And if there is an employer match, that part is free money, so if you have to contribute in order to collect, do it, if it’s at all feasible for you.
- If you don’t have access to an employer-sponsored retirement plan, you are probably eligible to contribute to an Individual Retirement Account (IRA). This may also be permitted if you do have access to an employer plan, but you're more likely to run into limitations.
- Invest at least moderately aggressively while you are still in your 20s, 30s, and 40s, unless doing so makes you feel too stressed. And don’t react, at those ages, to swings in the markets. Just ride them out, and keep contributing. You'll be glad you did.
- As you get closer to retirement, move toward more conservative investment. Timing this is tricky if you try to get it just right – so don’t worry about that. If you have some risky investments, shift money out of them when the market is high relative to its recent history, but don’t fret if you don’t sell at the very peak. Hardly anyone does, and when they do, it’s just dumb luck.
- One semi-contrarian piece of advice: avoid “target date” funds – i.e., the ones that start more aggressive and automatically get more conservative as you age. These usually have high fees, may be managed more by formula than by market wisdom, and usually target a level of risk that is still too high for normal people at retirement age. In most plans, it's very easy to shift how your funds are invested, so when you you get into your 50s, just look at it once in a while, and pick opportune times to make adjustments.
- Also as you get close to retirement, contribute more to your plan. This will not only add to your financial cushion in retirement, it will help accustom you to not overspending. You come out ahead on both ends!
When you retire
- As noted above, you should already have your funds in relatively conservative investments by then. If you don’t, try to rectify it as opportunity arises. It’s rarely a good idea to move everything at once on the day you retire. You aren’t going to need to spend everything immediately, so take your time, and wait for the markets to get into a favorable position before you sell off your riskier items. And even then, it is often better to spread this out over a period of time, rather than to do it all at once.
- If you have money in an employer-sponsored plan (usually a 401(k) plan, but there are several other variations), seriously consider moving it into a self-directed IRA plan. IRAs give you the same tax advantages as 401(k) plans, but with more flexibility and potentially at much less cost. In a 401(k), you typically have a choice of several funds of different kinds among which you can divide your account. You might even have a dozen or more such choices. But in an IRA, you can put your money into just about any kind investment you can think of, including real estate. That also means any mutual fund, individual stock or bond, or bank certificates of deposit. So you have much more choice. And among those choices are ones that have much lower fees than you are probably being charged in your 401(k) plan. If you do it yourself, you can save a lot of money in such fees. Even if you hire someone else to manage it for you, you can come out well ahead.
- When it comes to withdrawing money from these plans, keep in mind two things: that such withdrawals are generally taxed the same way ordinary income is taxed, and that once you take it out, it’s out, and there’s that much less for future needs. Determining what your needs are likely to be over the entire remainder of your life is a tricky business, and unfortunately, most of the tools that financial companies make available for this purpose are complete inadequate, and are as likely to lead you into disaster as not. Be cautious. Increasingly, people are retiring without having guaranteed pensions for life the way their parents had. Except for Social Security, they need to get by on what they have saved. So it’s up to you to be prudent – keeping in mind, that if you start running out of money when you are well into your 70s or 80s or older, your odds of being able to find a job or some other new source of funds is pretty darn small.
- When considering withdrawals from savings during retirement, keep in mind your tax situation. Many retired people pay no income taxes at all, because they no longer work, and because Social Security is largely tax-free (though not if you have a lot of other income). This means that if you don’t take too much at once, you can take “taxable” income from your 401(k) or IRA or other plan, and maybe still be in the zero tax bracket. And even if you are in the 10% or 15% bracket, that’s still not bad. But the more you take out, the higher tax bracket you will be in, and the more your Social Security income will be taxed, too, so can get hit twice by making such withdrawals. So if you have both taxable sources of funds (such as 401(k) and IRA plans), and non-taxable sources (such as Roth 401(k) or Roth IRA plans, or bank savings or other investments where you have been paying taxes as you go, so there is not another hit when you spend the money), you have more flexibility. If you need to withdraw money to pay your living expenses, you can take some from the 401(k) or IRA that is potentially taxable, and take some from the sources that will not generate a tax liability. And you can alter this proportion from year to year, depending on other factors that affect your taxes. And again, you can do this yourself, or with advice from a professional. (Also keep in mind that if you retire under age 59-1/2, withdrawals from tax-advantaged retirement plans may be subject to a 10% penalty tax, though there are ways to get around this. In this situation, do some research, or consult an expert.)
- You can consider converting some or all of your retirement account to a guaranteed lifetime income. Some employer-sponsored plans offer such an option. Or you can roll funds over into an “annuity” product that you buy yourself from an insurance company, who then will pay you out for life no matter how long you live (or you can choose to cover your spouse or some other dependent as well). Again, by going outside the plan, you have all kinds of options that you wouldn’t get inside the plan.
So, as usual when it comes to retirement matters, there are lots of possibilities to think about. The best advice, though, is not to make any irrevocable decisions until you are sure about it, and have really considered your long-term plans and long-term risks.
Chuck Yanikoski is a retirement adviser who lives and works in Harvard. For more about him, visit http://www.ChuckYRetirement.com.