Retirement
Planning Guide
Retirement planning is a multistep process that evolves over time. To have a comfortable, secure and fun retirement, you need to build the financial cushion that will fund it all. The fun part is why it makes sense to pay attention to the serious and perhaps boring part: planning how you’ll get there.
Retirement planning starts with thinking about your retirement goals and how long you have to meet them. Then you need to look at the types of retirement accounts that can help you raise the money to fund your future. As you save that money, you have to invest it to enable it to grow.
The surprise last part is taxes: If you’ve received tax deductions over the years for the money that you’ve contributed to your retirement accounts, then a significant tax bill will await when you start withdrawing those savings. There are ways to minimize the retirement tax hit while you save for the future and to continue the process when that day arrives and you actually do retire.
We’ll get into all of these issues here. But first, start by learning the five steps that everyone should take, no matter what their age, to build a solid retirement plan.
Key Takeaways
- Retirement planning should include determining time horizons, estimating expenses, calculating required after-tax returns, assessing risk tolerance, and doing estate planning.
- Start planning for retirement as soon as you can to take advantage of the power of compounding interest.
- Younger investors can take more risk with their investments, while investors closer to retirement should be more conservative.
- Retirement plans evolve through the years, which means portfolios should be rebalanced and estate plans should be updated as needed.
Understand Your Time Horizon
Your current age and expected retirement age create the initial groundwork of an effective retirement strategy. The longer the time from today to retirement, the higher the level of risk that your portfolio can withstand. If you’re young and have 30-plus years until retirement, you should have the majority of your assets in riskier investments, such as stocks. There will be volatility, but stocks have historically outperformed other securities, such as bonds, over long time periods. The main word here is “long,” meaning at least more than 10 years.
Additionally, you need returns that outpace inflation so you can maintain your purchasing power during retirement. “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it” Albert Einstein once said.
In general, the older you are, the more your portfolio should be focused on income and the preservation of capital. This means a higher allocation in less risky securities, such as bonds, that won’t give you the returns of stocks but will be less volatile and provide income that you can use to live on. You will also have less concern about inflation. A 64-year-old who is planning on retiring next year does not have the same issues about a rise in the cost of living as a much younger professional who has just entered the workforce.
You should break up your retirement plan into multiple components. Let’s say a parent wants to retire in two years, pay for a child’s education at age 18, and move to Florida. From the perspective of forming a retirement plan, the investment strategy would be broken up into three periods: two years until retirement (contributions are still made into the plan), saving and paying for college, and living in Florida (regular withdrawals to cover living expenses). A multistage retirement plan must integrate various time horizons, along with the corresponding liquidity needs, to determine the optimal allocation strategy. You should also be rebalancing your portfolio over time as your time horizon changes.
You might not think that saving a few bucks here and there in your 20’s means much, but the power of compounding will make it worth much more by the time you need it.
Determine Retirement Spending Needs
Having realistic expectations about pot-retirement spending habits will help you define the required size of a retirement portfolio. Most people believe that after retirement, their annual spending will amount to only 70% to 80% of what they spent previously. Such an assumption is often proven unrealistic; especially if the mortgage has not been paid off or if unforeseen medical expenses occur. Retirees also sometimes spend their first years splurging on travel or other bucket-list goals.
As, by definition, retirees are no longer at work for eight or more hours a day, they have more time to travel, go sightseeing, shop, and engage in other expensive activities. Accurate retirement spending goals help in the planning process as more spending in the future requires additional savings today.
Your longevity also needs to be considered when planning for retirement, so you don’t outlast your savings. The average life span of individuals is increasing.
Actuarial life tables are available to estimate the longevity rates of individuals and couples (this is referred to as longevity risk).
Additionally, you might need more money than you think if you want to purchase a home or fund your children’s education, post-retirement. Those outlays have to be factored into the overall retirement plan. Remember to update your plan once a year to make sure that you are keeping on track with your savings.
Calculate After-Tax Rate of Investment Returns
Once the expected time horizons and spending requirements are determined, the after-tax real rate of return must be calculated to assess the feasibility of the portfolio producing the needed income. A required rate of return in excess of 10% (before taxes) is normally an unrealistic expectation, even for long-term investing. As you age, this return threshold goes down, as low-risk retirement portfolios are largely composed of low-yielding fixed-income securities.
If, for example, an individual has a retirement portfolio worth $400,000 and income needs of $50,000, assuming no taxes and the preservation of the portfolio balance, they are relying on an excessive 12.5% return to get by. A primary advantage of planning for retirement at an early age is that the portfolio can be grown to safeguard a realistic rate of return. Using a gross retirement investment account of $1 million, the expected rate of return would be a much more reasonable 5%.
Depending on the type of retirement account that you hold, investment returns are typically taxed, namely capital gains. Therefore, the actual rate of return must be calculated on an after-tax basis. However, determining your tax status when you begin to withdraw funds is a crucial component of the retirement planning process.
Assess Risk Tolerance vs. Investment Goals
Whether it’s you or a professional money manager who is in charge of the investment decisions, a proper portfolio allocation that balances the concerns of risk aversion and return objectives is arguably the most important step in retirement planning. How much risk are you willing to take to meet your objectives? Should some income be set aside in risk-free asset protection class strategies for required expenditures?
Stay on Top of Estate Planning
Estate planning is another key step in a well-rounded retirement plan, and each aspect requires the expertise of different professionals, such as lawyers and accountants, in that specific field. Life insurance is also an important part of an estate plan and the retirement planning process. Having both a proper estate plan and life insurance coverage ensures that your assets are distributed in a manner of your choosing and that your loved ones will not experience financial hardship following your death. A carefully outlined plan also aids in avoiding an expensive and often lengthy probate process.
Tax planning is another crucial part of the estate planning process. If an individual wishes to leave assets to family members or a charity, the tax implications of either gifting or passing them through the estate process must be compared.
Estate planning is another key step in a well-rounded retirement plan, and each aspect requires the expertise of different professionals, such as lawyers and accountants, in that specific field. Life insurance is also an important part of an estate plan and the retirement planning process. Having both a proper estate plan and life insurance coverage ensures that your assets are distributed in a manner of your choosing and that your loved ones will not experience financial hardship following your death. A carefully outlined plan also aids in avoiding an expensive and often lengthy probate process.
Tax planning is another crucial part of the estate planning process. If an individual wishes to leave assets to family members or a charity, the tax implications of either gifting or passing them through the estate process must be compared.
$11.7 million
The 2021 ceiling for assets in an estate that aren’t subject to federal estate taxes. Amounts that exceed this limit are. The amount excluded from federal taxes is $12.06 million for 2022.
What is Risk Tolerance?
Risk tolerance is how much of a loss you’re willing to endure within your portfolio. Risk tolerance depends on a number of factors, including your financial goals, income, and age.
How Much Should I Save for Retirement?
One rule of thumb is to save 15% of your gross annual earnings. In a perfect world, savings would begin in your 20’s and last throughout your working years.
What Age is Considered Early Retirement?
Age 65 is typically considered early retirement. When it comes to Social Security, you can start collecting retirement benefits as early as age 62. But you won’t receive full benefits as you would if you wait to collect them at full retirement age instead.
The Bottom Line
The burden of retirement planning is falling on individuals now more than ever. Few employees can count on an employer-provided, defined-benefit pension, especially in the private sector. The switch to defined-contribution plans, such as 401(k)s, also means that managing the investments becomes your responsibility, not your employer’s.
One of the most challenging aspects of creating a comprehensive retirement plan is striking a balance between realistic return expectations and a desired standard of living. The best solution is to focus on creating a flexible portfolio that can be updated regularly to reflect changing market conditions and retirement objectives.