With Baby Boomer clients retiring by the thousands, the proper handling of their retirement accounts, such as 401(k)s, has become more vital.
This isn’t rocket science, according to a recent Morningstar report. Then again, clients must decide how they’ll get that money to last them through retirement. And the first half of 2018 has been volatile enough that pre-retirees and retirees should check up on how their bucks are doing.
“You have to make sure that you're not spending more than is prudent and that your investment portfolio appropriately balances safety and growth potential,” according to Morninstar’s Christine Benz.
So here are the five key strategies to consider or clients nearing retirement:
1. Year-to-date spending
Clients’ withdrawal rates are the first place to start. Calculate that by dividing the total amount a client’s expects to spend this year by the portfolio's balance. Be sure to take tax effects into account.
If the client is spending $70,000 each year and need to pull $85,000 from the IRA each year to arrive at the target amount after taxes, the withdrawal rate should obviously be based on the higher number. A lot of guidance considers the 4 percent withdrawal guideline as a reasonable starting point. But clients should consider their own situation before taking out 4 percent.
Their anticipated drawdown time horizon is crucial. That’s because the original 4% research was based on a 30-year horizon. But older clients should shorten that time while younger ones should lengthen it.
2. Check the asset allocation
Over time, portfolios with higher equity weightings tend to have higher withdrawal rates than more conservative portfolios. Much of the recent research related to withdrawal rates points toward connecting withdrawals to market performance, which may make the portfolio last longer.
After all, clients’ withdrawal rate “is the key gauge of the viability of their plan, but their portfolio's asset allocation is a close second,” according to Morningstar. “Bonds have been no great shakes lately, but not having enough safe securities could force you to withdraw from stocks when they're down, which could impede clients’ portfolios’ long-run sustainability. So, if they err on the side of holding too much in safe securities, they risk inflation gobbling up their skimpy returns and even more.”
Morningstar considers three “buckets” of portfolio withdrawals and how they might affect returns: ultra safe is cash, reasonably safe is high-quality bonds, and aggressive is equities or stocks.
Bonds, for instance, have been flat to down the first part of 2018, and investors have been reluctant about them. But starting bond yields predict what to expect for this asset type. Rising yields mean bond prices decline in the short term (it’s an inverse relationship), so clients will benefit from those higher yields eventually.
3. How’s the cash doing?
Cash or liquid, reserves also need a closer look. Morningstar considers a six-month to two years’ worth of portfolio withdrawals as a reasonable cash allocation for retired clients. But they may want to consider pushing it to three years of withdrawals as higher cash yields are offered.
Also, don’t forget that inverse relationship in No. 2: The difference in yield between FDIC-insured cash and high-quality bonds is still low. But interest-rate increases are a net positive for cash clients but they can hurt bond investors.
4. Don’t forget converting individual retirement accounts (IRAs)
In late 2017, the biggest tax reform in 30 years was passed. Under the Tax Cuts and Jobs Act (TCJA), converting some of clients’ traditional IRA balances to Roth accounts may cost less than it would have cost last year.
Clients will pay income tax on converted amounts (unless the account includes after-tax dollars), they’ll avoid taxes on withdrawals after they’ve converted if they’ve met the five-year rule and also avoid required minimum distributions. That makes it a good time to consider IRA conversions, which offer more control over incomes and tax bills in retirement years.
“A tax advisor or tax-savvy financial advisor can help [clients] determine how much to convert without pushing into a higher tax bracket,” according to Benz.
On the flip side, IRA balances have grown. That means that any taxes payable upon conversion will be based on the higher balances. One of the key retirement-related changes in the TCJA is that re-characterizations of IRA conversions made after year-end 2017 are no longer allowed. That means there’s no do-over if clients convert an IRA at a bad time.
5. Clients should determine how they want to take required minimum distributions
There are several ways to do this. Clients who are older than 70-1/2 and must start taking required minimum distributions (RMDs), should start thinking about where they’ll get the money for the RMDs.
They have until the end of the year to do that, and may even get a tax benefit from waiting. But don’t wait too long. Retired clients may want to take their RMDs from the income that their stocks generate, which creates a type of ready-made RMD, according to Morningstar.
Other retirees might take RMDs by rebalancing, which can also reduce portfolio risk. Something else to consider: The interaction between RMDs and withdrawal rates.
If the distributions will be more than clients need or be more than they want to take, they can invest them in a taxable account. Or, invest them in a Roth IRA as long as that isn’t more than the annual allowed contribution limit.
About Terry Sheridan
Terry Sheridan is an award-winning journalist who has covered real estate, mortgage finance, health care, insurance, personal finance, and accounting and taxation issues for newspapers, magazines, and websites. A Chicago native and former South Florida resident, she now lives in New England.