It's one thing to know you should be making a real effort to save enough money for retirement, and it's another to actually do it. In a recent study, researchers looked at the relationship between how much people save and two personal biases that could be holding them back.
Called "present bias," this is the tendency to procrastinate on decisions that could benefit you in the long run but require you to give up something in the short term. Saving for your future involves a short-term cost in that you have less money to spend now. The researchers found that individuals who do not have this bias had 19% more in savings than those who do.
Not Perceiving the Power of Compounding
This bias can also wreak havoc on people's savings. Compounding is what happens when the money you save is invested and earns a return. That money is then reinvested, giving you a chance to earn a return on your earnings as well as on the initial amount you invested. Over time, compounded earnings can really boost your savings. According to the study, people who appreciate the power of compounding have about 20% more saved than those who do not. The researchers found that most people have one or both of these biases. Working to overcome them could help you be more proactive when it comes to retirement saving.
Management of Multiple Retirement Assets
The retiree with only a single-employer pension has become a rare species. With career changes and the availability of different types of tax-favored retirement plans, many successful individuals have built an assortment of assets to use for their retirement income. Each type of asset may have different payout options, distribution rules, and tax situations. So, it's not simple to decide what strategy will be best for generating retirement income with the least tax impact. When you retire, you'll need to carefully manage how you will draw on your assets. Any decisions should be based on carefully examining all of your choices.
The Tax Status of Your Assets
The law places restrictions on your freedom to use your assets. Access to your tax-deferred assets will be subject to distribution requirements and possible tax penalties. (Tax-deferred assets include rollover and ordinary IRA money, annuities, and deferred compensation from an employer.) Capital gains tax consequences may limit how you can make use of your personal investments and other assets. Under most circumstances, you will have only one opportunity to make choices affecting the amount of income you receive from Social Security and a company pension plan. A similar mix of assets and constraints may affect your spouse's assets.
Because you may not get a second chance on many of your retirement asset decisions, it's smart to get a professional to help you. The suggestions that follow can help start your thinking.
Look at the Total Picture
You can begin by listing everything you have to work with -- each of your assets and how much income each is likely to produce. Maybe, you won't have to use all your assets for income right away, or ever. But when you do draw income, you may be better off using some sources completely and holding others for later use. You should also make a list of the dates when you must start taking your distributions. With each asset you own, you should find out both the tax consequences and distribution options.
Use Taxable Assets First
If you draw down your ordinary investments and savings before your tax-deferred assets, you will be able to keep the tax-deferred assets growing longer without being affected by annual taxes. Take care, however. This strategy may be difficult to follow because the minimum distribution rules for tax-deferred assets prevent long delays in using tax-sheltered assets. You generally must start taking minimum amount distributions by April 1 of the year after you turn age 70.5 (or after retirement, if later). You can't afford to start late because of the heavy tax penalties that apply (for example, 50% on 401(k) plan amounts that should have been withdrawn but weren't).
Consider Annuity, Installment, or Lump-Sum Distributions
As for your tax-deferred plans (company pension, 401(k), or profit sharing), you may be able to choose among annuity, installment, and lump-sum payments. With annuity payments, common options are income that will last for your life, or for both your life and your spouse's life. With installment payments, you receive amounts over a number of years based on your life expectancy according to an IRS table. With a lump-sum payment, you receive a distribution of your entire retirement plan benefit right away. Your payout decision should follow a careful analysis of your individual financial situation and needs. Many retirees don't carefully consider the lump-sum choice. They know it can cost a large income-tax payment. But (provided you have no need to use your distribution) you can roll your distribution over directly into a tax-deferred IRA and therefore put off the tax, however there are many considerations to think about prior to making any final decisions such as costs and fees, investment options, services provided, and whether there will be protection from creditors or legal judgements. But if you are receiving a lump sum from a non-qualified pension plan, you can't roll it over into an IRA.
Pause and Carefully Consider All Options
Paying minimum taxes on multiple retirement assets will most likely require you to use both your personal investments and some distributions of tax deferred money. You need to step back and carefully consider all your alternatives and the associated taxes before you act and-if you need to-do it with an expert's help.
When Retirement is Near
You've worked hard during your career. As you approach retirement, think about how you want to spend your time, what you want to accomplish, and how your finances will be affected. Plans you make today will help you prepare for a fulfilling future.
Where Will You Live?
When you retire, are you planning to relocate to another part of the country, move to a smaller place, or stay in your current home? Where you decide to live during retirement could have a big impact on your lifestyle and expenses.
If your dream is to relocate to a geographic region with a different climate or live closer to family and friends, do your research now. You will want to become familiar with the housing costs, income and property taxes, senior services, and health care available in the targeted location.
Maybe you want to stay in the area where you live now, but move to a smaller home that's easier to maintain. If so, don't forget to factor into your retirement budget the costs of moving and a new mortgage, if applicable. If you want to stay in your current home, consider the costs necessary to maintain it when you are developing your budget.
Is Your Home a Retirement Asset?
After years of making mortgage payments and tending to repairs and improvements, you may have a large investment in your residence by the time you retire. Maybe you're planning to finance your retirement with some of that investment. But before you count home equity as part of your retirement savings, ask yourself a few questions.
How Much Equity are You Likely to Have?
You can estimate this amount by subtracting how much you'll still owe on your mortgage and home equity loans when you retire from how much you expect your house to be worth.
Will You Want to Sell Your Home?
There are basically two ways you can turn home equity into cash for your retirement: sell your home or take a reverse mortgage. In general, your most practical option will be selling, so think about whether you'll be willing to go that route when the time comes.
How Much Will a New Home Cost?
You'll need a place to live after you sell your home. Renting is one option. But, if you'd rather own your home, you'll have to buy another property. So the next step is to think about where you want to live and how much you'll have to pay to buy a home there.
What's the Bottom Line?
To add anything to your retirement savings, the new home you buy will have to cost less than the amount of equity you unlock when you sell your old home.
1. Gopi Shah Goda, Matthew Levy, Colleen Flaherty Manchester, Aaron Sojourner, Joshua Tasoff, "The Role of Time Preferences and Exponential-Growth Bias in Retirement Savings," NBER Working Paper No. 21482, 2015
2. Deadline is April 1 of the year following the year the participant turns age 70112 or retires, whichever is later. Certain owners must begin distributions after reaching age 70112.
3. Deadline is April 1 of the year following the year the IRA owner reaches age 70112 (only applies to traditional IRAs).
This information is for general and educational purposes and not intended as legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Information obtained from third party sources are believed to be reliable but not guaranteed. ©Copyright 2018 M Financial Group. All rights reserved.
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