For quite a few Americans, the answer is old age.Read More
Lately, I have had a lot of questions from people who are feeling ready to do something with their finances. Sometimes it's a matter of making your way out of a difficult financial situation (recovering from illness or unemployment, finishing a degree, paying off a debt, etc...), but often it's just a sense that you've been just wandering along without any particular plan or purpose. Thanks to a flood of shiny ad campaigns from the big brokerage houses, people often think this boils down to opening a retirement account somewhere. Here is what I tell people to think about before you go shoving all your money into an IRA.
Retirement Accounts are Great...But Not If You Need Money Now
The reason personal finances is so hard is that it demands that we think near-term, mid-term and long-term pretty much all at once. Like any financial advisor, I love getting my clients on track for the post-65 years. But dreams of a cushy retirement are only moderately comforting if you unexpectedly have to replace your car next week. Worse yet, if you do have to reach into your retirement account for an emergency, you will probably pay a penalty 10% of your hard-saved earnings for the privilege of getting your money back. All of those well-advertised retirement accounts (401k, IRA, Roth, Pensions, etc...) are great vehicles for the long-term. And unless you have reached your 60's, they are pretty useless for dealing with life as it is right now. Put the retirement account on the list, but not at the top. Instead—start with your emergency fund.
Life is Poetry, Budgets Are Fiction: Why You Need An Emergency Fund
How many times has someone told you that all you need to do is create a budget and stick to it? The advice usually comes with an ugly but orderly spreadsheet and a sort of smug assurance that all you need to do is follow the numbers. But experienced advisors are usually happy to admit it—budgeting doesn't work. The reason of this is simple, really. You don't live in a spreadsheet.
It isn't just that people have emotions and stressors that flicker through their thinking, changing their decision-making moment by moment. We all know what it's like to leave the house with one plan for the day only to have chucked the whole thing out the window by lunchtime. The problem is that even if we stick to the plan, the world won't necessarily cooperate.
Budgets depend on the illusion that we can forecast the future, so they don't tend to leave room for broken tail lights and dry cleaner emergencies, much less emergency room visits and sudden layoffs. You can't control these things, and you can't plan for them, but you can create an emergency fund that will soften the blow. And this is the crucial part of thinking short-term—emergencies can happen next week or next month or even tomorrow. Make sure to start (but not necessarily finish) your emergency plan before you start on the long-term thinking.
Saving is Simple. Leaving the Money Alone? Not So Much
As every Top 10 Financial Tip list will tell you, you should auto-deposit part of your check every month into a savings account. But those lists often fail to mention what the savings is for. Creating an emergency fund and saving for a big purchase are very different things. In fact, you are almost always better off to use separate accounts for them. Let's call this second account the "Occasion Fund." You use it to build up money for the big occasional spend (wedding, new place, the big birthday party...). Discount the need for these things at your own peril. Sure you can survive without them, but survival is not our goal here, and life demands some celebrations.
Unless you possess superhuman discipline, you will find yourself reaching for a just a little extra money from somewhere when they come up. It's better to have these moment in your plans. A word of caution, though—unless you are far wealthier than I, that fund won't cover every event you could turn into an occasion. This fund is all about mid-term thinking. Before spending out of this account look a little further into the future to decide which of the upcoming events in life most merit the spend.
Life Doesn't Work Step By Step
In the orderly world of planning, we want to tell you to do all these steps in order: first put aside 3-6 months expenses for the emergency fund, then start the long-term retirement planning, and then the occasion fund. But the truth is, this is rarely realistic. You do need to start putting money in for emergencies first. But it won't be long before that opportunity for a weekend away comes up. So, don't fight it. Split your automatic savings between the emergency account and the occasion account. Sure, it will take you a little longer to meet your goal in both accounts. But life, unlike financial plans, is about a lot more than the end goals.
And remember what I said about that Budget spreadsheet? I can't tell you when or why, but some day you are going to spend down one or both of those accounts. Stuff happens. Having charge of your finances means being knowing you have the know-how to build it all back up again.
We have a client at the firm who has been planning for years to retire to Costa Rica. Another client has moved to Mexico where she enjoys the fruits of her labor from a little house surrounded by, well, fruit. As the snow piles up every February here in Boston, the whole idea of escaping to another life sounds more appealing. Even those of us who can't imagine not having some sort of work during retirement are tempted by the idea of retiring to a whole new adventure. And in some cases, moving to another part of the world promises a better standard of living. So what are the practicalities of a retirement outside your home country?
Retiring abroad almost always means having financial transactions going on in two countries. Fortunately, our global banking systems have made this significantly easier than it once was. Like most immigrants/expats, you will want to do some careful planning with your cash flow. Start by keeping a U.S. bank account open to receive your social security checks (in most cases, you are still eligible while living abroad), pension checks or any other income. The same account can automatically pay any expenses you have left in U.S. dollars—these might be related to insurance policies, properties you own in the U.S., cash support for family still in the states, or just having your favorite U.S. peanut butter shipped over once a month.
Keeping all of that income and expense in the same (U.S.) currency saves you the added expense of currency exchange—and that can be a big savings. On the other side of the financial border, figure out what your monthly budget will be in your adopted country and have that automatically deposited in a local account once a month (but be sure to account, again, for the exchange rate and any bank fees).
Speaking of your monthly expenses, expect the unexpected in your new life. On one of our family's first trips to Singapore, we plunked ourselves down for lunch at a cafe designed for tourists on the island of Pulau Ubin. After giving three rambunctious children and four hungry, tired adults license to order anything and everything they wanted, we ended up with two tables overflowing with food and specialty drinks...all for a tab of about $14 bucks.
On the other hand, owning a little tin can of a car in Singapore will cost you a small kingdom. My point? Look carefully at what is and isn't expensive in your new home. Your housing or groceries might be ridiculously cheap compared to what you had at home, but your utility bills or transportation might be higher than you ever dreamed possible. And as an aside, don't expect to find cheap food in Singapore anymore—inflation can happen anywhere.
This one has been a big factor for U.S. citizens. In fact, our astronomical insurance premiums and health care costs in this country have made it almost inevitable that Americans save money on health care by going just about anywhere else in the world (why this hasn't been a red flag for us, I don't know). And the quality of health care in other countries hasn't been much of a compromise either. But you do need to know what the arrangements are in your new country before you move. Keep in mind that Medicare will not cover you abroad.
Some nations let immigrants participate in the national health system; others offer private health alternatives (often still cheaper than what we have here). Make sure you look into eligibility requirements and take into account your particular health care needs when choosing where in the country you will live; as is the case here, cities often offer more sophisticated care. And if you still need more coverage, look into international health insurance, which will cover you just about anywhere in the world (with the frequent exception of—you guessed it—the U.S.).
Surely this is the least appealing part of retiring abroad! If you are a U.S. Citizen, you will almost certainly need to keep filing a U.S. tax return, even if you don't owe anything. And you will have local taxes to think about. If your new home country has a tax treaty with the U.S., you might be able to avoid paying income taxes in both countries simultaneously. But there are all sorts of taxes to think about. For those in retirement who are buying property in their adopted nation, estate taxes are likely to be a concern. And if you have more than $10,000 during the year in almost any sort of account abroad, including an insurance policy, make sure to file an FBAR (Report of Foreign Bank and Financial Accounts). Even if you were one of those people comfortable doing her own tax returns and estate planning before, taking on the taxes and procedures of two national treasuries will probably require some professional help.
An Extra Seat At The Table
Ready to start planning your second life as an immigrant to some charming foreign nation? Research thoroughly, plan carefully and most of all, be flexible. And one more thing, make sure there's extra seat at the table for friends and family visiting from back home. After all, it gets pretty cold here in February.
The Secretary of State's Bureau of Consular Affairs has a web page to guide you through the basics of planning a retirement abroad.
My clients might well be surprised to see this post—I spend a lot of time railing about the over-selling of annuities and the hefty commissions that go to the advisors who sell them. But the annuity has a long, respectable history and can actually be a good financial tool for the right situation. So what is that situation?
First, it helps to know how annuities work. They aren't quite as dreary as they sound. Way back in the 17th and 18th centuries, annuities were a great way for a very wealthy person to fund the retirement of a widow, an artist or a beloved servant. For that matter, they were one of the original prizes in government lotteries. Essentially, an annuity is a contract that gives the beneficiary the right to receive a certain sum of money every month or every year for the remainder of his or her life. Sounds great, right?
There is a little more to it, though. These days, annuities are insurance products. Like any insurance policy, the insurance company has used statistics about people's life spans to predict how much they need to charge you (and how much they could pay to the beneficiary) in order for the insurer to make a profit on the deal. So, for instance, Wholesome Life Insurers, Inc. are happy to sell you an annuity that costs $100,000 up front and pays $20,000 per year to your Aunt Betty for $100,000 if they think she'll drop dead after the second year of payouts.
And there are necessary costs. In addition to paying the people who sell you the annuities, the insurance company needs to pay people to file the required reports, process the applications, run the office, etc... That isn't all, though. In point of fact, your insurance company is hoping to make most of their profit by investing your initial $100,000 until it needs to be paid out. For that, of course, they need to pay investment managers. All of these costs are built into how much the annuity costs you.
So why not just invest the $100,000 yourself and skip the other costs? This is the question at the heart of the matter when it comes to annuities. In most cases, it is cheaper to fund your own (or your Aunt Betty's) annuity. But relying on your $100,000 investment to grown enough that it can pay you back the money you need in retirement is a gamble—a gamble on the investments and a gamble on your lifespan not going longer than planned.
In the Bloomberg article with which I started this series, David Little, Director of the Retirement Income Planning Program at the American College of Financial Services, chose to take care of most of his own investing, trusting that he would do better than the relatively high fees and low returns that an insurer would get. But he also purchased an annuity as a supplement to the investments. The annuity offers him a baseline amount that he will get every month during retirement to prop up his social security benefits in case the investments disappoint or in case he lives to, well, 103.
As Little's plan suggests, annuities make sense in those instances when security matters to you much more than cost. Whether it's being able to insure a comfortable living for your Aunt Betty, or locking in a baseline for yourself, annuities are about covering a basic need—often psychologically as much as financially.
Just one last note on annuities—there is no such thing as a "guaranteed" investment. Make sure you feel as confident about the insurance company you buy from as you do about your choice to buy. If you want to learn more about the types of annuities out there, check out the SEC's online guide to annuities.
Of all of the topics that come up in my line of work, this has to be the one that creates the most confusion. We Americans are at the point where we have all heard about 401k's and pensions and probably about IRA's and Roth's. And for the most part, we are relying on these strange creatures to feed and house us in the last years (decades?) of our lives. But precious few of us really understand retirement accounts. This post is meant to give you a bit of a run-down on how retirement plans work with a quick graphic at the end to get you thinking about the plans that might work for you.
The Magic of Tax Deferral
Let's start with the basics—anytime we call something a "retirement" account, we are actually saying that the account has some special mention in the IRS's regulations that will amount to a temporary tax break. You noticed the word "temporary", right? Except for the Roth, which I'll get to in a minute, retirement plans allow you to put a certain amount of your income into the account instead of paying taxes on it...for now. It's called tax deferral, and you not only get out of paying the taxes the year you earned them, you also don't have to pay any capital gains taxes when you sell investments in that account over the years. That gives you the ability to freely move in and out of investments without the usual tax consequences and lets the income you originally put in keep compounding—assuming those investments you chose are any good.
But you do have to pay taxes eventually. In the case of retirement accounts, this happens when you start taking money out— a process known as taking distributions. What's more, the IRS has something to say about when you will be doing this. In most cases, you will pay a penalty for "early withdrawal" if you take your first distribution before age 55. And you will be required to start taking your money at age 70 1/2, because after all, the IRS won't wait forever.
The Roth IRA (often just called a Roth) is a little different. Like 401k's and regular IRA's, your money can grow free of capital gains taxes over the years in a Roth. But if you open one of these accounts, you put your money in after paying the income taxes. This means you won't get that immediate tax break, but believe it or not, this might actually work out well for you. When you do go to take money out of the Roth account, you don't have to worry about the taxes on the money you first put in the account (you already paid those taxes, after all). This can reduce the strain of taxes in retirement and may even mean paying a lower tax rate on that money, say, if you are in a higher tax bracket in your mature years.
In reality, the most successful savers will use both Roths and whatever other accounts they can. The caps on how much you can contribute to a retirement account often mean layering accounts to the extent you are able.
Defined Benefit vs. Defined Contribution
This is the biggest change in the U.S. retirement system over the past 50 years. Defined benefit plans are exactly that—the plan defines in advance how much you will get in benefits. Most of us just call these pensions, and they were the most common type of retirement income for most of our history. Based on the length of time you've worked at a job and the amount you earned, your HR department will calculate how much you get in your monthly check during retirement. Nowadays, though, you are far more likely to be offered a defined contribution plan. These plans set terms for how much you can contribute and make no promises whatsoever about what you get back later.
This change is a big deal— and not just because people are less likely to contribute to the often-voluntary defined contribution plans. In the case of a pension (defined benefits) someone else is taking the risk that the markets will go down or that the beneficiaries (including you) will live longer than expected. If you have a defined contribution plan, that risk is all on you. This means that you need to do some careful calculating and some educated guessing to come up with a balance of investments that will grow enough to cover your needs and will likely be there when you need them. The change over from defined benefits to defined contributions has made it necessary for Americans to become smart investors.
The Magic of Timing
If you are worried about living for more than a few years after your retirement, you are going to want to focus on your timing when it comes to retirement accounts. I am not referring to when you start putting money away here—the earlier the better, of course. Honestly, though, most successful retirees started saving at the peak of their careers, not the beginning. Get started when you can and work from there.
But you should be strategic about which accounts you put money into first and which accounts you start withdrawing from when.
The timing of adding to accounts is relatively simple for most people. We always start by looking to see if a client's employer will "match" contributions. If so, we maximize that first (getting someone else to fund your retirement is always good). If the client has his or her own business, even if it is a "side" business, we have a lot more to play with and timing will often depend on the needs of the business, which is often itself part of the retirement solution.
Taking out the money is different matter. The trick here is to take advantage of the incentives that employers and the government give you and to recognize the requirements. Social security, for instance, gives you all sorts of incentives to wait until 70, so if you can draw from a 401k account or an IRA instead during your 60's, you probably should. Likewise, an old company pension might give you a much better monthly payment for waiting. But you can only wait so long on IRA's and 401k's—as I mentioned above, the IRS requires that you start taking at least some distributions when you reach 70 1/2. The Roth, always the exception, allows you to keep money in that account as long as you want. Choosing which accounts to draw from and when is a delicate game of knowing your income needs, getting the most you can from the incentives and keeping an eye on the taxes you will pay as your start taking that retirement income.
Which Retirement Accounts Should You Use?
Retirement accounts are only one piece of the puzzle when you are coming up with a plan for enjoying life after 65. But they are one of the most important pieces. Here is a quick graphic showing the most popular types of retirement accounts and which ones you might want to learn more about: