Your job, in retirement, is putting together the income you'll need to live comfortably.
Remember the retirement rule of thumb: You'll need roughly 70% to 85% of your preretirement income to live the way you've grown accustomed to. To provide that successfully, you'll need to get your finances in order.
BUILDING YOUR MENTAL ACCOUNTS
You don't walk into a bank or brokerage firm to open a mental account. It's a way of organizing your assets in your mind, separating the money for living expenses from what you're using to build your investment portfolio.
If you've spent much of your investing life thinking about protecting your principal and increasing your net worth, it may be a jolt to readjust your thinking to start spending what you've worked hard to accumulate. One approach may be to divide your retirement assets themselves into three categories: one for income, one for emergencies (including long-term healthcare), and the third for continued growth.
Income. Some of your current investments, such as bonds, may already produce income on a monthly, quarterly, or annual basis. Others, such as annuities, can be converted to an income stream. Still others can be sold and the proceeds used to buy income-producing investments such as bonds or an immediate annuity.
Emergencies. It's important to have investments that you can count on if you have a medical or other emergency that isn't covered by insurance. Liquidity is important, so the assets can be readily converted to cash. So is stability. You don't want to worry about having to sell your investments at a loss because you're under pressure to pay a bill. Investments you might consider to provide both liquidity and stability are US Treasury bills, money market mutual funds, and certificates of deposit (CDs). The drawback, of course, is that when interest rates are low there's an increased risk of losing ground to inflation and not having enough to live on.
Growth. Part of your retirement account should be invested to produce potential and to increase the probability you'll have money as long as you live. The same type of equity investments that you selected help you build your assets may also be appropriate choices for growth, though you may want to emphasize more dividend-paying stocks. Through 2012, dividend income on qualifying stocks is taxed at a lower rate than ordinary income — 15% if your regular federal income tax rate is 25% or higher, and 0% if your regular rate is 10% or 15%. But remember that investment income is not guaranteed, so your return could be disappointing, especially in the short term.
UNDERSTANDING GROWTH
One of the reasons for stressing growth potential in making long-term retirement plan choices is that if the value of your investment account increases, your long-term financial security increases as well. Generally stocks, stock mutual funds, and stock exchange traded funds (ETFs) are considered growth investment, based on their historical total return.
For example, the market price of a stock may go up. The stock could split, adding to the number of shares you own. Down the road, you would have the alternatives of selling your shares at a profit or leaving them to your heirs. Additionally, you might receive dividend income from your stock, which you may decide to reinvest to buy additional shares or other investments. Or you could use the money to cover current expenses.
Of course, the risk is that a stock's price may also remain flat or go down, and the company may cut its dividend or stop paying it. That's the trade-off for the opportunity to benefit from continued growth.
You might also realize long-term growth from bond investments, whose total return reflects interest plus potential increase in market value based on fluctuations in interest rates and credit ratings as well as investor attitudes.
USING YOUR MENTAL ACCOUNTS
Perhaps your primary challenge will be providing the additional annual income you'll need from various investment sources. And remember that keeping ahead of inflation means that the dollar amount you'll need in the first year after you retire is likely to increase each year as the cost of living increases.
SPEND IT OR SAVE IT
When you're deciding which investments to convert to income and which ones to leave alone, here are some questions to ask yourself or your financial adviser:
- How will the income be taxed and how much will be left to spend?
- Will the investments continue to accumulate tax-deferred earnings?
- Are distributions required, and at what rate if they are?
- Will the income be a lump sum or a series of regular payments?
- Will you face any penalties for converting the investment to income?
- What will your beneficiaries owe in tax if you leave them the investment rather than using it to provide retirement income?
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