Phyllis Bear reaped the rewards of the tech boom in the 1990s. She not only worked for a tech company, she invested in tech stocks and had stock options from her employer, Cisco Systems. Based in part on Cisco's strength, she and her husband Ed McKeon, planned an early retirement -- three times. But turmoil in the tech sector made them scrap those plans twice.
Phyllis, 60, says she wishes she had stuck with her initial strategy of investing in a diversified portfolio of mutual funds. But once the tech bubble was fully inflated, the temptation was too great. "I started investing in stocks, which was against my plan. When the bubble burst, we lost quite a bit of money."
Despite some bumps along the way, their careful saving and planning for retirement paid off. She and Ed, 59, a retired insurance company executive, moved last year to their dream home in Bend, Ore. Phyllis now has time for nature photography and reducing her 30-plus golf handicap. Ed is trying to catch up on all the reading he's missed over the years and to finally get his handicap down to the single digits. And the couple recently celebrated Phyllis's 60th birthday with a trip to Hawaii.
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Like many of their fellow baby-boomers, Phyllis and Ed don't expect to just while away the hours in retirement. They also plan to work -- on their own schedule -- and reap the many rewards that the extra income and business deductions can offer early retirees, who are too young to collect Social Security benefits or to qualify for Medicare.
Now that they have entered the brave new world of retirement, they will face their biggest financial challenge ever: making their savings last a lifetime. Luckily, the financial-services industry, including several major mutual funds, has stepped up to the plate, offering investors a variety of online tools and in-person advice to identify their retirement-income needs and create a strategy to fulfill them.
A new set of rules
One of the many surprises confronting new retirees is the responsibility for details once handled by their employers. No more paychecks generally means you have to file your own estimated federal and state income-tax returns each quarter. (Those collecting Social Security benefits can elect to have taxes withheld from their monthly checks.) And once your mortgage is paid off, the property taxes that were imbedded in your monthly payment become yet another bill you must remember to pay on your own.
Perhaps the biggest shock to new retirees, particularly those under 65 who are too young to qualify for Medicare, is the cost of health insurance. Only about one-third of major employers now offer subsidized health benefits to their retirees, and many of them plan to reduce or eliminate those benefits in the future (see "Disappearing Retiree Health Benefits," on page 70). Fidelity Investments estimates that a 65-year-old couple retiring today without employer-provided health benefits would need about $200,000 to pay out-of-pocket medical costs and insurance premiums over their lifetime, not including long-term-care costs.
Phyllis and Ed knew going into retirement that health care would be one of their biggest expenses. Before retiring, they met with an insurance agent for advice. They decided their best bet was to take advantage of the federal COBRA (Consolidated Omnibus Budget Reduction Act) law, which allows former employees to continue their group health insurance coverage for up to 18 months. There's just one catch. You must pay the entire premium -- both the employer and employee share -- plus up to 2% in administrative costs. They also decided to purchase long-term-care insurance.
The monthly bill for both kinds of policies comes to about $1,000 and breaks down to roughly $10,000 a year for health insurance and $2,000 a year for long-term care. "We think both are absolutely necessary," Phyllis says. Once the COBRA insurance expires, the couple anticipate that a new health plan will add about $200 to their monthly insurance budget. To save some money, they gave up the dental and vision coverage in their current insurance plan.
Income in retirement
Once upon a time, retirement income was a simple affair. You received a monthly pension check and another check from Social Security, and together they dictated how much you could afford to spend. If you were lucky, you had some savings on the side for discretionary spending, such as travel, or emergency expenses, such as roof repairs.
But those days of simple solutions are pretty much over. Most future retirees will have to rely on a patchwork of sources to meet their retirement-income needs. And in many cases, it won't come in the form of a monthly check. Instead, retirees will be increasingly responsible for investing their assets in a way that protects their nest egg from both market volatility and the ravages of inflation, while withdrawing funds at a modest rate -- usually no more than 4% or 5% a year -- to ensure that they don't outlive their savings. That's a tall order for the most sophisticated investors. The average Joe could use a little help.
When Phyllis retired, she and Ed rolled over their substantial 401(k) assets to IRAs. Not only did it allow them to preserve the tax-deferral on their retirement funds, it gave them more investment options.
They consolidated their assets into IRAs with Fidelity, which offers its own mutual funds plus hundreds from other companies. Fidelity also has one of the most comprehensive online retirement-income planning tools, which is available free to Fidelity customers. Even non-Fidelity customers can try out the planning tool free over the phone (call 800-343-3548) or in person at any of Fidelity's retail offices (see the box on the next page for other tools to help you transition from saving for retirement to living in retirement).
The Fidelity Retirement Income Planner lets you tally your expenses, project income, create a suitable asset allocation and calculate an appropriate withdrawal rate. Once you create an income plan, you can play with hypothetical scenarios, such as what if you live longer, delay your retirement by a few years, work part-time or wait longer to collect Social Security. The tool can also recommend which sources of income to tap first.
Timing matters
You'll want to squeeze every nickel out of your investments in retirement and to keep taxes to a minimum, says Bernie Kent, a personal financial-services partner for PricewaterhouseCoopers. He suggests you tap your taxable accounts first, letting your tax-deferred retirement accounts grow untouched for as long as possible.
Be aware that even within those taxable accounts, specific types of investments are taxed differently. Qualified dividends and long-term capital gains (on the sale of assets held more than one year) are taxed at a maximum 15% capital-gains rate. In contrast, interest income, short-term capital gains (on assets held less than a year) and retirement-plan withdrawals are all taxed at your ordinary income-tax rate, which can be as high as 35%.
Once you turn 59 1/2, you can tap your IRA without triggering the 10% early-withdrawal penalty, but you will still have to pay income taxes (unless you have a Roth IRA, from which you can withdraw all of your funds tax-free once you turn 591/2 and the account has been open at least five years). After age 70 1/2, you must start taking minimum annual withdrawals from traditional IRAs and 401(k) plans based on your life expectancy. Again, the Roth IRA is an exception. You are never required to make a withdrawal from a Roth IRA, and you can pass it on to your heirs tax-free.
Keeping your money in a tax-deferred account as long as possible makes a difference even when it comes to taking distributions within the same year, says Kent. For example, assume you plan to withdraw $50,000 in a given year and that the $50,000 is held in an account that earns 4% a year. If you wait until year-end to withdraw the money—instead of withdrawing it in equal portions at the end of each quarter and paying estimated taxes on the withdrawals -- you'd have an additional $1,000 left over (assuming you're in the 25% tax bracket).
Although Phyllis and Ed are old enough to start withdrawing funds from their retirement accounts, they hope to let those accounts grow untouched for a few more years. Instead, they expect to sell their stash of Cisco stock, which they acquired through stock options while working for the high-tech giant, to fund their first year in retirement. They also anticipate income from their new business, Start-Rite Consulting -- although money was only one reason for starting the business. "Ideally, I would love to be kept very busy for two years and then perhaps slow down a bit," says Phyllis. "I'd like to be able to pick my favorite clients, who can give me just enough work to keep me engaged and active."
Starting a business brings a host of benefits. For example, Phyllis and Ed can deduct 100% of their health-insurance costs as a business expense and a portion of their long-term-care insurance premiums, up to the IRS's age-based limits, which range from $270 a year for taxpayers 40 and younger to $3,400 a year for those 71 and older. And they can continue to save for retirement and reduce their income-tax bill at the same time by contributing to a retirement plan for their business (see "Flying Solo," on page 72).
Although they had initially planned to start collecting Social Security at 62, that may not be wise if they continue to work because they could lose some or all of their early-retirement benefits. In 2006, once your income tops $12,480, you start losing $1 in Social Security benefits for every $2 you earn over the limit. But once you reach the normal retirement age—66 for Phyllis and Ed and everyone else born between 1943 and 1954 -- you can earn as much as you like without jeopardizing benefits.
Wise withdrawals
A big variable in the retirement-income calculation is the amount of your portfolio invested in stocks. Although stocks are more volatile than bonds or cash accounts, over time they return two to three percentage points per year more than bonds. Christine Fahlund, senior financial planner for T. Rowe Price Investment Services, says people equate risk with volatility, and since stocks are more volatile than bonds, some people think stocks are too risky for retirement accounts. "But once you get into retirement, risk is much more than volatility," she says. "The real risk is outliving your money."
Figure that your investments need to last 30 years (among married couples, at least one spouse has a nearly 50% chance of living to 95). To make your money last, you should withdraw only 4% to 5% from your retirement portfolio each year. That ensures that even in a worst-case scenario -- such as a string of bad investment returns at the beginning of your retirement -- you won't run out of money.
Another piece of advice: These are rules of thumb, not set in stone. If your portfolio performs exceptionally well, you could take more. And if you have a few bad years, scale back your withdrawals. "Think back to where you were 30 years ago," says Fahlund. "That helps you reflect on how long that time period is and how ridiculous it is to think you can plan for every financial contingency."
Tracking your progress
To help you see if you're on track to turn your lifetime of retirement savings into adequate income in retirement -- and to make suggestions if you're not -- many financial companies offer online planning tools. Typically, you have to enter personal data, such as years until retirement, how much you have saved so far, projected expenses in retirement and expected sources of retirement income. Some excellent online tools, such as the one offered by Fidelity, require you to have an account with the company. (Fidelity will also help noncustomers with calculations if you visit one of its investor centers or call 800-343-3548.)
One of the best tools that doesn't require an account is offered by American Century www.americancentury.com); click on "retirement" under the "education and planning" tab. Other good retirement-income planning tools are available free through T. Rowe Price (www3.troweprice.com/ric/RIC/) and Vanguard (www.vanguard.com); click on "retirement" under the "planning and education" tab.
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