Exercise Patience You Will, Young Investor

I was very pleased to get a question from a young, fledgling investor who is ready to storm the market with a year's worth of income! Count me impressed. In this week's Q&A, I talk PDQ principles and enter a one-sided discussion about what percentage of pre-retirement income you can expect to spend annually in your Golden Years.

Names and personal information are excluded to protect privacy. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Q: How does a young person with a year’s worth of income begin investing?

A: I assume you mean you have the equivalent of a year’s worth of income saved and available for investing. If so, that means you have accomplished the first important step to becoming a wise investor… you’ve become a saver.

The next step is to develop an investment program you plan to follow for years to come. I like the “dollar-cost-averaging” approach; the buy and hold approach; the mutual fund versus individual stocks approach… in short, my PDQ Principles approach to investing. Buy Quality products, Diversify and be Patient. The easist way to do this is to buy good quality mutual funds, and to build your portfolio around an index fund (e.g. a total stock market index fund, S&P 500, etc.). And don’t go “whole hog” into the market. Consider instead buying a given dollar amount of quality assets on a certain date each period (week, month, quarter, etc.). Having established this approach, remain faithful to your investment portfolio. In short, stay put. Don’t join the thundering herd when the market goes up or down, particularly down in the instance of a major correction. Corrections are part of an investor’s life.

If you have built a quality, highly diversified portfolio, don’t bail out. Such a choice often results in the creation of a needless tax event, possibly a loss, and later, an opportunity cost of not getting back in the market on a timely basis when there is a recovery. To benefit from the stock market you have to be there, and you have to stay there to optimize the Amazing Power of Compounding. Every sell you make disrupts compounding. Don’t forget that.

Q: What are the advantages and disadvantages of rolling money from my previous traditional employer 401(k) plan to a new Roth brokerage Individual Retirement Account (IRA)? Secondly, when will I be paying the taxes due to conversion to Roth?

A: The primary advantage of a Roth is in retirement when an individual begins withdrawing money… tax-free. But this raises a thorny issue… will you be in a higher or lower tax bracket in retirement? If you think you'll be in a higher tax bracket, then the Roth is the way to go. So basically, a crystal ball would be helpful in making this decision. I absolutely favor a Roth IRA, but as with all things in life, it depends.

Age Matters: At age 72, one can no longer contribute to… and must make minimum withdrawals (RMDs) from... a traditional IRA. Why? Uncle Sam wants his cut. A Roth IRA has no age 72 restrictions as to contributions or withdrawals. Uncle Sam already has his piece of that pie. And as long as sufficient “earned income” is available, anyone can contribute to either type of IRA (no dice if it’s income from selling property, stock, etc.). Also, Traditional IRAs (for workers without 401(k)s) have no income restrictions. They’re open to all. Roth IRAs, however, have upper-income limits. Currently, if individuals makes more than $140,000 a year, no Roth IRA for them. And if couples (filing a joint tax return) earn more than $208,000 a year, no Roth IRA for them. The government frequently increases these upper limits from year-to-year. The current annual contribution limit for both Traditional and Roth IRAs is $6,000 ($7,000 after age 50).

Tax Considerations: The total taxable conversion amount depends on whether the underlying contributions to the IRA were deductible. Deductible contributions and subsequent gains are taxed at full current value. In short, if only deductible contributions were made to the IRA, taxes will be due on the full amount. Further, the tax due on a conversion will be collected by Uncle Sam along with the rest of income taxes due on the return filed in the year of the conversion. And yes, you may be required to make estimated tax payments in the year of the conversion, before you do your return. Logic tells me those taxes come due and payable during the quarter the conversion occurs. Again, converting to a Roth can have a significant impact on current year’s taxes since previous untaxed contributions and subsequent earnings within the IRA are considered to be taxable income.

Administrative Advantage: Direct the financial institution holding your 401(k) assets to transfer the funds directly to the trustee of your Roth IRA. This avoids the possibility of violating the 60-day rule regarding transfers from one account to another, which could entail tax penalties.

Q: I'm nervous about the money I have in the market, which hasn't really grown much, and about an annuity. I've run into a tough time and debt is rising exponentially. Please advise.

A: I usually suggest to people that they buy and hold. However, in today’s healthy market, if your portfolio hasn’t grown much, you might want to take inventory of its content. Perhaps you’re too bond heavy. As to the annuity, you may be locked into a long-term choice… and most likely without inflation adjustments. It’s hard to comment on your exponentially rising debt without knowing why, except to say quit borrowing. As to your nervousness about the market, it seems a bit toppy, but you have to be there to reap its benefits. Take a hard look at the quality and diversity of your current holdings. Changes may be in order… more so than abandoning the market.

Q: Is 80% of my pre-retirement annual income a good number for a comfortable retirement income?

A: Eighty percent of pre-retirement income may be a place to start the planning process, but factors such as potential years to retirement, anticipated lifestyle including enhanced travel plans and health expectations must all be considered to help estimate future retirement expenses.

Most pre-retirees have probably read about the 4% rule – the concept that if you spend 4% of your retirement portfolio the first year of retirement, and then adjust spending upward each year to account for Izzy the Inflation Monster, your portfolio will likely accommodate that level of spending through a 30-year retirement. A shortcoming of this concept is that folks dedicated to the idea often consider it a “no-no” to spend more than 4% (inflation-adjusted) regardless of changing circumstances. Spending more than 4% per annum isn’t necessarily risky. As usual, it depends… for example, depending on your age, spending more than 4% might make perfect sense, because you don’t need your portfolio to last 30 years. Or perhaps you desire to spend at a lower rate, hoping to leave a significant portion of your estate to heirs.

As to what percentage of pre-retirement income is a good number for a comfortable retirement income, it’s largely a function of pre-retirement income and the amount of money saved for retirement. Based on a number of studies I’ve read, in the early years of retirement, it’s not uncommon for folks to spend in retirement as much as they had spent while still working, but as they age, spending levels off. Logically, retirement spending on food, entertainment, and transportation remains relatively stable (except, perhaps, for travel), while spending on housing (due to downsizing, mortgage payoff, etc.) tends to decrease… offset somewhat by spending on healthcare, which tends to increase with age. One might conclude from this statement that spending in retirement might remain fairly steady.

As to the significance of pre-retirement income, a person making $50,000 a year might wish to adjust the 80% factor of their pre-retirement income to 100% during those early years of retirement as opposed to someone making $200,000, who might only need 50-60% of their pre-retirement income to fund a retirement lifestyle, particularly in the waning years of retirement.

In summary, consider using 80% of pre-retirement income as a starting point, plot the range somewhere 50% and 80%, and then make those necessary adjustments for travel, lifestyle, medical considerations, etc. to get to a final number… and then expect to adjust it to accommodate life’s many surprises.