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15 Financial Planning Concepts You Should Know Thumbnail

15 Financial Planning Concepts You Should Know


15 Financial Planning Concepts You Should Know

  1.  Asset Allocation is the concept of balancing your investment risks and rewards by spreading your investments into different asset classes like stocks, bonds and cash. But how do you know what percentage should go into each class? We start with “risk tolerance” which is the amount of risk an investor is comfortable taking (can you sleep at night?). But it is also important to look at “risk capacity”, the amount of risk an investor must take to meet his or her goal, and “risk ability”, the amount of risk an investor can take based upon his or her time horizon. Only by balancing these three risks can an investor determine an appropriate asset allocation.
  2. Should you save for retirement on a pretax basis or a Roth basis? The decision should be based upon a comparison of your current tax rate vs. your tax rate in retirement when you will be withdrawing money from your accounts. If your current tax rate is higher, save on a pretax basis, if lower, save on a Roth basis. The problem is that no one knows what their tax rate will be in retirement. That is why it may make sense to split your savings between pretax and Roth. Tax diversification can be just as important as investment diversification!
  3. Asset Location is the third component (after asset allocation and tax diversification) of an investment plan. It allows you to minimize the taxes you pay on your investment returns. Rather than having an equal mix of stocks, bonds and cash across all types of investment accounts (traditional pretax, Roth and outside brokerage), we take the tax status of each account type into consideration. This allows the investor to keep more of their earnings and reduces Required Minimum Distributions and taxes for the investor’s heirs.
  4. In the 401(k) world, we’ve learned that automating savings is the most effective way to build retirement wealth because the money comes out of your paycheck before you ever see it. You can use the same strategy to build wealth outside of retirement as well. I suggest having money automatically transferred from your checking account the day after your paycheck is deposited. One transfer could go into an online savings account for an emergency fund and another transfer could go into a discount brokerage account for longer term savings. You will be amazed how quickly your accounts will grow if you make savings automatic!
  5. How much can you spend each year in retirement? The rule of thumb used to be the “4% rule” which states that you can spend 4% of your assets in the first year of retirement, increase that by inflation each year, and your money will last at least 30 years. This assumes you invest at least half of your money in stocks. So if you retire with $300,000, you can spend $12,000 per year. Some academic researchers now say that the 4% rule is a 3% rule because of historically low interest rates. A good retirement income plan can help determine the appropriate spending rate for your portfolio.
  6. Do you intend to stay in your current state after you retire? State taxes and cost of living can differ significantly. Understanding the difference between your current and future states can change the decision as to how much to save and whether to contribute to your retirement plans on a pretax or Roth (after-tax) basis.
  7. Mortgage rates are at historic lows. If you have good credit and can lower your rate, it may make sense to refinance. If you do refinance, consider a 10 or 15-year mortgage so you can have it paid off before you retire. Not having a mortgage in retirement can be valuable from a tax standpoint. For example, if your mortgage is $2,000 per month ($24,000 per year), you would need to withdraw around $30,000 per year from your pretax IRA or 401(k) to net $24,000. That addition $30,000 of taxable income could cause up to 85% of your Social Security income to become taxable and could cause you to move from the 0% long term capital gains tax rate to the 15% rate. Remember, in retirement, money not going out can be even more powerful than money coming in!
  8. There is a 25% probability that a 65 year old male will live to age 93, a 65 year old female will live to age 96 and one member of a 65 year old couple will live to age 98. That is why it is important for people who retire at normal retirement age to financially prepare for a 30 year retirement. There are a number of strategies we use to deal with longevity including Social Security claiming strategies, safe withdrawal rates and longevity insurance. The earlier you prepare for longevity the better, but it’s never too late to start.
  9. Health Savings Accounts (HSAs) can be a great way to save for medical expenses in retirement. They are generally available if you participate in a high deductible health insurance plan. The 2020 annual HSA contribution limit is $3,550 for individuals with self-only coverage and $7,100 for individuals with family coverage. There is an additional $1,000 catch-up contribution for HSA eligible individuals age 55 or older. HSAs can be invested in mutual funds just like an IRA or 401(k). The best part about HSAs is that they are the only type of savings plan that is Quadruple Tax Free! HSA contributions are contributed on a pre-tax basis and, unlike 401(k) contributions, they are not subject to FICA taxes. Earnings on HSA investments grow tax deferred and whenever you withdraw money from your HSA to pay for qualified medical expenses, everything comes out tax free! So if you can afford to pay your current medical expenses out of pocket, saving and investing in a HSA can be an incredibly powerful retirement savings tool.
  10.  If you earn too much to make a Roth IRA contribution, there are still ways you can save on a Roth (after-tax) basis. First, there is no compensation limit on the Roth 401(k) option in your retirement plan. Also, there are strategies known as the “Backdoor Roth IRA” and the “Mega Backdoor Roth 401(k)” which enable you to fill the Roth bucket through Roth conversions and catch up on your retirement savings if you’ve had a late start. 
  11.  In general, Social Security can be claimed at any time from age 62 to age 70. The longer you wait, the higher your benefit will be. On average, Social Security replaces about 40% of a person’s income. Delaying the benefit, if you are healthy and have a long life expectancy, is a great way to protect yourself from longevity risk. Claiming the wrong way, however, could cost you and your spouse hundreds of thousands of dollars over a lifetime. 
  12.  Net worth is the value of all your assets (house and investments) less all your liabilities (mortgage, other loans). For most middle income families, home equity is a large portion of their net worth. For that reason, many retirees will need to tap into home equity to achieve a financially successful retirement. Two basic ways of using home equity are (1) downsizing to a less expensive home or (2) using a reverse mortgage. While they can be expensive, reverse mortgages allow you and your spouse to stay in your house and they can be paid in the form of a lump sum or annuity or taken as a line of credit.
  13.  Retirees need to invest a portion of their portfolio in stocks to ensure that inflation doesn’t eat away at their spending power.   But with stocks comes volatility and the potential for negative returns.  Sequence of return risk happens when those negative returns come early in retirement. When you withdraw money from your investments, negative returns early in retirement can cause your portfolio to fail faster than if those same negative returns instead occurred later in retirement. There are a number of different strategies to help mitigate against sequence of return risk including limiting your withdrawal rate (eg., the 4% rule of thumb), bucketing strategies, income laddering with bonds or CDs or tapping a reverse mortgage line of credit when the market is down.
  14.  How do retirees actually spend in retirement?   David Blanchett of Morningstar coined the term “retirement spending smile” to illustrate that for most retirees, spending continually decreases throughout retirement until the very end when medical and long-term care costs can cause spending to increase.   Practically, this means that it is possible to spend more than generally recommended early in retirement as long as you are willing to cut back spending in your later years and have a plan in place for end of life care.
  15. Many people have the majority of their retirement savings in pre-tax 401(k) and 403(b) plans and IRAs.  Saving on a pre-tax basis is often the best option, especially during your highest income years, because it reduces the amount you pay in taxes when you are in a relatively high tax bracket.  Sometimes, however, people get to retirement and discover that withdrawals from pre-tax accounts combined with Social Security causes them to pay higher taxes in retirement.  The additional income may also cause them to lose the opportunity to receive ACA (Obamacare) tax credits or be hit with Medicare surcharges.  Strategic Roth conversions (converting pre-tax accounts to Roth) during your “tax planning window”, the time between when you retire and when you begin claiming Social Security, can reduce overall taxes and extend the life of your portfolio.