By Jim Amell
After a decade of extremely low inflation, the rapid increase in costs of living we are experiencing has been difficult for most households, particularly retirees on a fixed income.
Many retirees are facing declining income along with increased expenses. Our current economic environment also provides lessons for everyone on how to position their personal finances for their retirement.
How should retirees respond so as not to be overwhelmed by increased cost of living? First, determine your monthly income. Social Security benefits have and will continue to increase at a rate roughly equal to the core inflation rate. Unfortunately, Medicare premiums withheld may also increase, leaving beneficiaries with only a slight increase in net social security benefits.
Revisit your sources of income other than social security. The stock market has declined significantly this year, and whether your retirement savings are in a 401k/IRA/Roth IRA, taxable investments, cash savings, or a combination of the amount you can comfortably withdraw depends on the nature of your investments and income generated by those investments. If you withdraw from investments based on a fixed percentage of invested assets you will most likely be withdrawing less than in recent years.
Sure, you can withdraw more than the percent planned but doing so will increase funds available for the future. Plan your withdrawals to minimize taxes, including State income taxes. Take advantage of the New York state exclusion of the first $20,000 of pension income from tax. Consider selling investments that have little appreciation or even a loss, to minimize taxable gains.
After estimating available income, review and estimate your monthly expenses and divide into recurring costs such as housing and household costs, transportation, food, medical, recreation/entertainment, dues and subscriptions and income taxes; and nonrecurring costs such as travel, major repairs, new vehicle and/or appliances, and gifts and contributions. Further divide these expenses into necessary and discretionary.
If your budgeted expenses are covered by your estimated income, congratulations! If not, time to start paring down your spending. Look at discretionary expenses first, and if they can not be cut or deferred, at least consider paying for them with nontaxable assets.
For example, if $20,000 is needed for a new roof pull $20,000 out of a Roth IRA rather than a taxable account. If you want to continue making charitable contributions at previous levels, consider donating appreciated stock rather than cash. Then look more closely at your necessary/recurring costs. Consider cancelling magazine subscriptions and going to the library instead. Try to consolidate errand to use less gas. Take advantage of coupons and senior discounts.
What can be learned by pre-retirees from the current economic circumstances? First, it shows the importance of setting aside at least six to twelve months of expected spending in cash or cash equivalents that are not subject to changes in the stock market. This allows for withdrawals from cash reserves without needing to sell investments at a reduced value.
Next, consider the effect income taxes will have on your sources of income. Once you reach age 72 minimum distributions (RMDs) will be required from your taxable pension accounts and even if under age 72 it is likely that you would need to withdraw funds from a taxable account. Withdrawals from Roth IRAs on the other hand are not taxable so every dollar of distribution is available for spending. The bright side of depressed stock market values is it makes this an opportune time to convert taxable retirement accounts to a Roth IRA.
Yes, you will pay taxes now but future appreciation will never be taxed. Third, revisit your asset allocation. Historically, a typical portfolio includes a mix of equities and bonds under the assumption that equities are riskier but allow for long-term growth while bonds are more conservative but provide income and security of principal. Well, we see what has happened to bond values as interest rates increase.
Asset allocations should be based on not only the type of investment (equities or bonds) but also asset sectors. Try to structure your investment portfolio so that sufficient dividends and interest will be generated to cover the majority of your expected annual withdrawals. Finally, when projecting your expenses once in retirement, factor in inflation! Assuming an inflation rate of 2.5 percent, $50,000 of spending today would be $64,000 in ten years. If assumed inflation is 6 percent, the same $50,000 today would cost $89,500 in 10 years.
If you are currently retired do not panic; reduce spending where you can and be strategic when withdrawing funds. If you have not yet retired take steps to position you finances to survive inflation and stock market declines more easily in ten or more years from now.