6. How to Stop Working Someday: Saving and Investing for Retirement

If you can live on $1,000 a month, then you can skip this chapter. That’s about how much Social Security pays the average retiree.

Most of us will want a less spartan lifestyle in old age, which means we must save some of our current income for our future needs. Figuring out how much to save and how to invest it isn’t really rocket science. Although plenty of variables are involved, the average person can manage to accumulate a substantial sum simply by contributing regularly to retirement accounts, staying diversified, and not pulling out in a panic when markets swoon.

The time you need to talk to an advisor is when you’re closing in on retirement. Several times in this chapter, I advise people to turn to fee-only financial planners. That’s because retirement decisions can be extraordinarily complex, and you may not be able to correct a bad or uninformed choice. It pays to have someone in your corner who can review your individual situation and give you advice that puts your interests first.

A: There’s nothing wrong with paying down a mortgage as long as you’re saving enough for retirement and your other important financial goals.

The problem comes when people skimp on their retirement savings, thinking they can make up for lost time later. They typically can’t, and the longer they delay adequate contributions to their retirement, the more hopelessly behind they fall. You need to get money into your retirement funds as early as possible if you want to put the miracle of compounding to work for you. Every $1,000 you don’t contribute in your 20s, for example, could cost you $20,000 or more in lost future retirement income.

To find out how much you should be saving, start with Choose To Save’s Ballpark Estimate (www.choosetosave.org). AARP also has an excellent retirement calculator, at www.aarp.org/work/retirement-planning/retirement_calculator.

I do have about $4,000 in savings right now. Do you think I should go ahead and open an IRA? If so, what should I be looking for in the bank or investment company with which I open the account?

A: There’s really no such thing as “too little” when it comes to retirement savings. Everything you set aside can help you on your journey to financial independence.

Furthermore, waiting until you can contribute more is a bad idea, since your expenses will probably rise over time and you’ll always find ways to spend the money if you don’t make saving a habit. Start with those $25 contributions and try to bump up the amount every few months. After you graduate, look for a job that offers a good workplace retirement plan that will allow you to contribute 10% to 20% of your earnings—preferably with a company match.

For now, though, opening up an IRA or a Roth IRA is a great idea. You may be able to get a tax credit for your contributions if your modified adjusted gross income is below certain limits ($27,750 for a single person in 2011). You can learn more about this saver’s credit by reading Publication 590, Individual Retirement Arrangements, or the instructions for Form 8880, Credit for Qualified Retirement Savings Contributions.

Avoid banks and full-service brokerages, as their hefty fees will eat heavily into your returns. Instead, start with an account at a company that offers low fees, such as discount mutual fund company Vanguard Group or discount online brokerage ShareBuilder.

Vanguard has a $3,000 minimum investment requirement on most accounts and a $100 minimum for additional investments. If you choose its target date retirement funds, though, the minimum is only $1,000, with a $1 minimum for future automatic investments. You’d need to tap some of your savings or save up in another account (such as an online savings account) and transfer the money when you have enough. Alternatively, ShareBuilder allows you to invest without minimums. Automatic investments in certain mutual funds are free, and automatic investments in other funds and stocks cost $4 apiece.

A: The most important thing you need to know about investing is that there is no such thing as a truly risk-free investment.

You won’t lose your principal if you invest in “safe” investments, such as Treasuries and FDIC-insured bank accounts. But you won’t earn enough to keep ahead of inflation. Basically, you’ll never be able to save enough to retire, since the purchasing power of your funds will erode over time rather than grow.

To stay ahead of inflation, you need to take more risk. Over time, stocks have consistently offered returns that beat inflation. In every 30-year period starting in 1928, stocks have returned average annual returns of at least 8%. But they certainly don’t gain that much every year, and some years, you’ll face steep losses. When you invest in stocks, you have to be prepared for volatility. In other words, sometimes your investments will lose money.

You can reduce that volatility somewhat by diversifying your stock investments (some small companies, some large; some U.S. companies, some foreign) and by including a diversified mix of bonds in your portfolio, along with cash.

A fee-only financial planner can help you design an investment plan that makes sense for your situation. Or you can consider opting for the “lifestyle” or “target date retirement” funds your plan offers, since they do the diversification and rebalancing for you.

A: Remember the Depression? World Wars I and II? The Cold War? The assassination of President Kennedy? Vietnam? Watergate? Probably not, because you weren’t around. Regardless of the setbacks we’ve faced, however, our economy continues to grow. So do stocks.

Investing in stocks is essentially investing in the productivity of our companies. If you want a graphic representation of that growth, use a search engine to find a chart showing “Dow Jones historical average.” You’ll see that this market benchmark has had numerous setbacks, many of them serious, but its growth has been exponential. The Dow started 1932 at 100. In the 1970s, it bobbed around 1,000. People were pretty disgusted with stock market returns, and many were pessimistic about the future of our economy. Yet in 2012, the Dow was 12 times higher than its 1970s level.

In every 30-year period since 1928, stocks have had an average annual return of at least 8%. Those who hung on through bad times were eventually rewarded for ignoring the doom-and-gloomers. Yes, there will be scams and scandals and people gaming the system. The fact remains that no other investment has the inflation-beating history or potential that stocks have. If you hope to retire someday, a good portion of your portfolio likely needs to be in stocks.

As for gold, here’s another little bit of history you should know. Although its price jumped dramatically during the recent financial turmoil, the cost per ounce still hasn’t returned to the peak in value it enjoyed in 1980, after you adjust for inflation.

A: The short answer is, yes, although you may want to reconsider contributing to your workplace 401(k) as well.

As long as you have earned income that’s less than the Roth limits, you can contribute to a Roth account, says Mark Luscombe, principal analyst for tax research firm CCH Inc. Your status as a dependent and your parents’ household income aren’t factors.

This fact allows many wealthier parents who make too much for their own Roth IRAs—the limits are $179,000 for a married couple filing jointly and $122,000 for singles—to give money to their lower-earning children to fund the kids’ Roth accounts.

“The dependent would need to have earned income for the year at least equal to or greater than the amount of the Roth IRA contribution,” Luscombe says. “[But] the Roth IRA contribution would not have to come from that earned income.” The money could come from the parents’ gift.

All that said, you should reconsider your aversion to your company’s 401(k), especially since you may be misunderstanding how it works. You typically can leave with your own contributions, and the earnings on those contributions, at any time. What you may not be able to take with you is your employer’s full match, since it may take several years for you to be fully vested. Still, you may be able to leave with part of the match, which would make it free money that you shouldn’t turn down.

A: You can enjoy life and still refrain from doing stupid things that will jeopardize your retirement.

Tapping retirement funds early is typically pretty stupid. You’re giving up all the future tax-deferred returns that money could have earned. By the time you’re 60, that $38,000 could have grown to nearly $450,000.

You also may be underestimating the tax bite. You can withdraw up to $10,000 from an individual retirement account for a first-time home purchase, but the remainder of the withdrawal will be penalized at a 10% federal rate, plus whatever penalty your state assesses. The entire withdrawal will be taxed at your current income tax rates.

The taxes and penalties are substantial for a reason: You’re supposed to leave this money alone. Since you probably won’t be able to contribute to a retirement account for awhile, it’s even more important not to squander these funds.

Besides, the extra $30,000 would lower your monthly payment by about $160 on a 30-year fixed-rate mortgage at 5%. That doesn’t seem like much of a payoff, considering what you’d be giving up.

A: Your approach is likely the smarter one. People who retire in bear markets are in far greater danger of running out of money than those who retire in better times, according to analyses by mutual fund company T. Rowe Price. That’s because bear market retirees draw from a shrinking pool, and the withdrawn money isn’t there to earn gains when investment markets rebound.

In most years, retirees have an almost 90% chance of being able to sustain their retirement income over a 30-year retirement if they limit their initial withdrawal to 4% of their investment portfolios and increase the withdrawal 3% each year to offset inflation, T. Rowe Price found. But poor market performance in the first five years of retirement can reduce that strategy’s chances of success from nearly 90% to just 43%. In other words, you would be far more likely to run out of money.

The best way to cope with a downturn, the company found, is to reduce withdrawal rates 25% until the markets improve.

If the proceeds from your home sale were enough to pay off your current mortgage, your husband could make the argument that reducing your monthly expenses would, in turn, reduce the amount you’d have to withdraw from your retirement accounts. But in this case, paying down your debt won’t change your monthly costs.

What you really should do, however, is take this question to a fee-only financial planner who can review your situation and advise you about your next moves. You can find referrals to fee-only financial planners from the Garrett Planning Network (www.garrettplanningnetwork.com), the National Association of Personal Financial Advisors (www.napfa.org), the Alliance of Cambridge Advisors (www.acaplanners.org). Each site offers advice about how to evaluate and choose a planner.

A: Continue contributing to your 401(k), no matter what. You may save a few bucks in interest in the short run if you stop contributing to pay down the loan, but you’ll lose out on the much bigger compounded gains your contributions could have made over the coming decades.

A: You don’t need your employer to help you save for retirement, fortunately. Since you’re over 50, you can contribute up to $6,000 to an IRA or Roth IRA annually. (People under 50 are limited to $5,000.) You can open an account at virtually any bank, brokerage, or credit union. Look for one that doesn’t charge you account service fees and that has a broad array of low-cost investment options. Vanguard, for example, waives its service fees for IRA investors who sign up for electronic statements.

If you’re able to save more, you can do so in a regular, taxable brokerage account. You won’t get a tax break for your contributions, as you would with a traditional IRA, but you can qualify for low capital gains tax rates if you hold your investments for at least a year.

Your Social Security benefits will be based on your 35 highest-earning years. The Social Security Web site has a benefits calculator (see www.ssa.gov/planners/calculators.htm) that enables you to see your estimated future benefit based on your work record so far and create different scenarios—such as a lower salary going forward or different retirement ages—to gauge their effect on your future checks.

A: You’re lucky—you actually have more options to save for retirement than people who don’t own their businesses, if you can spare the cash to make significant contributions.

You can contribute up to $14,000 annually to a SIMPLE IRA (the limit is $11,500 for people under 50). Another option is a simplified employee pension, or SEP. You can contribute as much as 20% of your net business profit or 25% of your salary (if you pay yourself with a W-2), to a maximum of $49,000 in 2011. For more details on SIMPLEs and SEPs, see IRS Publication 590.

If you want to contribute more than the SIMPLE’s $14,000 limit but a SEP won’t allow you to put aside enough, you can contribute a greater percentage of your income to a solo 401(k) or a solo Roth 401(k). With these plans, you can contribute 100% of your first $22,000 in income from the business (or $16,500 if you’re under 50), plus 20% of net profit, until you hit the $54,400 maximum for people 50 and older ($49,000 is the maximum for younger people). Your contribution to a solo 401(k) would be tax deductible (and your contribution to a Roth 401(k) would not be), but your withdrawals in retirement would be tax free.

If you’re really raking in the dough, consider a traditional defined-benefit pension plan. These plans can cost thousands of dollars to set up and administer, but you can put aside hundreds of thousands of dollars a year.

You can take advantage of any of these options and contribute an additional $6,000 to a Roth IRA. (You can’t, however, contribute $6,000 each to both a traditional IRA and a Roth IRA; the limit for both accounts combined is $6,000.) Having at least some money in a tax-free retirement bucket can give you more flexibility to control your tax bill in retirement.

You’ll probably want a tax professional’s advice, since retirement can be a complex area to navigate.

A: You probably would have more investing choices with an IRA, but you might also wind up paying more. A good, large-company 401(k) plan often offers access to institutional funds that charge less (sometimes much less) than what a retail investor would pay for a similar investment through an IRA. There’s a reason brokerage firms are after you to roll over your IRA: They typically make more money.

If your new employer’s plan is a good one, transferring the money there is often the simplest and most cost-effective solution. Or you may be able to leave the money where it is, if you like the plan. Only if neither option is palatable, or if you’re convinced that you can find better, lower-cost options on your own, does an IRA rollover become the clear best choice.

A: You’re right to worry about wasting this windfall—that’s what often happens. A few thousand dollars here, a few thousand dollars there, and suddenly what once seemed like a vast amount of money is gone.

First, you need to talk to a tax pro to make sure you won’t get a tax bill from your home sale. Then you need to use a small portion of your inheritance to hire a fee-only financial planner who can review your situation and suggest some options.

You’re closing in quickly on retirement age, and you should know that Social Security typically doesn’t pay much. The average check is around $1,000 a month. This windfall can’t make up for all the years you didn’t save, but it could help you live a little better in retirement if properly invested.

You should read more about investing so you can better understand the relationship between risk and reward. It’s understandable that you want to keep your money safe, but investments that promise no loss of principal don’t yield very much. In other words, keeping your money safe means it won’t be able to grow, which, in turn, means your buying power will be eroded over time.

A: If your advisor gets paid a commission for selling annuities, as she probably does, she’s not an objective source for you on this topic. Consider investing a few hundred dollars to consult a fee-only financial planner who can review your financial situation and your investments and offer advice.

Variable annuities aren’t always a terrible option, but they’re a poor fit for IRAs, which already offer the tax deferral that’s a big part of an annuity’s appeal. The so-called living benefits that guarantee a certain payoff typically come at a high price, which is why you should always run these investments past an objective source before you buy.

A: Let’s be clear: You have no assets. Your mother does, and she may plan to give those to you, but those plans could change. She might need her money for living expenses or long-term care, which could easily eat up that nest egg. Other setbacks, such as a stock market downturn or a well that runs dry, could devalue what’s left in her accounts.

You need to start saving on your own for retirement. If you have a work-place retirement plan such as a 401(k), start contributing to that. If you don’t, put aside money in an individual retirement account. Resolve to save as much on your own so you won’t be dependent on an inheritance that may never come.

A: Financial planners typically recommend an initial withdrawal rate of 3% to 4% of your portfolio. With $2.6 million, your first year’s withdrawal would be $78,000 to $104,000. The idea is that you could adjust the withdrawal upward by the inflation rate each year and still be reasonably confident that you won’t run out of money after 30 years. Some studies indicate that you can start with a higher withdrawal rate, as long as you’re willing to cut back in bad markets.

There is still some risk of going broke, though, even with a 3% withdrawal rate. Particularly poor stock market returns at the beginning of your retirement, for example, could increase the chances that your nest egg will give out before you do.

This is an issue you really should discuss with a fee-only financial planner who can review your investments and your spending to make personalized recommendations. If you’ve chosen especially risky stocks or have too much of your portfolio in bonds, for example, your retirement plan could fail even if you choose a conservative initial withdrawal rate. (Stock values can crash, and bond returns may not keep up with inflation.)

You’ll also want to talk about how you’re going to get health insurance and how much it’s likely to cost. If you’ve been arranging coverage through your business, you might face some sticker shock when you have to buy a policy on your own. But it’s essential to have this coverage, since you won’t qualify for Medicare until you’re 65.

If you’re not tired of your business, you might consider phasing in retirement, if that’s possible in your situation. That would mean starting to take some long breaks to travel or pursue the interests you plan to indulge in retirement. Delaying retirement even a few years can dramatically increase the chances your nest egg will last.

A: Sure. You got extraordinarily lucky. You retired during a massive bull market, which is the best possible scenario for someone who hopes to live off investments. You were drawing from an expanding pool of money. Your stocks probably were growing at an astonishing clip of 20% or more a year for several years. Although later market downturns probably affected your portfolio, those initial years of good returns kept you comfortably ahead of the game.

Contrast that with someone who retires into a bear market. She’s drawing from a shrinking pool of money as her investments swoon. The money she takes out can’t participate in the inevitable rebound, so she loses out on those gains as well. All that dramatically increases the risks that she’ll run out of money before she runs out of breath.

The first five years of retirement are crucial, according to analyses by mutual fund company T. Rowe Price, which has done extensive research on sustainable withdrawal rates. Bad markets and losses in the first five years after withdrawals begin significantly increase the chances that a person will run out of money during a 30-year retirement.

Some advisors contend that a 3% initial withdrawal rate, adjusted each subsequent year for inflation, is too conservative. If you retire into a long-lasting bull market, it may well be. But none of us knows what the future holds, which is why so many advisors stick with the rule of 3% to 4%.

A: You’re right. The math typically favors delaying Social Security payments for as long as you can. Your benefit gets bigger for every year you delay until age 70. Also, your benefits are sharply reduced if you apply for Social Security before your “full retirement age” (currently, age 66, although that will increase to age 67 for people born after 1959).

Far too many people grab their Social Security checks too early, locking themselves into lower payments for the rest of their lives. Some do so in the mistaken belief that their benefits, or Social Security itself, will go away or be dramatically altered if they don’t “lock in” their checks. It’s true that Congress needs to change the Social Security program if it is to meet all its future obligations. But lawmakers are far more likely to change benefits for young people than they are to mess with promised benefits for people close to retirement age.

Another factor to consider is your spouse. Delaying your benefit maximizes the amount your spouse could claim in survivor benefits if you die. This is especially important if your spouse didn’t earn much during her lifetime and the survivor benefit would be more than she could claim based on her own earnings record.

But this is yet another area where there are no one-size-fits-all solutions. Some people may opt to apply for benefits early, perhaps because their life expectancies are short, they want to let their investments continue to grow tax deferred, or they simply want (or need) the money. Others may delay for as long as possible to maximize their payouts.

You can’t know for sure which is the right approach, since so many variables are involved—including how long you’ll live and how long you’ll enjoy good health. But online calculators can help walk you through the math, including Maximize My Social Security, at http://maximizemysocialsecurity.com/.

Another good resource is Personal Finance for Seniors For Dummies (Wiley, 2010), by Eric Tyson and Robert C. Carlson, who spend a fair amount of ink on the “when to retire” conundrum, and Social Security For Dummies (Wiley, 2012), by Jonathan Peterson, who goes into similar depth. You also should check out mutual fund company T. Rowe Price’s information about “practice retirement” at http://troweprice.com/practice, which details the benefits of continuing to work through your 60s while saving less for retirement. The growth in Social Security benefits and retirement accounts is so great during that decade that it often more than offsets a sharp reduction in savings, which would mean you’d have more money to spend on vacations and other fun pursuits even before you retire.

As you approach retirement, make an appointment with a fee-only financial planner to review every aspect of your retirement plans, including this particular issue.