Being older can save you money

Your age when you leave your employer is important because it determines whether you have to pay a 10 percent early withdrawal penalty on money you withdraw from the 401(k), in addition to taxes.

If you’re at least 55 years old when you leave your employer, you don’t have to pay the penalty on money withdrawn from that employer’s plan. You still have to pay income tax on the untaxed portion of your account withdrawal, though.

The exemption from the 10 percent early withdrawal penalty doesn’t apply to any untaxed 401(k) money you still have with employers you once worked for but left before turning 55.

If you’re under 55 years old when you retire, you will owe a 10 percent early withdrawal penalty on any 401(k) money you withdraw, in addition to taxes. (There are a few exceptions called 72(t) withdrawals, which I explain in the following section.) When you reach age 59½, though, you can withdraw your 401(k) money without a penalty, even if you retired from your employer before age 55.

Just to complicate matters, your plan can refuse to let you withdraw money until you are the plan’s “normal retirement age,” which is often 65. This is unusual but make sure to find out the rules for your plan before you do anything drastic, like retire.

No matter how old you are, you can avoid the early withdrawal penalty tax by rolling over your untaxed 401(k) money into an IRA. Remember, though, that after it’s in the IRA, you’ll generally owe a 10 percent early withdrawal penalty on any money you withdraw before you turn 59½. (The mysterious 72(t) withdrawal exception, which I explain in the following section, applies here, too.)

Foiling the dreaded early withdrawal penalty

But what if you need your money before age 55 or age 59½? Here’s where the 72(t) withdrawals (distributions) come into play — you can use them to avoid the early withdrawal penalty. It’s called a Section 72(t) distribution because it comes under that section of the Internal Revenue Code. These distributions are a list of exceptions to the penalty, such as being disabled or having medical expenses exceeding 10 percent of your income (see Chapter 16 for the complete list). However, one of the exceptions, called a SEPP, can be used by anyone. (SEPP stands for substantially equal periodic payments.)

When you use SEPP withdrawals, you set up a schedule of periodic payments that continue for five years or until you’re 59½, whichever is longer. Monthly, quarterly, semi-annual, annual, or some other form of equal payments work provided you withdraw the same amount each year. (You determine the amount using an IRS formula based on your life expectancy. Several approved methods exist. The simplest is the same one used to determine required minimum distributions, described in the section “Paying Uncle Sam His Due: Required Withdrawals.”) You can set up SEPP payments with your 401(k) if your plan allows these periodic payments. If it doesn’t allow them, you can roll your 401(k) balance into an IRA and take the SEPP payments from the IRA.

The three methods for SEPP withdrawals are

• The amortization method: Your annual payment is determined by amortizing your balance over a single or joint (you and your spouse) life expectancy. This method produces the largest and most reasonable amount you can remove. The amount is fixed annually.
• The minimum distribution (or life expectancy method): This method uses a dividing factor from the IRS’s single and joint life expectancy table. This factor is divided into your annual account balance. The annual withdrawals are likely to vary each year but not substantially. The lowest possible amounts can be withdrawn with this method.
• The annuitization method: This option requires using an IRS annuity factor to determine a fixed annual payout that typically falls between the other two methods.

Use a SEPP to avoid the 10 percent penalty tax if you retire before age 55 and start withdrawals from your 401(k) before age 59½, or if you need to make withdrawals from your IRA before age 59½.

If you move your 401(k) money into an IRA, remember to have it transferred directly. Don’t accept a check made out to you personally. If the 401(k) service provider makes the 401(k) check out to you, 20 percent of the amount must be withheld for taxes. You must make up this difference when depositing the money in the IRA; otherwise, the 20 percent withheld will count as taxable income.

Here’s an example of a situation requiring SEPP withdrawals. Say you stop working at age 56 and leave your money in your 401(k). Everything’s fine for two years, and then you decide you need to withdraw some money. You don’t have to worry about the 10 percent early withdrawal penalty because you were at least 55 years old when you left your employer. However, you still have to think about income tax. If you withdraw the entire 401(k) balance, you’ll have a big tax hit. Your employer may allow you to take installment payments from your 401(k) in the amount of your choosing, which would solve your problem. However, if your employer requires you to take a lump-sum withdrawal, what do you do? (If you’ve read the earlier chapters, I expect you to belt out this refrain like a Broadway chorus by now.) That’s right, roll over the 401(k) into an IRA to preserve the tax advantage.

There’s one complication, though. (There’s always something.) If you take a distribution from an IRA before you’re 59½, you have to pay the 10 percent penalty tax. It doesn’t matter that you were over 55 when you left your employer. To get the money out of the IRA without the penalty tax, you need to take a Section 72(t) distribution that must continue for at least five years — until you’re 63, in this example.

An alternative is to take a partial distribution from your 401(k) for just the amount you need right away, and roll over the rest of the money into an IRA. For example, assume that you have $200,000 in your account, and you need to use $35,000 before you turn 59½. You can take $35,000 (plus enough money to cover the tax) from your 401(k) plan and transfer the rest of the money directly to the IRA.

I recommend having the bulk of your savings in an IRA after you retire because IRAs give you greater withdrawal flexibility after age 59½ and more investment flexibility than a 401(k).

Leaving money with your former employer

If you don’t need to use any of your 401(k) money for retirement income and your account exceeds $5,000, you can leave the money in your 401(k). Your employer can’t force you to take the money out prior to your plan’s normal retirement age. Participants who are comfortable with the investments they have in their 401(k) and/or who don’t like making decisions are more likely to leave their money in the plan. Those who aren’t thrilled with their 401(k) investments usually can’t wait to get their money out of the plan and into other investments they think are better.

There is no right or wrong decision. Either arrangement is fine if your 401(k) investments are satisfactory. One thing to remember is that money in a 401(k) may have somewhat greater protection from creditors than money in an IRA, depending on your state of residence, should you declare bankruptcy. (IRA protection depends on state law where you live, whereas 401(k) protection is afforded by federal law.)

On the other hand, an IRA offers much greater investment flexibility. An IRA also gives you greater flexibility in naming a beneficiary: You don’t have to get your spouse’s approval before you can name someone else as beneficiary, as you have to with a 401(k).

As you decide whether to leave your 401(k) money with your former employer, also consider the fact that the corporate landscape changes constantly. In a continuous merger-and-acquisition climate, I usually advise participants to get their money out of the 401(k) plan as soon as they can. Not only can former employers be elusive, but they can also change your plan investments at any time. Your money can be moved from one set of investments to another without your approval.

Which comes first: Plucking the chicken or emptying the nest egg?

You most likely have some money saved in taxable (nontax-advantaged) accounts like Roth 401(k) contributions or a Roth IRA as well as in your 401(k) or traditional IRA. How do you decide which money to spend first?

Historically, many professional advisors recommended keeping as much money as possible in a tax-deferred account, even during retirement. The rationale was that you would continue to benefit from the fact that no interest, dividends, or gains were taxable while the money was in the account.

But the game changed in 1984 when Congress revised the tax rules regarding Social Security benefits. Although this tax-deferred advantage is still true, you also have to factor in taxation of your Social Security benefits. When you start receiving Social Security, your benefits are taxed if your income is over certain limits. Non-Roth distributions from a 401(k) or traditional IRA are taxable retirement benefits included in the income you must count to determine what portion, if any, of your Social Security benefits are taxable. So, if you take money out of your 401(k) or traditional IRA when you start receiving Social Security benefits, you may have to pay tax on your Social Security benefits.

Do some basic planning before deciding on your retirement withdrawals, bearing in mind that receiving income over a certain level means you pay tax on your Social Security benefits. Chapter 2 explains when your Social Security benefits are taxable, and you can check the Social Security Administration website at www.ssa.gov for updates.

If you retire a few years before taking Social Security benefits, you may want to use up your tax-deferred accounts first, rather than your other savings, per the following example that assumes you

• Retire at age 60
• Plan to start receiving Social Security benefits when you reach age 62, before you reach your full retirement age
• Have $150,000 of personal savings
• Have $350,000 in your retirement account
• Will need $45,000 of income (after taxes) each of your first two years of retirement (before Social Security kicks in)

You can either use your personal savings or withdraw approximately $50,000 from your retirement account during each of these two years. (I am assuming that a $50,000 withdrawal will leave you about $45,000 after paying taxes. If you have other taxable income, your tax rate may be higher.) Withdrawing the money from your 401(k) right away will reduce the size of the taxable distributions you’ll receive after you become eligible for Social Security. It reduces your taxable income after you start to collect Social Security benefits, so perhaps you won’t have to pay as much, or any, tax on your benefits. This may be a better tax deal than the tax break you receive by keeping more money in your retirement account. And you’ll still have your personal savings available, which you’ve already paid taxes on.

You need to do some fairly complex calculations to see what’s better in your situation, so I strongly encourage you to consult an experienced accountant or other qualified advisor who does this type of planning.

Dealing with that darned company stock

You need to consider taxes when you decide what to do with the company stock you may have accumulated in your 401(k) account or other employer-sponsored plan, such as an employee stock ownership plan (ESOP). As I discuss in Chapter 13, you get a special tax break when you receive company stock as a distribution. You pay tax only on the value of the stock when it was credited to your plan account, not on its current value. You pay a capital gains tax on the difference whenever you eventually sell the stock. These capital gains taxes are lower than the income taxes you would otherwise pay. Finally, if you pass the stock to your heirs when you die, they won’t pay tax on any gains that occurred before it was given to them.

This type of estate planning is feasible only if you don’t expect to use the stock during your retirement, and you’re willing to take the risk of having a chunk of money tied to one stock for many years.

Holding stock in an individual company is much riskier than investing in a number of different investments. If you’re not sure why, check out Chapter 14.

If you roll your company stock into an IRA, you can sell it and diversify into other investments. You have to pay income tax on your eventual withdrawals. If you take your distribution of stock, you must pay tax on the value of the stock when you received it in the plan. You can then sell the company stock, paying only capital gains tax on the gain, and use the money to invest in more diversified mutual funds or a portfolio of stocks. However, returns on these “taxable” investments will be subject to income tax every year. Still, the benefits of diversification probably make either one of these strategies more palatable than holding on to the company stock, unless you really aren’t going to need the money during your lifetime.

Don’t let the tax tail wag the dog. Passing company stock on to your heirs is an instance when tax planning for them may get in the way of good investment planning for you.

Live long and prosper

Maintaining an income stream that will last for the rest of your life is more difficult now than it used to be. A generation or two ago, retirees commonly converted all their available funds into income-producing investments. For most retirees, this meant converting their funds into bank certificates of deposit (CDs). Those who owned stocks typically stuck to the ones that were popular for widows and orphans — in other words, stocks such as utilities that paid high dividends and had a history of steady income with low price fluctuation and modest long-term growth.

Keeping up with inflation wasn’t a big deal when the average retiree lived for only 10 to 12 years after retiring. A 3 percent inflation rate reduced the amount of income a retiree can spend by only 23 percent after 10 years.

Today, if you retire during your 50s or early 60s, you need to plan for at least 30 years of retirement income. Your buying power will be reduced by 58 percent after 30 years of inflation at 3 percent. You’ve probably read that you have to keep some money invested in stocks during your retirement years to help offset the impact of inflation. This advice makes sense because stocks have produced a higher level of return on average than other investments over 20- to 30-year time periods. But you also need to know how much stock, and which types of stock, to own.

Stay practical

When you do your retirement planning, don’t expect an annual return of 10 percent or higher. Too many 401(k) and IRA investors have come to expect just that during the high-performance 2010s and early 2020s. The stock returns that investors experienced during these years can’t continue indefinitely — you can expect a typical market crash. It appeared the crash would happen in 2021 due to the COVID-19 pandemic, and it most likely would have if the Federal Reserve hadn’t printed a lot of money. I don’t know when the next prolonged, major downturn will occur.

Retirees who were following traditional investment advice during 2008 incurred losses in the 30 percent range. Such a loss shortly after you retire is a horrible way to start your retirement years. More aggressive retiree investors incurred even larger losses.

A $100,000 account that drops to $70,000 due to a 30 percent loss must increase by 43 percent to get back to $100,000. Assume you need to withdraw $4,000 per year from your retirement accounts — the 4 percent generally recommended by investment professionals. You assumed your $100,000 would grow by 6 percent each year. If both happened during the first year of your retirement, you would have roughly $102,000 in your account at the end of the first year. If, instead of a 6 percent gain, you experience a 30 percent loss, your account becomes worth approximately $66,000 after the first year rather than $102,000 — a 55 percent gap from which you most likely will never recover.

It’s important to have a plan in place and reserves at the ready in case there is a drop in the market. Read on to find out how to manage your investments when things don’t go quite according to plan.

Balancing investments

One way to avoid having to sell stocks when they’re down is to invest about 20 percent of your nest egg in low-risk, fixed-income investments, such as a money market fund or short-term bond fund. Hold these investments in your regular IRA or in a separate IRA. Use this money as a special cash reserve fund during down periods. You can tap this fund rather than be forced to sell stocks and bonds when their value is down.

Imagine you have a retirement nest egg worth $250,000. You withdraw 4 percent, or $10,000, for living expenses the first year. The next year you withdraw $10,300 to keep up with 3 percent inflation. Now say the value of your investments drops 10 percent the first year and another 4 percent the second year. Finally, assume that you based your plan on a 6 percent return during your retirement years.

If you’re particularly thrifty, you may think that you don’t need to adjust for inflation. Don’t fool yourself. You’re not living on the same income now that you had 20 or 30 years ago, and you won’t want to live on today’s income 30 years from now. Some argue that, despite inflation, expenses decrease during retirement years. That’s true for some expenses, but medical expenses usually increase, and you may ultimately need to cover the cost of an assisted-living facility. Keeping some of your investments in stock should help you make up the gap that inflation causes.

A 6 percent return may have looked like a sure thing when you retired, but instead the market drops by 14.6 percent during the first year and gains 10.8 percent the second year as it did in 2008 and 2009. Table 17-2 shows returns for a mutual fund with a 47/53 stock/bond mix that was considered appropriate for a retiree early in the 21st century. Table 17-2 shows the fluctuations in value of a $250,000 nest egg in these circumstances, compared to your original investment plan, which assumes 6 percent gains per year.

The actual results were a 14.6 percent loss during 2008 and a 10.8 percent gain during 2009. If your plan is based on a 6 percent average annual return, this example shows how badly your plan can be disrupted if the year you retire is when the market crashes.

Although no one can predict when the market will go up and down, you do need a predictable stream of income during your retirement years. But withdrawing money when the value of your investments is declining can be gut-wrenching.

Buying an annuity

Buying a fixed-income annuity is an option to consider if you have less than a few million in assets to provide the retirement income you need.

There are many types of annuities on the market. The only one I recommend is a fixed-income annuity that provides a guaranteed monthly income for the rest of your life. A joint life annuity will provide a guaranteed income to both you and a spouse.

The amount you pay to buy a fixed-income annuity depends on your current age, the age when you want the monthly income to begin, and the monthly annuity amount. It costs a lot to buy $1,000 of monthly annuity income when you are age 67 with immediate monthly payments because the insurance company must pay you for the rest of your life — potentially 20 to 30 years.

You can choose from many annuity options:

• Buy one that starts payments when you retire.
• Buy one that doesn’t start paying you until you reach an older age such as 75 or 80. Doing so will assure you a guaranteed monthly income at that age, reducing the risk that your nest egg will run dry while you are still living.
• Buy two annuities — one that starts paying when you retire and another one that starts payments during your later years.

A life-income annuity is the reverse of life insurance. With life insurance, you pay premiums each year for a benefit paid to your beneficiaries when you die. This benefit is meant to help replace your lost income. With an annuity you receive monthly benefits for as long as you live. The annuity protects you from living too long. The monthly payments end when you die unless you select one that guarantees an income to a spouse or someone else after you die. You receive the largest monthly benefit if payments end when you die.

The biggest risk with a life annuity is incurred if you die shortly after buying it, making the insurance company that sold you the annuity the big winner.

Your health and gene pool are factors to consider before buying a fixed income annuity. You need to judge how likely you are to live into your 80s or 90s based on your health and genes.

A lot more needs to be considered about this type of annuity than I can cover in this book. I think “Stan the Annuity Man” has the best information available. Go to www.stantheannuityman.com and order his free books to get access to a lot of good information even if you never buy an annuity from Stan.

The amount of annuity income you get varies a bit by state due to state taxes. Annuity rates also change frequently for a variety of reasons, with changes in interest rates the biggest factor. You can buy a larger annuity income when interest rates are higher because insurance companies factor their expected return into their pricing. Interest rates are low today making it less attractive to buy an annuity. Delaying your annuity purchase is an option to consider if you expect interest rates to go up in the near future.

Take a look at some examples of how annuities work in different situations:

• Example #1: The first example is how much monthly annuity income can be provided for a 65-year-old male with payments starting immediately. The answer on April 19, 2021, was $1,202.87 using $250,000 from an IRA. The $1,202.87 amount will be paid for as long as the buyer lives, and it will end when the buyer dies. A buyer who lives until age 100 would be a big winner.
• Example #2: This example is the same as Example #1 except the monthly payment is reduced to $969.83 so payments continue to the buyer’s spouse for the rest of the spouse’s lifetime if the spouse outlives the buyer. This is known as a 100 percent joint and survivor annuity. Monthly payments end when the buyer dies if the spouse pre-deceases the buyer. The buyer isn’t permitted to name another joint survivor if the spouse dies prior to the buyer.
• Example #3: This example is the same as Example #1 except the monthly payments are $1,079.51 to the buyer for life, with 50 percent of this amount continuing to the spouse after the buyer’s death. This is known as a 50 percent joint and survivor annuity.

The monthly payment for the above annuity payment options drops to $831.51, $637.26, and $747.79 when a feature is included that will increase the payments by 3 percent each year to help offset the impact of inflation.

Note: In all these examples, I assume the annuity purchase is made using a traditional IRA; therefore, the full annuity payment is taxable.

Adding up the expenses

It may be smart to sell your home and use the proceeds to generate income, and then find a place to rent. Why rent if you own a home without a mortgage? Consider that a home is indeed an asset, but it doesn’t produce money — it eats it up. It costs a lot of money to live in your home even if you don’t have a mortgage. If you own a $300,000 home, your annual costs to maintain it are likely to be pricey:

• Real estate taxes are probably in the $5,000 range.
• Homeowner’s insurance may be $1,000, more or less.
• Routine annual maintenance and utilities, such as water, sewer, insurance, and lawn care are probably in the $6,000 range. (Check all your expenditures for a year if these estimates seem high.)
• Periodic repairs, such as a new roof and indoor and outdoor painting or upkeep.

All told, you probably spend at least $12,000 per year for the privilege of owning your $300,000 home — even with the mortgage fully paid. This additional expense is okay if you have adequate retirement income but is less than okay if your retirement resources are limited. The situation is much worse if you still have mortgage payments.

You can probably find a nice place to rent for $1,500 per month in the same area as your $300,000 home. The rental will cost you $18,000 per year compared to the $12,000 it may cost to live in your present home. You’re paying a bit more for the rental, but you don’t have the hassle of home ownership. Most importantly, you can reinvest the money from the sale of your home and make up the difference. Investing $300,000 at a 4 percent return gives you an additional $12,000 annually, and you have the $300,000 available as needed.

Making use of your equity

A reverse mortgage or home equity loan are other ways to tap into your home’s value if you really want to stay where you are and in the house you own. Equity is the difference between what your home is valued at and the amount you owe on it.

Up-front costs for a reverse mortgage are in the $10,000 to $15,000 range. All you get for those fees are the right to draw against your home equity as needed and no repayment schedule. No repayments are due during your lifetime, and you and your spouse can live in the house for the rest of your lives regardless of how long you live. You must keep up with taxes and maintain the home.

I recommend delaying applying for a reverse mortgage until you need to tap into your home equity; however, apply a year or more before you reach this point because the process takes a while.

A reverse mortgage may not be in the best interest of your heirs. They may not have much time to pay off the balance after your death. The mortgage holder’s primary interest is to get their money out of the property as soon as possible. Getting a price high enough so your heirs get some money usually isn’t a concern.

Obtaining a home equity line of credit is another option to consider rather than selling your home. Do this while you’re still working because a bank must approve your request based on your ability to repay the loan. Your income while still working should enable you to get the loan approved.

Save using your home equity loan until the later stage of your life for repayment reasons. Assume you obtain a $100,000 home equity loan when you’re age 65 but don’t need to use it until you reach age 80. Assume you start drawing $1,000 per month. My bank requires paying back 2 percent of the loan balance plus interest every month. There’s usually no fee or only a small one with this type of loan, but monthly repayments are required, and they will grow if you make $1,000 monthly withdrawals. Eventually you will probably need to sell the home because you won’t be able to make the monthly payments.