Armchair Millionaire

Cracking the Retirement Nest Egg

Question of the week:I'm three years away from retiring and starting to look at my options for safely withdrawing money from my portfolio for living expenses. How do you suggest I go about it? --Early Retiree in KC

Dear KC,

As you're probably discovering, drawing a regular income out of your portfolio during retirement can be even more complicated than growing the portfolio in the first place.

It's a balancing act. You need to use your capital to generate income while simultaneously preserving that principal so that it lasts as long as you need it. When we asked members of the Armchair Millionaire community how they plan to tap their retirement accounts for income, we received a range of responses:

CDs. "Starting at age 59 1/2, I'll take 2 percent out my retirement accounts each year and place into a 5-year CD. The first one is due at 65, then the next one at 66, and so on. It will take at least 50 years, or until I am 115, to go through all the money. I'll supplement this with payouts from a fixed-income fund." --Joe M.

Bonds. "Our portfolio is mostly in U.S. Treasury and Agency bonds. We'll spend 3 percent of the portfolio per year to supplement pension income. Social Security is a nice addition, but not an essential element of our retirement. This plan will provide us with 115% of our pre-retirement income." --Allen and Kay

A blend of CDs, bonds and money markets. "I'll have a mix of stocks and bonds. Three years before retirement, I'll start monthly transfers of one-half percent of the portfolio to cash-short-term bonds, CDs and money markets. So long as the portfolio averages six percent annual returns (below the long-term average), I can maintain or improve my lifestyle, plus have something left for the children or charity." --Mike

As you can see, there is no single correct way to construct a retirement portfolio. But every sound approach does have one critical ingredient: good planning. My checklist will guide you when making your own plan.

The Armchair Millionaire's Checklist for Tapping Retirement Funds

• Run the numbers. Figure out precisely how much income you'll need each month. Look closely at your current expenses and how they might change once you stop working. While some people may need less income than during their working years, I suggest that you plan on being able to generate at least 100 percent of your pre-retirement income.

• Get professional advice. Counsel from a financial planner at this stage can be worth its weight in gold. A good advisor will be able to recommend an appropriate asset allocation, income vehicles and tax-minimizing strategies. He or she can also do some long-term projections to help ensure that your portfolio lasts as long as needed.

• Find the right balance between safety and growth. While a portfolio made up entirely of fixed income investments (such as bonds, CDs or money markets) might feel "safe," it actually has the risk of your principal being eroded away by inflation. At the same time, if you're entirely in stocks, you risk the ups and downs of the market. The key is finding a balance that offers a reasonable return and still allows you to sleep well at night.

• Think long term. Depending on the age you retire, plan on making your portfolio last 30, 40 or even 50 years. While retirees are naturally more skittish of the market's short-term volatility, keep in mind that funding your retirement is still a long-term objective. Stick with your plan, and don't be swayed by short-term market moves.

THE BOTTOM LINE: After a lifetime of working, you deserve to be able to retire on your own terms. Take an active role in your success through careful planning, discipline, a balanced portfolio and a long-term outlook.

No Need For Social Security

Question of the week:I'm starting to seriously save for retirement and am looking at all my different options. I'm wondering about Social Security--do you think it's reasonable for me to plan on it for any part of my retirement income? Dear Gen Y, We recently asked members of the Armchair Millionaire community about the role that Social Security plays in their retirement plans, and got a range of responses: It will be essential. "My retirement is made up of bond funds, stock funds, annuities and Social Security. I look at these as the four legs on my retirement stool. --Joe G. It won't be there at all. "I plan on zero Social security benefits. At 26, we are already maxing out our Roth IRAs and 401(k) plans, so we will be fine when we retire." --Trevor It will just be it gravy. "I am not counting on Social Security for any of my retirement. If I get anything, I will consider it a bonus." --Michael H. Even the Social Security Administration says that your Social Security benefit should be only one of three parts to your retirement savings formula, along with a pension and personal savings. For the growing number of us not covered by a company pension, that leaves just Social Security and savings. And if you're skeptical of ever receiving any significant Social Security benefit, you should plan on taking care of all of your retirement yourself. But this really isn't bad news. With the myriad options of retirement savings vehicles now available, funding retirement all on your own is within easy reach. My checklist has the steps to get you started. The Armchair Millionaire's Checklist for an Abundant Retirement Make a plan. Start with a clear understanding of exactly how much you'll need, when you'll need it, how much you'll need to save, and how to invest it all. You may find the services of a financial advisor especially useful when planning your retirement savings program and assessing your future needs. Defer your taxes. The best deal Uncle Sam has going is retirement savings tax-deferral. Simply put, when you use a retirement account like a 401(k) or IRA you can often deduct your contribution and you won't have to pay taxes on the growth of that money until you withdraw it. (In the case of the Roth IRA, your contribution is not tax-deductible, but your money will grow tax-free forever.) Deferring your taxes in this way can add hundreds of thousands of dollars to your nest egg by the time you retire. Don't look a gift horse in the mouth. Every type of retirement account has some kind of limit on the amount you're allowed to contribute each year. Do yourself a favor: Contribute the maximum allowed, or at least as much as you possibly can. Capture compounding returns. Over time, the thing that will make up the lion's share of your retirement savings will not be what you've contributed, but the returns (and the returns on your returns) on your contribution. So whenever you invest for the long term, make sure that you have all your interest and dividends automatically reinvested. THE BOTTOM LINE: Stashing away the entire amount that you'll need for the golden years seems like a daunting task, but it's one you can easily whittle down to size. By starting immediately and saving regularly into retirement accounts, the fate of Social Security will become something you just don't need to worry about.

The Battle of the IRAs

Question of the week: My current employer doesn't offer a 401(k) but I'm determined to continue saving for retirement on my own. I've started to look into individual retirement accounts, but I'm not sure which choice is best--the traditional IRA or the Roth IRA. What do you think? --Naomi G.

Dear Naomi,

When you open your IRA, you'll be in plenty of good company. According to the Investment Company Institute, about 42 percent of U.S. households owned IRAs as of last year. The reason for their popularity is simple: IRAs offer terrific tax advantages that mean you keep significantly more of your money than if it was invested in a regular taxable account.

Your first step in IRA investing is to understand the key differences between the two major types of IRAs. The traditional IRA allows your money to grow tax-deferred until you withdraw it and, in some cases, lets you deduct your contribution. The Roth IRA, on the other hand, allows your money to grow tax-free, but you are never allowed a deduction for your contribution and can contribute only if your income does not exceed a set limit.

When we asked members of the Armchair Millionaire community which type they prefer, we got a range of responses:

Go for the Roth. "For me, hands down the best choice is the Roth. The reason is two of the greatest words ever put together in the English language: TAX FREE!" --Sean D.

Go for the traditional. "I love getting that tax deduction every year, so I always invest the maximum I can in my traditional IRA." --Seattle Sailor

Go for both. "I'm equally invested in both. My income fluctuates, so if I make more than the Roth limit, I invest in a traditional. If not, I invest in a Roth." --Josh L.

To help you decide which type is right for you, use my overview of IRA rules.

The Armchair Millionaire Checklist of IRA Rules

• Who can contribute. Traditional IRAs are available to anyone under age 70 1/2 who has any amount of earned income. If you participate in an employer retirement plan, your contribution may not be tax deductible, depending on your income. Roth IRAs are available to anyone earning less than $110,000 (for single filers) or $160,000 (married filing jointly).

• How much you can contribute. Both types let contribute up to a combined total of $3,000 for 2002. If you're age 50 or older, this amount is $3,500.

• When you can make withdrawals. In general, you'll have to pay a 10 percent penalty, plus taxes, if you withdraw money from a traditional IRA before age 59 1/2. For the Roth, you can withdraw your contributions at any time without penalty, but will have to pay the penalty and tax on withdrawals of your earnings if you're under 59 1/2 and have had the account open less than five years. There are some important exceptions that allow you to avoid these penalties for both types of IRAs, so be sure to check with a tax advisor before making withdrawals.

• When you must make withdrawals. You're required to start making withdrawals from (and paying taxes on) a traditional IRA by age 70 1/2. The Roth has no such requirement.

THE BOTTOM LINE: When it comes to choosing between a Roth IRA and a traditional IRA, don't ignore the forest because of the trees. The most important move is to begin and maintain any kind of long term savings plan. Either choice will help to ensure a long and fulfilling retirement.

Financial Advisors--A Must Have for Uncertain Times?

Question of the week: I've always been a do-it-yourselfer, but with the uncertainty of the market these days, I'm starting to think that I might need a financial advisor. What's your take on advisors? --Mac G. Dear Mac, In my opinion, financial advisors too often get pigeonholed as primarily investment advisors. Advisors can help you in several areas of your financial life, including insurance, estate planning, and even taxes and bill paying. So, it depends on your situation. If you're young and have settled into a long-term, common sense plan that you're comfortable with, I think you're perfectly capable of managing your portfolio yourself. For people who are closer to retirement, however, or who have more complex issues (for example, lump sum distributions or inheritances), or want someone to "coach" them through financial decisions, hiring a financial advisor can be a very wise move that will pay off handsomely. Over the years, the members of the Armchair Millionaire community have gotten a great deal from their relationships with their financial guardian angels. Here's what they think about advisors: To keep on track. "A good financial advisor helps you stay the course and not succumb to the crisis du jour. Their fee will pay for itself many times over when everything is said and done." --WK To decipher the rules. "You must use an advisor. There are simply too many rules and regulations for most people to keep straight, especially in the areas of tax planning and of maximizing tax deferred savings plans." --Larry C. For one-stop shopping. "I had a CPA who did my taxes for many years and when he became a CFP it was an easy move to solicit his advice on retirement and financial planning." --Steve To supplement what you know. "A basic understanding of how your money is working for you, coupled with the expertise of someone who can plan out your financial goals and work to achieve them is a great combination, and a necessary one for most people." --Michael R. If you do decide to go the financial advisor route, use my checklist to find the best one. The Armchair Millionaire Checklist for Choosing a Great Advisor Use referrals with caution. Be careful to distinguish between recommendations from people who like their advisors personally and those who are qualified to judge an advisor's skill and knowledge. Make sure to get recommendations for at least three different advisors and interview all three so you can see the range of possibilities. Do your homework. Any potential advisor should be prepared to meet you in an initial interview and explain their approach to investing and planning. Ask them who their ideal client is based on their expertise and background. There should be a match between you and their ideal client. Stick with fee-based. Your advisor should be compensated primarily through a fee structure you agree on in advance, and not by brokerage commissions. Advisors who work on commissions may be more likely to recommend frequent transactions in your portfolio, which has never been proven to increase investment returns. Get a written investment policy statement. This statement should provide specific guidelines about your asset allocation, target return, risk tolerance, time horizon, tax constraints and anticipated withdrawals or contributions. You should understand this document completely before moving forward. THE BOTTOM LINE: Your portfolio is more than just your stocks and bonds; it's your whole financial future. If you don't have the time or inclination to closely manage it, a well-chosen advisor can be a terrific ally in achieving long-term financial freedom.

Rethinking Retirement

Question of the week: I'm 40-something, have been saving for retirement for about 15 years, and have always planned to retire by age 55. But over the last couple of years I've watched my retirement fund do nothing but drop and I'm starting to get really concerned about losing my dream of early retirement. What should I do? —Worried in LA

Dear Worried,

Your situation is certainly common these days. A recent survey done by the folks at Quicken showed that almost a third of respondents had lost more than a quarter of their retirement savings since the market hit its peak back in March 2000.

Even the savviest investors are feeling the pinch these days. But by committing to long-term, common sense plans, you'll be well prepared-both emotionally and financially-to deal with a down market. Here's some advice from the members of the Armchair Millionaire community on staying the course:

Take advantage of the down market. "Since I'm a couple decades away from retiring, I'm actually happy that the market downturn has taken place. It means that I'm buying more stock for less when I make my monthly 401(k) and 'pay myself first' investments." —Charlie P.

Get diversified. "I have only taken about a 15 percent hit on my portfolio because I have a well diversified set of funds and stocks and I'm sticking with them. You should take a good look at how long until you need the money, how much risk you are willing to take, and how much money you think you need." —A. Hamilton

My checklist will help you see your retirement investments safely through tough times.

The Armchair Millionaire Checklist for Keeping Your Retirement on Track

• Watch your costs. All investments have costs, too. Whether it's fees or commissions, these costs can make a big difference in the long run. My all-time favorite low-cost investment is index funds.
• Allocate and diversify. If you're allocated correctly it means you have the right balance between stocks and bonds, between small stocks and large stocks, international and domestic, and so on. If you're diversified properly it means you have a big enough selection of each of these allocations so poor performance of a few companies doesn't damage the whole portfolio.
• Consider bonds. After the years of fabulous returns in the stock market, many people have neglected bonds. Bonds will help diversify your portfolio and provide income. They can play an important role in your portfolio especially as you near retirement age. The easiest way for most individuals to invest in bonds is through bond mutual funds.
• Hold steady. If you've been investing regularly in a well-balanced portfolio, stick with it. Many people foolishly cash out when they see their portfolio values drop, but this only puts them in poor position to catch up once the market turns around.

The BOTTOM LINE: Financial markets have always had their winners and losers. The winners always have one thing in common: a long-term approach. Keep your plan on track and you'll get the gold.

The Sky-High Cost of College

Question of the week: As a new dad, I'm worried about paying for college for my baby daughter. It seems like tuition costs these days are astronomical. What should I be doing to get ready? —Sanji

Dear Sanji,

Your daughter should thank you for having such a long-term view about these things so early in her life. According to the College Board, today's average cost for tuition, room, board and books at a four-year private college is a cool $25,000 per year. For a four-year public school, it's a bit over $10,000. If you factor in inflation over the next 18 years until your daughter is ready for college, you could be looking at a total cost for four years of up to $300,000, depending on the kind of school she chooses.

Before you bite your fingernails completely off, you should know that there are things you can be doing to prepare for the bill for that bachelors degree in medieval studies. Here's some advice from parents in the Armchair Millionaire community who are successfully tackling sky-high college costs.

Save automatically. "We set up an automatic withdrawal each month from our checking account into our tax-deferred college fund—a 529 plan. We find that this makes saving fairly painless and ensures that we don't put it off. My parents also make annual gifts to our children's college fund for their birthdays." —LimaLiz

Start young. "When our son was born, we did some calculations that really motivated us. We figured out that if we started saving $200 a month immediately, we'd have almost $95,000 by the time he was 18. If we waited until he was 10, we'd have had to put away $700 a month just to get that same amount." —Barbary Jaspers

In addition, the folks in Washington, DC have created programs that make it easier to save by easing your tax burden. And each of these programs got a bit better with the recent changes in the tax law. Here's a rundown on your college savings options.

The Armchair Millionaire Summary of College Savings Programs

• Roth IRA. If you're funding a 401(k) or other plan for your retirement, a Roth IRA may be a good place for your college stash. As long as your distributions are used for qualified college expenses, the earnings in your account will grow tax-deferred. Starting this year, you can contribute up to $3,000 in your Roth IRA (if you fall under certain income limits), and that amount will increase over the next several years.
• State college savings plans. These are incredibly flexible plans with no income restrictions and very high contribution limits (over $200,000 per student in some states). You can contribute to any state's plan, regardless of where you live, and use the money to pay for any college. And beginning this year, withdrawals from these plans are exempt from federal tax. Many states offer a break on state income taxes, as well.
• Education IRA. Money in these accounts grows completely tax-free, as long as you use it to pay for college. You can now contribute up to $2,000 a year per child to an education IRA, up from a paltry $500. Anyone, like grandparents or that favorite uncle, can contribute on behalf of the child as long as they meet certain income limits.

The Bottom Line: You don't need a Ph.D. in Finance to send your kids to college. Start saving when they're young and take advantage of tax-favored savings programs. Investing in your child's future may be the smartest thing you ever do.