To ensure your retirement nest egg doesn’t crack, it’s critical to abide by several retirement plan fundamentals — especially in today’s uncertain economy. Doing so can mean the difference between a comfortable retirement and a retirement filled with regrets.
Maintain a cash reserve
Economic uncertainty isn’t the only danger your retirement nest egg faces. In fact, you could present one of the biggest dangers — if you make early withdrawals from your IRA or take a 401(k) plan loan.
For example, in addition to being subject to income tax, traditional IRA withdrawals before age 59½ will likely be subject to a 10% early withdrawal penalty. A 401(k) loan won’t create a tax liability, but, if you default on it, your outstanding balance will be treated as a distribution and trigger any attendant tax liabilities and penalties.
Perhaps more important, the amount that can continue to grow tax-deferred — tax-free in the case of a Roth account — will be reduced after a retirement plan withdrawal or loan, which can significantly shrink what you have at retirement.
To avoid having to tap into your retirement plan, maintain a cash reserve. The optimal amount will vary depending on your age, health, available credit and job situation. But generally you should have enough cash on hand to cover three to six months of living expenses.
While market volatility may make you leery of putting more into your retirement plan, for most people it’s advantageous to do so. First, the power of a retirement plan is tax-deferred — or, in the case of Roth accounts, tax-free — growth. The more time funds have to grow, the larger your nest egg can become.
Second, when the value of stocks is low, you can buy more shares for the same amount of money. Assuming retirement is still at least several years away (so there’s ample time for the market to recover), a down market can be a great time to buy.
Third, if your employer offers a match, at minimum you should contribute enough to get the maximum match. If you don’t, it’s essentially like turning down additional compensation.
Consider taxable accounts
Because retirement plans are subject to annual contribution limits, many people also need to save for retirement outside these tax-advantaged accounts. Consider the tax consequences of investments that create realized capital gains or dividend distributions, because they’ll affect your return on investment. And remember that timing can have a dramatic impact.
A taxpayer’s long-term capital gains rate can be as much as 20 percentage points lower than his or her ordinary-income rate. The long-term rate applies to investments held for more than 12 months. So holding on to an investment until you’ve owned it more than a year may help substantially cut tax on any gain.
Also examine your investments to see whether the allocation percentages are in harmony with your current risk tolerance and financial objectives. Diversification — which offers some protection during market declines and higher potential returns over the long run — continues to be a critical investment strategy.
Factor in disability insurance
If you’re like most Americans, your biggest asset is your ability to earn income. Disability insurance can protect that asset.
Although many employers offer short-term disability insurance, you may wish to obtain additional, long-term coverage. In computing the level of coverage to carry, plan so that monthly income (based on disability benefits and your current resources) equals at least 60% of your pretax salary.
Stick with the fundamentals
Of course, your situation will likely differ from your neighbor’s. But everyone should carefully plan out a road to a comfortable retirement. Your tax and financial advisors can help ensure you’re on the right track.
If you have any questions regarding this article, please contact Friedman LLP at firstname.lastname@example.org or 877-538-1670.