Many of us look forward to it for decades — retirement! Work can be pleasant or even fun, but it’s exciting to think of when we can stop working and enter our golden years, perhaps even achieving an early retirement, if we made smart personal finance decisions and met our retirement goals.
Retirement is a major life milestone, and it comes with many changes. Your routine will be different, your finances will change, and the general transition can be mentally and emotionally taxing. If retirement is on your calendar for 2022, it’s time to make or review your plan so the process is as smooth as possible. You might not have anyone teach you how to retire when you leave the workforce, but the steps below can get you started on the right foot.
1. Save the Dates You Don’t Want to Miss
Maximize your benefits, and avoid being penalized by scheduling essential retirement-related milestones on your calendar.
Apply for Social Security 4 Months in Advance
Sign up for Social Security benefits four months before you’d like to start receiving income. It’s the earliest you can apply, it and gives the Social Security Administration time to process your request.
Most people can take Social Security retirement benefits as early as age 62. However, you get a bigger monthly payment if you wait until your full retirement age. Full retirement age is between 66 and 67, depending on what year you were born. If you claim your benefits early, they will be permanently reduced. Plus, if a surviving spouse takes over your benefits, the amount they receive will be based on the reduced amount.
Sign Up for Medicare 3 Months Before Age 65
Most people get Medicare at age 65, and you can sign up for Medicare as early as three months before the month in which you turn 65.
If you’re still working as you approach age 65, and your job (or your spouse’s job) provides health coverage, ask your benefits department and insurance providers how to handle Medicare. The rules are extremely complicated. You might need to sign up for Medicare even if you have group health coverage. Missing your first enrollment deadline can cause significant problems, such as a gap in coverage and a late enrollment penalty.
If You’re 72, Set Up RMDs
If you have money in pre-tax retirement accounts, the Internal Revenue Service requires you to take required minimum distributions (RMDs) from those accounts each year after you turn 72. Examples include:
- Traditional IRAs
- 401(k)—including Roth 401(k), 403(b), and 457(b) plans
- SIMPLE and SEP plans for small businesses
- Other retirement accounts with pre-tax money
If you were born after June 30, 1949, you do not have to take RMDs until you turn 72. Technically, you can wait until April 1 of the year following the year you turn 72 to take your first RMD. That might make sense if you want to hold off as long as possible, but you don’t have to wait that long if you don’t want to. Note that waiting to take the RMD until April 1 of the year following the year you turn 72 will require you to take two RMDs for that year.
When your money is in a workplace retirement plan like a 401(k), you might not need to take RMDs until after you retire (unless you own more than 5% of the employer sponsoring the plan). Retirement plans that are not associated with your current employment at age 72 and older, however, will still be subject to RMDs.
2. Refine Your Retirement Health Care Strategy
Ensuring that you’re planning for an adequate level of health care coverage is a key part of your retirement strategy. As you age, your health care needs will increase, and you’ll want to make sure that you’ve saved enough to get covered. A recent Fidelity study found that a couple will spend $300,000 on co-pays, additional premiums and other uncovered expenses during retirement.
These out-of-pocket costs will take a bite out of retirement savings, so it’s wise to prepare. One way you can get ahead of these issues is by understanding your options when it comes to Medicare.
Every American is eligible to enroll in Medicare when they turn 65, and there can be penalties for failing to enroll on time. It’s wise to sign up a few months before your 65th birthday, giving you ample time to meet the deadline and to ensure coverage when you turn 65. Beyond that, you’ll need to decide whether to opt for traditional Medicare or Medicare Advantage—as well as if you want Medigap coverage.
3. Know Your Income Needs
One essential part of a successful plan is determining how much money you need on an annual basis. Having a target helps you know whether you’re on track or whether you need to make adjustments. Ask yourself how much you plan to spend each month and what additional expenses might come up each year. There are at least two ways to estimate your spending in retirement.
Income-Replacement Ratio
You might assume that you’ll spend at a similar level in retirement, with a slight reduction. For example, you’ll no longer need to pay payroll taxes or save money for retirement. Plus, any expenses related to work, like commuting and clothing, may be significantly reduced.
An income-replacement ratio can help you estimate how much of your current income you will need. According to the U.S. Government Accountability Office, target income-replacement rates typically range between 70% and 85% of pre-retirement income. Fidelity found rates to be somewhat lower—between 55% and 80%.10 For example, if you currently earn $100,000 per year, based on an 80% replacement ratio, your target becomes replacing $80,000 of annual income.
Detailed Monthly Budget
A more granular approach would be to make a list of your expenses, similar to a monthly budget. This method allows for the most control and insight into your spending. You can remove expenses that are temporary (if you’ll pay off your mortgage after eight years in retirement, for example) and budget for periodic items, like a big vacation every three years.
To create a detailed spending plan, start by tracking your current spending over several months. Then, add irregular costs (quarterly or annual payments, such as insurance premiums or property taxes), plus the estimate of healthcare costs calculated above. Finally, don’t forget to add any other costs you anticipate during retirement.
Set a spending goal, no matter what method you use. With a spending plan in place, you can better avoid unpleasant surprises and improve your chances of having the resources you need available.
4. Inventory Your Income and Assets
Social Security benefits and any pensions from an employer are two common types of income and are considered “guaranteed.” Those payments are likely to last for your entire life and don’t depend on how your investments perform.
Your ultimate goal is to figure out how to retire comfortably with that income base plus supplemental withdrawals from your retirement savings accounts.
Social Security
Nine out of 10 people age 65 and over receive Social Security benefits. The average retirement payment was $1,555 per month in 2021.
Depending on your earnings history and when you claim benefits, your monthly benefit might be higher or lower. Review your Social Security statement to understand how much you can expect to receive at different ages.
Unfortunately, the calculations that determine your monthly Social Security payment are getting less generous, especially after 2021. The penalty for claiming early (before full retirement age) is not new, but as the full retirement age rises—from 66 to 67, depending on when you were born—your benefits are reduced more now than they used to be.
Pension Income
If you’ll receive pension income from an employer, you can include that income in your “guaranteed” base, but you need to find out whether your pension will interfere with Social Security retirement benefits. For example, some people have worked for both private organizations that pay into Social Security and government organizations that do not. When that’s the case, you might see your Social Security benefits reduced or eliminated altogether. Ask your employer and the Social Security Administration whether you need to worry about the Windfall Elimination Provision or Government Pension Offset.
Retirement and Savings Accounts
Guaranteed sources of income might not meet your spending needs. If that’s the case, you’ll need to withdraw from your accounts to supplement your base income.
Your retirement assets are most likely in an employer-provided retirement plan like a 401(k), 403(b), or 457. You also might have savings in IRAs, annuities, high-yield savings, or taxable accounts. Take stock of where all of your money is and how it is invested. As you near retirement, you need a plan for managing and drawing on those assets.
5. Review Your Investment Risk
Your first few years in retirement are critical for your investments. Market losses in those years can have a surprisingly large impact on your chances of success, and they can increase your odds of running out of money.
Completely eliminating risk (keeping everything in cash) leaves you vulnerable to inflation: You might find it hard to keep up with rising prices and pay for the things you need over several decades, but taking too much risk can backfire. Finding the right risk level is challenging, because you need to make assumptions about the future and weigh the pros and cons of different portfolios. A financial planner can help you allocate risk across the investments in your portfolio in a way that reflects your income needs and risk-tolerance level.
6. Make a Withdrawal Plan
The best way to plan your retirement is to estimate year-by-year cash flows from your savings. But if you just want a high-level strategy, two popular approaches can help you understand how to manage withdrawals in retirement.
The amount you withdraw should be able to fill the gap between your guaranteed income sources and the amount you need to spend. Ideally, you can withdraw what you need without depleting your assets. The strategies below might help you accomplish that.
If you’re facing a shortfall and won’t have enough assets to fill the gap adequately, you may need to make some changes. Two potential (but probably unwelcome) solutions are delaying retirement or spending less each year.
The 4% Rule
Retirees often wonder how much they can withdraw from their accounts. The answer depends on several factors, and there’s no way to know in advance exactly how much you’ll earn (or lose) on those accounts. The 4% rule might help with initial estimates.
The 4% rule says that you can:
- Withdraw 4% of your retirement account each year
- Increase withdrawals with inflation
- Expect the funds to last for 30 years
Bucketing Strategy
A bucketing strategy involves planning your withdrawals with different time segments, or “buckets.” For example, you might imagine the withdrawals you need to take and put them into three buckets:
- The next four years (your first few years of retirement, 2021 through 2025)
- The subsequent six years (2026 through 2031)
- The remaining years of your retirement (2032 and beyond)
For your first bucket, use safe investments, such as cash in government-guaranteed bank and credit union accounts. You won’t need to worry about what financial markets do—that money is safe, and you can spend according to your plan in the first few years. The second bucket might invest in a relatively low-risk mix of investments, such as a portfolio of mutual funds with 30% in stocks and 70% in fixed income. Over time, you replenish the first bucket from this portfolio.
The third bucket, which holds funds you probably won’t touch for at least 10 years, could go into higher-risk investments. For example, you might build a portfolio of mutual funds with at least 70% of your money in a broadly diversified stock portfolio. The goal for that bucket is to pursue long-term growth, but that doesn’t mean you need to take excessive risks. Over time, refill the second bucket with some of the money in your third bucket.
7. Taxes in retirement: What you need to plan for and how to minimize taxes
Another key concern in retirement is taxes. Here’s what you need to know:
- Social Security: Your Social Security income may be taxed if your income crosses a certain threshold.
- Traditional IRAs and 401(k) accounts: The traditional forms of these retirement savings accounts let you contribute money on a pre-tax basis, shrinking your taxable income in the year of contribution. In exchange for that upfront tax break, your withdrawals in retirement will be treated as taxable income. (Note that your tax bracket in retirement may be lower than your bracket when you were working.)
- Roth IRAs and Roth 401(k) accounts: These accounts offer no upfront tax break, but if you play by the rules, you can withdraw money from them in retirement — tax-free. That’s because you were already taxed on the funds you contributed.
- Investment income: Your other investments face taxes, too. Short-term capital gains (from investments held for a year or less) are taxed at your ordinary income tax rate, while long-term capital gains get taxed at 0% or 15%. Dividend income from most stocks held for more than 60 days is generally taxed at 0% or 15%, as well.
- Interest income: Most interest income is treated as ordinary income and is subject to taxation. Treasury bonds and bills only face federal taxes, while corporate bonds are generally taxable at the federal, state, and local levels. Municipal bonds tend to be tax-free.
A Final Word on Retirement Planning
When it comes to retirement planning, the key is to start early and keep your eye on the ball. Retirement planning isn’t a one-time exercise, and monitoring your accounts and implementing strategies that will help you progress toward your goals should be an ongoing process.
Working with a professional financial advisor is one of the best ways to develop a realistic financial plan and investment strategy that will keep you on track to enjoy a financially comfortable retirement.
