What to Do If Your Current LTC Policy Has a Huge Premium Increase
In recent years, many people who already own an LTC insurance policy have been hit with budget-busting premium increases of as much as 40%. I can imagine how unsettling that is for households that were so careful and responsible to buy LTC insurance, only to struggle with whether they can afford to keep the policy. And as I explain in the LTC lesson in the previous class, the trend toward higher premiums could be here to stay for many years.
If you ever are hit with a steep premium increase, please promise me that you will do everything possible to keep some level of insurance. For starters, please reread the advice I just gave: Your kids may be very eager to step in and help with the added cost. If that is not practical, then talk to your agent about how you can adjust the level of coverage—maybe shorten the lifetime benefit or increase the elimination period—to bring down the cost of the new premium.
LESSON 3.
STICK TO A SUSTAINABLE WITHDRAWAL RATE
I have stated this elsewhere in the book, but I want to make sure retirees have heard this: If you have made it to retirement age, there is a very good chance that you will live two or three decades in retirement.
A 65-year-old man today has an average life expectancy of age 82 and a 65-year-old woman has an average life expectancy of age 85. Understanding what
average
means is important: If you are 65 years old with a life expectancy of age 85 you have a 50-50 chance that you will still be alive at 85. Life expectancy is not a statistical estimate of when you will die; it is a measure of the age at which 50% of an age group will still be alive. And if you in fact make it to those life expectancy milestones, your life expectancy resets again—about five years or so. My mom, God bless her, is still alive at the age of 95.
So that is why I want those of you retiring today to follow the 4% withdrawal rule in the first year of retirement if you are going to begin making those withdrawals in your 60s. That is, you should aim to withdraw no more than 4% or so of your savings in the first year of retirement. You can then adjust that amount upward each year for inflation, but try to keep your early withdrawal rate at 4%. If you have an age-appropriate mix of stocks and bonds, at a 4% withdrawal rate you minimize the chances your money will run out too quickly. An analysis by T. Rowe Price estimates that a retiree with a portfolio that is invested 40% in stocks and 60% in bonds would have a 90% probability of his money lasting 30 years if he chose a 4% initial withdrawal rate that was then increased each year to keep pace with inflation.
Now pay attention here: If that retiree instead chose a 6% withdrawal rate the probability he would still have any money left after 30 years falls to 24%. This person went from a 90% chance of having his retirement money last 30 years to a 24% chance because of a 2% increase in withdrawals. Wow—take a minute to process that. Let’s say you have a $500,000 retirement portfolio that you are going to start making withdrawals from this year. A 6% annual withdrawal this year comes to $30,000, or $2,500 a month. (Remember, though: Withdrawals from traditional 401(k)s and IRAs will be taxed as ordinary income, and you may owe a capital gains tax on withdrawals from regular taxable accounts as well.) But that $2,500 a month comes with a big risk that you might run out of money. To have a 90% probability your money will outlast you requires that you make do with a 4% initial withdrawal rate. That’s $20,000 a year, or $1,667 a month—nearly $1,000 less each month, in this example. It’s a significant difference, but then again, is there anything more important than the certainty that your money will last you throughout your retirement? In that two-percentage-point variance lies a world of difference.
Now, if you are many years into retirement, you may well be able to pull out more each year. If you manage to wait until your 70s to begin to make withdrawals, you can consider starting with a 5% withdrawal rate. And of course, if you have other reliable income sources such as a bountiful pension, you may indeed be fine with a higher withdrawal rate. But again I would caution you to be careful. I appreciate that with interest rates so low, the yield you can earn on your bond and cash investments has made it hard, if not impossible, to generate enough income to pay your bills. But the answer is not to withdraw big sums from your account. If you eat into that principal too much and you are fortunate enough to enjoy a long life, I am sorry to tell you that you very well may run out of money.
In the next two lessons I explain how to invest in today’s environment so that you can earn 4% to 5% interest on your retirement money. Can it be done? You bet, but it is not as easy as just walking into a bank or credit union and asking for a CD or leaving your money in a money market fund. To create your New American Dream you are going to have to be involved with your money, to know what to do and what not to do. And believe it or not, we are going back to the future. We just may have to do it the way our grandparents did, years ago.
HOW TO MAKE TAX-SMART WITHDRAWALS
When you make withdrawals from your retirement accounts, the tax you owe will be based on the type of account. In these times when you want to maximize every penny of your retirement income, you need to devise a withdrawal strategy that allows you to keep your tax bill as low as possible.
•
Traditional 401(k)s and traditional IRAs
are subject to a required minimum distribution (RMD) by April 1 of the year after you turn 70½. The firm that holds your retirement accounts can tell you what your RMD must be, or you can use the online calculator at
apps.finra.org/Calcs/1/RMD
. (If your spouse is the beneficiary of your accounts and is 10 years younger than you, your RMD will be lower than the amount shown in the calculator. I recommend you consult with your tax advisor.)
The tax you owe on RMDs is based on your individual income tax rate.
It is very important to follow the RMD rules; there is a 50% penalty (of the amount that should have been withdrawn) if you fail to make your annual withdrawal. That 50% is in addition to the income tax you owe on all withdrawals.
RMD Tip:
If you have multiple tax-deferred accounts, you do not have to take an RMD from each one. You can calculate the total amount due across all the accounts, but then make your withdrawal from just one account. That can cut down on administrative headaches. It also gives you more control over which assets you want to sell.
While you must take your annual RMD from your traditional 401(k) and IRA, I recommend you do not take out more than the RMD if you have other money you can access first. It is always smart to leave money that is sheltered from tax growing for as long as possible. If you have other savings you can tap, that is preferable, especially when those other accounts will bring a less painful tax bill.
•
Roth IRAs:
Withdrawals of money you contributed to a Roth IRA are always tax-free. To withdraw earnings from your account tax-free you must be at least 59½ or have had the account for at least five years.
•
Regular taxable accounts:
Money you withdraw from regular accounts will be taxed only if you have a gain, that is, if you are selling the asset for more than you paid. If you have owned that asset for less than one year, you pay the tax at your ordinary income tax rate. But if you have owned the asset for at least one year it is eligible for the long-term capital gains tax rate. The long-term capital gains rate is either 10% or 15%, depending on your income. Those rates are in effect through 2012. A maximum long-term capital gains tax rate of 15% is a lot better than what you might pay on ordinary income; the top income tax rate is 35%.
Another important consideration is that any loss you have in a taxable investment can be used to reduce your tax bill. (You cannot claim losses from 401(k) and IRA investments.) You can use any loss to offset any capital gains for a given tax year. If you don’t have any tax gains, you can claim up to $3,000 of your losses as a deduction. If your loss is more than $3,000 you can keep claiming more losses in subsequent years—either to offset gains in those years, or as a deduction.
Here is how I want you to think strategically about which accounts you withdraw money from to support yourself in retirement:
1.
If you are at least 70½:
Fulfill your RMD on traditional IRA and 401(k)s but do not withdraw more than the RMD.
2.
If you are under 70½ or you need more income than is generated by your RMDs:
Withdraw money tax-free from a Roth IRA.
3.
If you don’t have a Roth IRA:
Withdraw money from taxable accounts.
4.
If you don’t have a taxable account:
Make additional withdrawals from your traditional 401(k) and IRA accounts.
LESSON 4.
AVOID LONG-TERM BONDS AND BOND FUNDS
One of the biggest mistakes I see retirees making today is investing in long-term bonds (and bond funds) because they offer the highest current yields. That is an especially risky move to be making right now. Going forward it is likely we will see interest rates begin to rise and when that happens, the value of long-term bonds will fall. This hasn’t really been an issue for nearly 25 years, as we have been living in an extended period where interest rates have been falling. That cycle is coming to an end, and I fear that an entire generation of retirees is about to get a very costly lesson in how rising interest rates can hurt them.
Please read the next section carefully. If your retirement dream relies on income from long-term bonds that you are purchasing today, you may in fact be putting your dream at great risk.
WHAT YOU MUST UNDERSTAND ABOUT BONDS
The longer the maturity of a bond, the more its price will fall when rates rise. Since 1983 we have been in a long cycle of falling interest rates, and that has been great for long-term bonds. But now we are at the end of that falling-rate cycle. So going forward, it is the long-term bonds with the highest yields that will suffer the biggest price declines. Sure, if you buy a 20-year Treasury bond at 4% and you hold it until maturity you are indeed guaranteed to get 100% of your principal back. But during that 20 years your 4% yield will not budge, and it will be less than what you could earn if you invested in new debt. While you are stuck with your 4% yield, new debt in a rising rate environment could yield 5%, 6%, etc. Now when that happens, you could decide to sell your 4% bond so you could reinvest at the higher rates. But remember, the price you will get when you sell a bond before it matures, and with a below-market yield, will be less than what you paid for it. And here is what is also so very important. When interest rates rise so does inflation. Therefore, as your cost of living goes up, your retirement income should also increase. If you are stuck with 20-year bonds paying only 4% when you could be getting 5% or 6% or more you will not be very happy as you struggle to pay your bills or are frustrated your money isn’t earning more.
Because we will eventually be seeing interest rates rise, my recommendation is that you invest in bonds with maturities of less than 3 to 5 years. If you own shorter-term issues, when they mature you will have the ability to reinvest at what I expect will be higher rates.
HOW TO BUILD A BOND LADDER
A smart way to deal with the prospect of higher interest rates in the future is to construct your bond portfolio so you have some bonds maturing every year or so. This will allow you to reinvest that money in a higher-yielding bond. It’s what is known as bond laddering. I’ll give you an example. Let’s say you have $50,000 to invest. Rather than taking all $50,000 and investing it in a 5-year bond you could divide up the money among different maturities. For example:
That way every year you have $10,000 that will mature and you can reinvest it in a higher-yielding bond, assuming rates do rise. Even if rates don’t rise, your laddering strategy gives you more income than if you stuck with super-short maturities, and also protects you from the very real risk of rising rates. Given where we are with historically low rates, the important fact to stay focused on is that at some point rates will indeed rise. Bond laddering is a strategy I want you to keep handy for the future; once we see rates rise, you should think about staggering your maturities in order to have money available every year to reinvest at those potentially higher rates.
But I have to tell you that bond laddering is not the best move for right now. As I write this in early 2011, we have a very abnormal situation given how Federal Reserve policy is keeping all short-term Treasury issues very low. The yield of a 1-year Treasury bill (the technical term for Treasury bonds with shorter maturities) is 0.29% and the yield on a 5-year Treasury is 2%. At the same time you may be able to earn 1% in a 1-year bank or credit union certificate of deposit.
It does not make sense to invest in a longer-term security with a lower yield. My recommendation: Rather than ladder your portfolio as long as Treasury yields are so low, stick with a safe and simple bank or credit union CD. (Remember, up to $250,000—and potentially more depending on your mix of different accounts—is 100% safe if it is deposited at a federally insured bank or credit union.) You should be able to earn 1% or more. You can shop for the best deals at
Bankrate.com
.
Beware of Long-Term Bond Funds
I always prefer direct investments in individual bonds rather than investing through a bond mutual fund. There is no set single maturity date with a bond fund because the fund owns dozens or hundreds of different bonds that are being bought and sold. I think that’s a huge disadvantage when interest rates rise—as I expect them to in the near future. At least with a high-quality individual bond you know that if you hold it until it reaches maturity you will be repaid your principal. There is no such guarantee with a bond fund.