When you are recently divorced and approaching retirement, your financial focus shifts.
During your married and working life, retirement is about goals and planning. You know you should save – you put money in the 401k and general savings each month assuming that will take care of it The presumption is when you reach the “golden years” all will be well.
BAM! You are faced with a divorce in your late 50’s/early 60’s and splitting what you thought would be there for you both in retirement. Not only did you lose the safety and comfort of a life partner who provided for the family financially, you are faced with doing this on you own.
Whether married or single, in your 60’s the accumulation stage is largely over. You have your retirement portfolio in place, with a little room left for growth, and now it’s about managing and budgeting that wealth. What kind of life can you live based on what you’ve saved up?
For example, say that you’re an individual at age 65. You have $1.2 million in your pre-tax IRA and an expected $1,500 per month in Social Security benefits from your ex-spouse. What is your retirement budget?
Here are some things to consider. Keep in mind, a financial advisor can help you build an effective retirement plan.
Income and Portfolio Management
First, you need to figure out what kind of income your savings can reliably generate. That will depend on a handful of circumstances.
Social Security and Divorce
If you have been married for 10 years or longer, you are eligible to receive a portion or all of your ex-spouses benefit. Note this will NOT reduce your ex-spouses benefit and in fact, they will not know you are claiming a benefit on their work history.
You are eligible to receive the greater of 100% of your own benefit or 50% of your ex-spouses benefit as long as you do not remarry. If your ex-spouse pre-deceases you, you are eligible to receive 100% of their benefit. Let’s assume that you intend to retire at full retirement age of 67, to receive full Social Security benefits. That means you can start with an expected $18,000 per year of income ($1,500 * 12).
It also means that you can plan for two more years of growth in your IRA. The exact numbers will depend entirely on your investment strategy, but let’s say that you have your entire IRA invested in one of three benchmarks. Depending on market activity, at age 67 you might retire with:
- Corporate bonds, average return 5% – $1.32 million
- Mixed portfolio, average return 8% – $1.4 million
- S&P 500 index fund, average return 10% – $1.45 million
For the purposes of this article, we’ll assume middle of the road results and a retirement at age 67, so a $1.4 million IRA. From there, you could build a number of different income profiles. Three very different options might include:
- 4% Withdrawals – Combined income $90,800
At your most conservative, you might assume the 4% withdrawal strategy. Here, you invest for low-growth, high-security assets, withdrawing about 4% of inflation-adjusted income each year for 25 years. That could give you about $56,000 per year from your IRA ($1.4 million * 0.04). With Social Security, you can expect about $74,000 of inflation-adjusted combined income. This is relatively low growth, but much higher security. - Aggressive market returns – Combined income $174,800
Or you could go the opposite direction entirely. Let’s say you invest the entire IRA in an S&P 500 fund and take out each year’s returns as income. At the market’s average 10% annual rate of return, that might give you about $140,000 per year of portfolio income for a combined income of $158,000.
But that income would be incredibly volatile. Most years you will collect either significantly more, significantly less, or nothing at all. This is an unpredictable approach to retirement. Without a very good plan to manage the down years, you can easily find yourself spending a year living off Social Security alone while waiting out a bear market. - Annuity income – Combined income $147,180
Annuities are contracts that promise you a fixed income for life in exchange for an up-front purchase price. They have significant upside, in that annuities can offer relatively high payments and significant security. The major downside is that they generally do not adjust for inflation. Over a long retirement, the value of that contract can drop by as much as half.
A financial advisor can help you make projections for various scenarios and weigh your options for retirement income.
Tax Management
Since you have an IRA, all of your income calculations will be pre-tax. While a full discussion of the issue is beyond the scope of this article, Social Security benefits are taxable based on your total income. In this case, you will likely add about 85% of your benefits ($15,300) to your taxable income and will not pay taxes on the remaining 15% ($2,700). Beyond that, any income from your IRA-based portfolio will be taxed at the rate of ordinary income.
As an alternative, you could plan for a Roth IRA conversion.
With this approach, you would roll your entire or a portion of pre-tax IRA into a post-tax Roth IRA. The advantage is that you would not pay taxes on any future gains or withdrawals from this portfolio, and you’d be able to avoid required minimum distributions (RMDs, more below). The disadvantage is that you would pay taxes on the entire value of the conversion at the time you made it.
Required Minimum Distributions
If you don’t opt for a Roth conversion, your budget must account for required minimum distributions (RMDs). This is the amount that the IRS requires you to withdraw from any pre-tax portfolio each year starting at age 73. The starting age has been adjusted in the past few years and may adjust in the future. The amount is based on your current age and your portfolio’s value.
However, it’s important to at least be aware of this requirement. That’s particularly true for households with multiple retirement portfolios, since you cannot simply spend one down and leave the other in place.
A financial advisor can help you determine the most tax-effective strategy for your RMDs.
Long-Term Concerns
Finally, your budget should incorporate some of the long-term issues that retirees must anticipate. First, remember to budget for health care needs. While Medicare will pay for much of your health care, you should at least anticipate gap insurance to cover possible medical concerns that Medicare doesn’t pay for.
Then there is inflation. At the Federal Reserve’s benchmark 2% rate, a household can expect their spending power to halve roughly every 30 to 35 years. As retirements get longer, you can start pushing that boundary, so make sure your retirement budget anticipates inflation. This is particularly true for the high-security, low-growth assets common to a retiree’s portfolio, which often must be mixed with at least some growth-oriented assets to properly adjust for inflation.
This is a particularly urgent issue for households in high-cost areas. While 2% is the benchmark inflation rate, costs increase much more quickly in urban areas and other expensive communities. If you rent, in particular, be aware that costs for renters have historically outpaced inflation by a fairly wide margin. Make sure your budget anticipates this.
Tips On Managing Inflation
- Inflation is one of the sneakiest pitfalls in retirement investing. If you’ve ever seen someone grumble about how little things used to cost back in their day, you’re seeing the inflation trap at work. So let’s help you build a retirement plan around it.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. We offer a free introductory call to discuss next steps. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
The Bottom Line
For an individual with $1.2 million in an IRA by age 65, your retirement budget can be relatively comfortable. While this will require careful tax and investment management, this profile could have several options. A financial advisor can help you build a personalized retirement plan based on your specific circumstances.