Armed with that estimate, the next job is to determine how much of those expenses will be covered by certain sources of income such as Social Security or a pension.
Subtract those income sources from your annual spending needs; the amount that's left over is the amount your portfolio will need to supply. For example, let's say Paul and Amy, both 64, are expecting to retire in Step 2: Test sustainability. The next step in the process is to test the sustainability of that desired spending rate. To do so, divide the annual dollar spending amount by the total portfolio.
Much of the research around sustainable withdrawal rates points to the virtue of withdrawing less in down markets, while potentially withdrawing a bit more in better times. Step 3: Determine how much to park in cash Bucket 1. Assuming the planned withdrawal rate is sustainable, a retiree can then begin staging the portfolio by anticipated spending horizon.
Money for the next few years goes into cash; it will earn next to nothing, but it won't budge in value, either, meaning the retiree won't be forced to change her plans because she's had a loss of capital. In the Bucket framework that I've discussed on Morningstar. Step 3a: Determine emergency fund needs. Unplanned expenditures like a new roof, auto repairs, or big vet bills can crop up in retirement just as they do when you're working. Retirees can address these unplanned expenditures in one of a few ways.
First, they can include a substantial cushion when forecasting their in-retirement expenses; that will allow them to cover unbudgeted expenses out of their planned portfolio withdrawals. Alternatively, they can maintain a separate emergency fund to cover unplanned expenditures--or periodic splurges--as circumstances warrant.
If they go this route, they'd want to add the emergency fund to their cash total. Step 4: Determine how much to invest in high-quality bonds Bucket 2. There's an opportunity cost to holding too much in cash, so money you expect to need in years three to 10 of retirement needs to step out on the risk spectrum to help improve the portfolio's return potential and preserve purchasing power.
Normal inflation isn't a big deal over a two-year time horizon, but it can be corrosive over a year horizon. The first step is to decide how much overall you want to invest in stocks and how much in bonds. The younger you are, the more you typically want to rely on stocks for long-term retirement savings. Chances are your workplace plan or the brokerage where you have your IRA has a free online tool to help you hash out the right asset allocation mix.
For the stock portion of your portfolio, you will need to make one more asset allocation choice: how much to invest in U. With a three-fund approach, focus on index funds that take a broad-market approach. Most mutual funds and ETFs charge an annual fee called an expense ratio. You can get back to your desired asset allocation by selling shares of the fund that has grown too big and reinvesting shares in the fund s that are lighter than your target.
Note: When you exchange shares within a retirement account— k or IRA —there is no tax due on your gains. If all that three-fund work caused your eyes to start glazing over, one fund, such as a target date fund, may be the right choice. That can also work for older investors who are confident that they can cover their retirement living expenses from guaranteed income sources such as Social Security and a pension and prefer to keep their retirement portfolio focused on long-term growth.
I specialize in explaining the how and why of retirement planning so consumers can make confident choices and get on with their lives. My work has appeared in Money magazine, Consumer Reports, Bloomberg.
John Schmidt is the Assistant Assigning Editor for investing and retirement. Before joining Forbes Advisor, John was a senior writer at Acorns and editor at market research group Corporate Insight. Select Region. United States. United Kingdom. Carla Fried, John Schmidt. Contributor, Editor. Editorial Note: Forbes Advisor may earn a commission on sales made from partner links on this page, but that doesn't affect our editors' opinions or evaluations. What Is a 3-Fund Portfolio?
You could correct this discrepancy, then, with a riskier mix in a three-fund portfolio. Three-Fund Portfolio Disadvantages If you go the three-fund route, you need to stay on top of your overall portfolio and handle rebalancing to make sure your portfolio retains the right mix of stock and bond funds as the market waxes and wanes. Alternatives to the 3-Fund Portfolio If all that three-fund work caused your eyes to start glazing over, one fund, such as a target date fund, may be the right choice.
Was this article helpful? Share your feedback. They typically also have knowledgeable representatives that will walk you through the process. You should take advantage of these resources if they are available to you, assuming you don't already have a financial advisor. You probably already know that spreading your k account balance across a variety of investment types makes good sense.
Diversification helps you capture returns from a mix of investments—stocks, bonds, commodities , and others—while protecting your balance against the risk of a downturn in any one asset class. Your decisions start with picking an asset-allocation approach you can live with during up and down markets, says Stuart Armstrong, a Boston financial planner with Centinel Financial Group. After that, it's a matter of fighting the temptation to market time , trade too often, or believe you can outsmart the markets.
Review your asset allocations periodically, perhaps annually, but try not to micromanage. Some experts advise saying no to company stock, which concentrates your k portfolio too narrowly and increases the risk that a bearish run on the shares could wipe out a big chunk of your savings. Vesting restrictions may also prevent you from holding on to the shares if you leave or change jobs, making you unable to control the timing of your investments.
It costs money to run a k plan. The fees generally come out of your investment returns. Consider the following example posted by the Department of Labor.
If you pay 0. However, increase the fees and expenses to 1. You can't avoid all of the fees and costs associated with your k plan. They are determined by the deal your employer made with the financial services company that manages the plan.
The Department of Labor has rules that require workers to be given information on fees and charges to make informed investment decisions. The business of running your k generates two sets of bills—plan expenses, which you cannot avoid, and fund fees, which hinge on the investments you choose.
The former pays for the administrative work of tending to the retirement plan itself, including keeping track of contributions and participants. The latter includes everything from trading commissions to paying portfolio managers' salaries to pull the levers and make decisions. Among your choices, avoid funds that charge the biggest management fees and sales charges. Actively managed funds are those that hire analysts to conduct securities research.
If you opt for well-run index funds, you should look to pay no more than 0. If you are many years from retirement and struggling with the here-and-now, you may think a k plan just isn't a priority. But the combination of an employer match if the company offers it and a tax benefit make it irresistible.
When starting out, the achievable goal might be a minimum contribution to your k plan. That minimum should be the amount that qualifies you for the full match from your employer. To get the full tax savings, you need to contribute the maximum yearly contribution.
The number of Americans who actively participate in a k plan. Source: American Benefits Council. In addition, you are effectively reducing your federal taxable income by the amount you contribute to the plan. As retirement approaches, you may be able to start stashing away a greater percentage of your income.
Granted, the time horizon isn't as distant, but the dollar amount is probably far larger than in your earlier years, given inflation and salary growth. In addition, as you near retirement, this is a good time to try to reduce your marginal tax rate by contributing to your company's k plan. Your tax rate may drop when you retire, allowing you to withdraw these funds at a lower tax rate, says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Massachusetts.
The federal government offers another benefit to lower-income people. This offset is in addition to the usual tax benefits of these plans.
The size of the percentage depends on the taxpayer's adjusted gross income for the year and tax-filing status. The income limits to qualify for the minimum percentage offset under the Saver's Tax Credit are as follows:. Once your portfolio is in place, monitor its performance.
Keep in mind that various sectors of the stock market do not always move in lockstep. For example, if your portfolio contains both large-cap and small-cap stocks, it is very likely that the small-cap portion of the portfolio will grow more quickly than the large-cap portion. If this occurs, it may be time to rebalance your portfolio by selling some of your small-cap holdings and reinvesting the proceeds in large-cap stocks.
While it may seem counter-intuitive to sell the best-performing asset in your portfolio and replace it with an asset that has not performed as well, keep in mind that your goal is to maintain your chosen asset allocation.
When one portion of your portfolio grows more rapidly than another, your asset allocation is skewed toward the best performing asset. If nothing about your financial goals has changed, rebalancing to maintain your desired asset allocation is a sound investment strategy. And keep your hands off it. Borrowing against k assets can be tempting if times get tight. However, doing this effectively nullifies the tax benefits of investing in a defined-benefit plan since you'll have to repay the loan in after-tax dollars.
On top of that, you will be assessed interest and possibly fees on the loan. Resist the option, says Armstrong. The need to borrow from your k is typically a sign that you need to do a better job of planning out a cash reserve, saving, or cutting spending and budgeting for life goals.
Some argue that paying yourself back with interest is a good way to build your portfolio, but a far better strategy is not to interrupt the progress of your long-term savings vehicle's growth in the first place. Most people will change jobs more than half-a-dozen times over the course of a lifetime. Some of them may cash out of their k plans every time they move, which can be a costly strategy. Even if your balance is too low to keep in the plan, you can roll that money over to an IRA and let it keep growing.
If you're moving to a new job, you may also be able to roll over the money from your old k to your new employer's plan if the company permits this. Whichever choice you make, be sure to make a direct transfer from your k to the IRA or to the new company's k to avoid risking tax penalties.
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