Advanced Personal Finance

At CNN/Money, their personal finance columnist, Walter Updegrave, fields a question from someone wondering if he has enough saved for retirement. The specifics of the question and the answer aren’t of particular interest, but Updegrave did write several things I agree with and want to emphasize.

In the letter, the writer says he wants a specific amount of income ($125,000 per year) in retirement, which happens to be his current income. He writes that he has an investment property and has saved a considerable amount already. He also states that he saves $30,000 per year after tax in addition to his 401(k).

Updegrave points out a couple of important points:

1. He correctly points out that $125,000 today will not have the same buying power 10 years hence. Inflation is something people often forget when and if they bother to calculate how much they need for retirement.
2. When considering how much income you need in retirement, it’s important to note how much you save for that goal now. That is, if you save $15,500 (the 2007 maximum) in your 401(k) and $4,000 in a Roth IRA (also the maximum for 2007), you’re really currently living on your salary minus almost $20,000. For example, if you are making $90,000 and saving like this, you’re really living on more like $70,000.

I’d add one more:

• What you need in retirement is largely dependent on your health. I’d wager that, for most people, their expected standard of living in retirement probably isn’t much different than what it is today. The big unknown, though, is just how healthy (or unhealthy) they’ll be at retirement. With health care costs climbing much faster than inflation every year, I believe this is the key factor in retirement income planning.

When I look at our retirement ‘number’ I try to look at each of these three things - inflation, actual current income, and expected health. Then, I just do the best I can to plan accurately. The plan will be wrong, but I believe the planning process is worthwhile.

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You can definitely break down personal finance concerns by age. Things that are important when you’re 22 become trivial at 55. Your key concern at 65 isn’t the same one you had at 45.

As another birthday passed, I started thinking about how those things break down. Obviously, not everyone will have all of these things happen during the time-frame I show (or at all, for that matter).

20 to 30

• Graduate from college and start repaying loans

• Get first ‘real’ job

• Buy first car and insurance

• Rent an apartment

• Get first credit cards and learn how to deal with them (or not)

• Marry? Have a baby? Buy a house? Maybe you even manage to save something

31 to 45

• Have kids and watch them grow up too fast

• Get a will

• Learn about and buy life insurance

• Buy a house

• Start saving for college

• Try to fund an IRA and 401(k) in between orthodontist bills and piano lessons

46 to 55

• Holy crap! College tuition is just around the corner (or here already)

• The thought of retirement gains in importance and you try to ramp up saving

56-65

• The kids are out of the house

• The mortgage is paid off

• These are prime earning years, and you’re able to save serious money for retirement

• Look into long term care insurance

65+

• Come up with a retirement fund withdrawal strategy

• Settle in to retirement

• Begin to think about estate planning

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There’s a cool way to save money on taxes when you retire. I (and most readers, I imagine) don’t have immediate use for this little trick, but I’m posting it for my own future benefit. Anyway, it’s a little-known technique called Net Unrealized Appreciation. It works like this.

When you leave you job, either at retirement or for any reason (as long as you’re 55 or over), and you have 401(k) money in company stock, you can take a distribution and save money on taxes.

Typically, it’s a really bad idea to take a distribution from a 401(k) - and that’s still true if you’re under 55 because you’ll pay the 10% penalty - but here it can work to your advantage. You can use the original cost basis for the company stock portion of your 401(k) to set your tax floor. An example is probably better than trying to explain it.

Let’s say you’re finally retiring to concentrate on your Hummel figurine collection. Because you didn’t read my post on selling your company stock right now, your 401(k) contains company stock worth $200,000. Your cost basis, though, is $90,000, meaning you have a net unrealized appreciation of $110,000. Instead of rolling over the entire amount to an IRA, you take the stock portion as an in-kind distribution. You pay taxes on the $90,000 as ordinary income, but the $110,000 is taxed as a long term capital gain.

As long as your tax rate is greater than the long term capital gains rate (which is 15% right now), you save money on taxes.

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By delaying retirement for a couple of years, you can significantly increase the amount of your pretax income during retirement. I found this interesting graph (reproduced - I couldn’t find an electronic version) courtesy T. Rowe Price. Read the assumptions below the graph carefully.

Assumptions: Portfolio returns 8% before retirement; 6% after. Taxes and inflation effects are excluded. Assumes a $150,000 nest egg at year zero.

To me, those are some pretty surprising results. Coincidentally, I just got that annual ’statement’ from the Social Security Administration. One know, the one where they estimate your benefit at full retirement and if you defer a few years.

In both cases, it’s pretty stark how much of a difference 5 years makes. Another illustration of the magic of compounding, I guess.

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