Richard, a college professor in Mississippi, and his wife are both age 54 and would like to retire in 10 years.
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Their investments: "I'm a good saver," he says. He certainly is, contributing the maximum of $22,000 to his 457 plan, and putting the maximum of $6,000 each year into both of their Roth IRAs. He's been a consistent contributor to the 457 plan and has funded the IRAs for the past 15 years. Assets among those three accounts total more than $550,000.
With regular investments dating back to his 20s and 30s, Richard also accumulated a sizable taxable portfolio totaling $585,000, more than half of which is invested in eight equity mutual funds. Included in the taxable portfolio is a collection -- and I do mean a collection -- of 31 individual stocks that he bought when very young. Of those 31 holdings, 16 have balances less than $2,500, including three that are worthless and seven with balances below $500. One position alone, AT&T at over $100,000, constitutes 17 percent of the taxable portfolio. Any slump in that one position could impact his ability to retire early.
The emergency fund: The family has six months' worth of expenses in a high-yield savings account and another $10,000 in a high-yielding CD -- both found on Bankrate.com. This represents the only cash holdings in a portfolio that is otherwise all equities, with no bonds or commodity exposure.
Their home and kids: Richard and his wife own their home, valued at approximately $150,000, free and clear. An auto loan with $10,000 remaining is the household's only debt. Credit card balances are always paid in full, using rewards cards he also found on Bankrate.com.
Richard has never utilized 529 college savings plans or Coverdell accounts for his children's college education. Those expenses have been funded for his older child strictly from earnings thus far, and he plans to do the same for a second child entering college in the next two years. Richard intends to help his kids all the way through college, and he is in the fortunate position of being able to do so. The almost immediate need for undergraduate funds would not give his money the necessary time to compound on a tax-free basis in order to offset the management fees in a 529 college savings plan. But if his children have graduate school ambitions, then it's worth considering opening a 529 plan.
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Their future: In retirement, both are in line to receive pensions, Richard's to the tune of about $38,000 annually while his wife will receive about $500 per month from a previous employer. At full retirement age, their total Social Security benefits of $3,520 per month, coupled with their pensions, will provide more than 80 percent of their current pre-retirement gross income.
Their retirement goals are very modest, with Richard indicating a desire to travel, perhaps taking "one major trip each year." They'll probably stay in the same home, but there is a possibility of moving to another state, perhaps to live in a university town with lots of cultural events to choose from.
*Portfolio consists entirely of equities.
*Emergency savings is the only cash component.
*Taxable portfolio contains 31 different stocks.
*Allocation is out of whack, even within equities.
Richard should start by trimming the collection of 31 different stocks in the taxable portfolio. This is way too many to keep track of, and with many congregated in the same sectors, there is notable overlap rather than diversification. And with so many low balance positions, this adds unnecessary clutter to his portfolio. Money could instead be reallocated to other asset classes. Richard was unaware that he could sell losing stocks to offset capital gains and even apply losses toward up to $3,000 annually in taxable income, carrying forward any losses into future years. This is one strategy he can employ when paring down the list. Fortunately, many of the smaller positions are held in dividend reinvestment plans that can typically be sold without commission.
The emphasis on dividend-paying stocks in the taxable side of the portfolio is fine, but the disparity in size between positions is not. A well-rounded portfolio of dividend-paying stocks will encompass a number of different industries with consistent amounts invested in each.
Address the risk: Looking at the overall portfolio, including taxable and retirement accounts, the current all-equity positioning is inappropriate for someone who will begin tapping his investments within 10 years. Dialing down the risk in the portfolio is a necessity. But before doing so, Richard must give some thought to this question: What assets will bridge the two-and-a-half-year gap between their intended retirement age of 64 and full retirement age?
Retirement income options: Here are a few retirement income options, some better than others: They could claim Social Security early, though that won't cover all their expenses, so they'd still need to tap their portfolio to fill the gap. Secondly, they could wait until their full retirement age to claim Social Security and use their taxable assets first, allowing the retirement assets to continue to grow. Or they could tap the retirement assets, such as Richard's 457 plan, to bridge the gap. This last option would also reduce the required minimums to be taken beginning at age 70½, giving more bang for buck as they'll likely be in a higher tax bracket at age 70 than at age 64, before the pensions and Social Security kick in. The Roth IRAs should be tapped last if needed, since they may come in handy as tax-free income at a later stage of their retirement.
As for which course they should take, the answer depends on their needs at the time. Over the next 10 years, while the couple is still in the workforce, there may be changes to the tax code or other life circumstances that may factor into their decision. For example, if dividend and capital gains rates go up, then maybe they would want to tap the taxable portfolio first.
In any event, a more conservative allocation is needed for whatever funds will be tapped at age 64. Richard has no exposure to bonds or commodities and the only real estate exposure is his home. But he has no real estate investment trusts, or REITs, in his retirement portfolio. On the bond front, foreign, inflation-protected, investment-grade and floating-rate bonds are all areas to consider for purposes of diversification.
Even though trimming stocks and adding bonds and cash in the taxable portfolio isn't a tax-efficient move, the reduction of risk is the greater need if Richard plans to tap those assets upon retirement. On the other hand, adding exposure to bonds, REITs, commodities and natural resources is best accomplished within a retirement account for tax efficiency purposes.
Look outside the U.S.: Even within equities, Richard could use some broader exposure. In the retirement portfolio, international equities -- both developed and emerging markets -- are under-represented. While the taxable side of the portfolio contains a more appropriate 19 percent allocation to international investments relative to domestic holdings, the majority is in small- and mid-caps. However, he does get additional international equity exposure via some of the multinational large caps he holds.
As long as they don't plan on tapping the Roth IRAs for early retirement or to bridge the gap until pensions and Social Security kick in, they can maintain a more aggressive stance with these funds since this is money they're unlikely to tap for decades, if ever.
Between pensions, Social Security and required withdrawals from retirement plans at age 70½, Richard and his wife will very likely have income well in excess of their monthly expenses -- a nice reward for decades of diligent savings. So they shouldn't be afraid to enjoy themselves in retirement. Although they plan on just one major trip per year, they have the resources to do more if they choose to do so. Their reserved lifestyle shows they're not about to go hog wild in retirement, but they have the comfort of being able to spend more freely in retirement than they've done in their working years.