Retirement can seem like a distant goal until suddenly it isn’t. When you’re just a few years away from retirement, the financial decisions you make take on new importance. Once you’re within the five-year window, it’s a good time to review your plan to make sure you’re on track. It’s helpful to understand why the last five years before you retire are critical. Talking to a financial advisor can give you some clarity on what works in your plan and what doesn’t.
Timing is important for retirement planning
When you’re younger, time is on your side when it comes to investing for retirement. The more time you have to save and invest, the more opportunities your money will grow. Waiting to start saving for retirement may mean having to play catch-up later. If you’re approaching the last five years before you retire, a late start can put you at a serious disadvantage. There are two reasons why.
First, you have less time to benefit from compound interest. Even if you’re maxing out annual contributions to a 401(k) or IRA, including catch-up contributions because you’re 50 or older, that may not be enough to make up for lost time in the market.
The second reason is related to the first. It’s natural that as you get older you may start to shift more of your assets into safer investments. Switching to more conservative investments, such as bonds, can reduce the risk of losing money before you retire. But this way you could also trade higher returns, something your portfolio may need if you’re a late starter in saving.
Because the last five years before retirement are fundamental
The last five years before retirement are essentially a test of your preparation and planning up to that point. When you’re five years away from retirement, there’s a big question you need to answer: Can I afford it?
Whether the answer is yes or no depends largely on everything you’ve done to plan ahead. Some of the most important factors that can influence retirement readiness include:
How much you have saved in workplace retirement plans or IRAs
The amount of debt you owe, excluding your mortgage
Your expected expenses in retirement, based on your preferred lifestyle
How long your savings will last, based on your age at retirement
If you’ve planned well and stayed consistent with your plan, you may not need to make many changes in the last five years before you retire. On the other hand, if your plan has gaps or if you have yet to start planning, you may have more work to do to prepare for retirement.
Checklist 5 years after retirement
If you’re five years away from retirement, it’s helpful to know what you should do to assess your readiness. Here are some of the most important things to address to ensure you can retire comfortably and on time.
Check your savings: To get to where you want to be in retirement, you’ll need to know where you are now. Specifically, this means understanding how much you have saved for retirement and how much you still need to save within the next five years to reach your goal.
Running the numbers through a retirement savings calculator can help you see how close or how far you are from your goal. You can use the resulting number to define the next steps in your financial plan.
If you’re behind, for example, you may need to substantially increase your 401(k) or IRA contributions. Or you may need to adjust your investment strategy to generate higher returns in the remaining years until retirement.
Know your sources of income: It’s a good idea to know what sources of income you’ll be able to count on once you retire. Depending on the situation, this could include:
Withdrawals from a 401(k) or similar plan
Traditional or Roth IRAs
Retirement income if your employer offers a retirement plan
Social Security benefits
Federal Employees Retirement System (FERS) benefits.
Rental income if you own a property
You may also have income from other sources, such as retirement accounts you inherit or a health savings account (HSA). An HSA is not a retirement account in itself, as it is intended to be used for eligible medical expenses. However, after age 65 you can withdraw money from an HSA for any reason, without penalty. You will only pay ordinary income tax on distributions.
Taking inventory of your potential sources of income can give you a better idea of how much you might need to spend. It can also help you determine things like when to start withdrawing from tax-advantaged plans, how much to withdraw, and the best age to claim Social Security benefits.
Estimated pension expense: Income is one side of your retirement budget and spending is the other. If you’re five years away from retirement, it’s a good time to start thinking about the kind of lifestyle you want and what you’ll be able to afford based on what you’ve saved.
Typical retirement expenses include housing, utilities, food, and healthcare. But your budget could also extend to travel, recreational activities, or new hobbies you’d like to try. Creating a fictional budget and then comparing the numbers to your expected monthly income can help you see how far off the numbers are.
You could even go a step further and try to live on your retirement budget for the last five years before you retire. This can help you gauge how realistic it is. If you expect to spend less in retirement than you do now, taking a test run of your budget could leave you with some additional money to save each month.
Consider long-term care needs: Long-term care costs can easily wipe out your retirement savings. If you’re within five years of retirement, it’s a good time to evaluate your personal risk.
Medicare doesn’t pay for long-term nursing care, but Medicaid does. There’s a problem, however, since qualifying for Medicaid usually means spending resources. If you don’t want to do this, you may want to consider purchasing a long-term care insurance policy in the five years before retirement.
Long-term care policies may provide benefits to cover necessary nursing care. If you’re unsure whether you need long-term care, you may want to consider a hybrid policy that also includes life insurance. If you don’t use your long-term care benefit, your policy may still pay a death benefit to your beneficiaries.
Check your tax situation: Managing your tax liability in retirement can allow you to keep more of your savings. You may want to consider making some tax changes in the last five years before retirement that may put you in a position to pay less to the IRS later.
For example, you could convert your traditional IRA to a Roth IRA to get the benefit of tax-free withdrawals in retirement. Converting a traditional IRA to a Roth doesn’t allow you to escape taxes entirely; Conversions are subject to the same tax rules as withdrawals.
However, once you convert to a Roth account, you won’t pay any taxes on distributions in the future. This could result in significant tax savings if you expect to be in a higher tax bracket when you retire.
The last five years before retirement can pass in the blink of an eye, and there’s no time to waste when it comes to finalizing your plans. Taking time to review where you are, and where you hope to be, can help ensure you aren’t left short once it’s time to leave your job for good.
Retirement Planning Tips
Creating a five-year retirement plan can also include planning for any unexpected events that may arise. Talking to a financial advisor can help you come up with a plan B if you’re worried that something could derail your retirement timeline. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory call with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you reach your financial goals, start now.
Investing in tax-advantaged accounts, such as a 401(k) or IRA, is a smart move for retirement planning. If you want to add another savings option to the mix, you might consider opening a taxable brokerage account. Taxable accounts are subject to capital gains tax when you sell investments at a profit. However, they do not have the same annual limits on contributions as tax-advantaged accounts, and there are no penalties for early withdrawal either.
Photo credits: ©iStock.com/PeopleImages, ©iStock.com/AzmanL, ©iStock.com/Onfokus
The post How to Manage the Last 5 Years Before Retirement appeared first on SmartReads CMS – SmartAsset.